School Gifts That Skip Uncle Sam
Many grandparents are offering to foot the ever-steepening tuition bills for their grandchildren, whether the kids are in preschool, prep school, or college.
There are several ways to help, though each has its shortcomings. Writing checks directly to the school is one possibility, but that works only while grandma or grandpa is alive. Opening a 529 college savings plan is another, but contributions are subject to state and federal caps, and the funds can be spent only on higher education.
High-net-worth individuals can avoid each of these drawbacks by setting up a Health & Education
Exclusion Trust, or HEET. Unlike 529s, a HEET can pay for all levels of education, for one generation or many. And there's no limit to how much you can put in.
A key benefit is that it gets around the onerous generation-skipping transfer tax (GST). This is a levy of 45% on the amount of a grandparent's gift to grandkids that exceeds $2 million. That applies whether the gift is made during life or at death.
To escape the GST, the HEET must incorporate two features. First, the trust must make payments directly to the schools (or, in a less common use of these trusts, health-care providers). The second requirement is rather quirky. A HEET must have a charity as a co-beneficiary, says David Handler, a trusts-and-estates lawyer at Kirkland & Ellis in Chicago and co-author of a 2000 article in Trusts & Estates magazine that coined the term HEET. There's a technical reason for this arrangement. If grandchildren were the only beneficiaries of the trust, it would be subject to the GST.
No statute spells out the terms of a HEET. Lawyers crafted it based on their interpretation of tax law, and the Internal Revenue Service has not challenged it in court. One gray area is how much of the trust distributions the charity should get. Michael Delgass, a lawyer and financial adviser at Sontag Advisory in Westport, Conn., thinks half the trust's annual income is a reasonable amount, and that's what he uses when setting up HEETs. Other lawyers give the charity a preset amount each year, subject to a cost-of-living adjustment.
VARIATIONS ON A THEME
Delgass gives this example: Let's say the grandparents fund the trust with $5 million to cover tuition bills of $50,000 a year that are expected to increase 5% a year. Assume the trust principal grows 6% a year and throws off 2% in income through dividends and interest. Half the $100,000 of income in the first year would go to the charity, and the rest would be available for tuition. Although the trust pays ordinary income tax and capital gains tax, it would receive an income tax deduction for the distribution to the charity. Plus, there's no GST, which is what allows the assets to grow by leaps and bounds (chart).
Within this basic framework, there are many variations on the theme, says Pam Schneider, a trusts-and-estates lawyer and GST expert at Gadsden Schneider & Woodward in Radnor, Pa. For example, the trust can be limited to just one generation or go on perpetually in states that permit dynasty trusts. If there's extra money and no one left to educate, the trust can authorize the remaining balance to be divided between family and charity. At that point, distributions to grandchildren and their descendants would be subject to GST, since the funds are no longer directly paying for education. Conversely, to avoid a shortfall in a growing family, principal can be used to pay tuition, and assets could be added to the trust as long as charity continues to receive its distribution each year.
Lawyers think HEETs would withstand any IRS challenge. Delgass says he has set up about 50 in the past five years. These trusts make sense, he says, for individuals with a net worth of at least $10 million who can afford to fund the trust with at least $2 million. A simple setup costs about $3,000 to $5,000.
HEETs can also be combined with other plans. Clare Springs, an estate-planning lawyer at Titchell, Maltzman, Mark & Ohleyer in San Francisco, recommends that clients both create HEETs and fund 529 plans. That's because a HEET can only cover tuition, while a 529 can also be spent on room and board.
Grandparents--or a great aunt and great uncle, for that matter--can set up a HEET while alive or provide for it in a will. In the latter case, people often arrange to fund the trust with the proceeds of a life insurance policy or by leaving part of their estate to the trust.
If the grandparents fund a HEET while still alive, they might trigger a 45% gift tax. First, they can each put $12,000 per year into the trust for each beneficiary--it's called the annual exclusion. Any gift that exceeds the annual exclusion counts against the $1 million per person lifetime gift-tax exemption. Beyond that limit, the gift tax applies. Even paying that hefty tax up front has benefits. It moves assets out of the grandparents' estate, and any subsequent appreciation in those assets is not subject to estate tax.
While they are alive, the simplest way for grandparents to help with education expenses--and avoid gift and generation-skipping transfer taxes--is to write a check directly to the school. But the HEET allows them to fund education for generations to come. Now that's a worthy legacy.
By Deborah L. Jacobs