Note #2

Prepaid Tuition: A Win/Win for Both Schools and Families

While the federal tax code imposes taxes on gifts of property, there are several exceptions that permit a transfer of property without a generation skipping tax or gift tax.  There is one exception to be aware of that is especially significant for independent schools.  

Internal Code Section 2503(e) (2) (A) excludes from gift tax any amount paid on behalf of an individual for tuition at an educational organization.  (This does not include room and board, books and supplies or other expenses.)  There is no limit to the amount that may be paid.  This means that a grandparent, for example, could pre-pay $200,000 of tuition for a child, covering multiple years, and avoid paying any transfer tax, including gift or estate taxes. The tuition must be paid directly to the institution and cannot be reimbursed. In the event of withdrawal, the institution retains the money; no portion may be refunded.

If a school enters into such an agreement, there are a number of details that must be observed:
a.    The prepayment cannot be indexed.
b.    The prepayment cannot accrue interest to cover future costs.
c.    At no time can the payment be considered a charitable gift – even if the child withdraws.
d.    Any donor, regardless of his or her relationship, may make these tax-free payments on behalf of the student.
e.    There is no obligation on the part of the school to “freeze” tuition or provide a guaranteed rate of tuition.

There are a couple of considerations which are unclear regarding the withdrawal of the student before the funds are completely used up.  Some schools have included in their agreements a clause that states that any unused balance may be transferred to another qualified educational institution which the student would be attending.  The IRS has yet to rule on whether or not this falls within the scope of the tax exclusion.
The other consideration is whether or not the money could be transferred to another child at the institution.  Again, the IRS has not yet ruled on this.  In either of these two cases, it might be wise to seek a private letter ruling from the IRS prior to entering into such arrangements.

When entering into pre-payment agreements, the school must protect itself and the payee by drawing up a contract that explicitly states all the terms of the arrangement.  The contract should include:

a.    a statement of the amount being paid, and when portions of it will be applied to tuition costs
b.    designation of who is responsible for any incidental expenses and for any amounts of tuition that remain unpaid after application of the pre-payment
c.    reference to the IRS Internal Code Section 2503(e) as the basis for this qualified transfer of funds
d.    the person(s) who shall be the responsible party to the agreement should the payee die or become incapacitated
e.    That this agreement provides no guarantee of admission or  continued enrollment at the institution
f.    That the school does not guarantee tuition rates (unless the school should do so)
g.    That the payment becomes property of the school so no interest will accrue to the payee

The above list is not exhaustive. The contract should be reviewed by the school’s counsel to ensure compliance with all State, Local and Federal regulations and to ensure that the contract properly protects the school’s interests.

It is expected that as baby boomers retire and age, there will be a huge generational transfer of funds.  Pre-payment of tuition is likely to become a popular vehicle for transferring funds to heirs as a means of avoiding high inheritance taxes or gift taxes.  Schools should be prepared to encourage and support such agreements.  Often such arrangements are made as last minute accommodations for a dying relative.  Having a pre-payment contract on hand and ready to go can be of great help to both the families under stress and to the school’s business officer, who will be able to quickly and confidently respond to such circumstances.

Below are web links to examples of prepaid tuition agreements:

http://www.nais.org/files/PDFs/Prepaid%20Tuition06.pdf
http://www.sidwell.edu/documents/tuition_prepayment_contract.pdf

For additional information:

http://www.irs.gov/pub/irs-wd/0602002.pdf
http://trustsandestates.com/news/estate_taxfree_gifts_prepaid/

N.B.  Please note that the information provided above should not be construed as legal advice nor should it be used as a substitute for consulting with legal counsel.
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