Paying the College Directly to Avoid Gift Taxes
September 27, 2012
When a grandparent or any other third party pays a student’s college bills, including distributions from a grandparent-owned 529 college savings plan, that is considered “cash support” and must be reported as untaxed income to the student on the student’s FAFSA. For example, in the 2012-13 FAFSA, this would appear in the answer to question 44j: “Money received, or paid on your behalf (e.g., bills), not reported elsewhere on this form.”
The subregulatory guidance appearing on page AVG-20 of the 2012-13 Application and Verification Guide confirms this interpretation:
j. Money received (44 only). The student reports any cash support he received, but if dependent he does not count his parents’ support, with one exception: money from a non-custodial parent that is not part of a legal child support agreement is untaxed income to the student. Cash support includes money, gifts, and loans, plus housing, food, clothing, car payments or expenses, medical and dental care, college costs, and money paid to someone else on his behalf. For example, if a friend or relative pays his electric bill or part of his rent, he must report the amount as untaxed income. If he is living with a friend who pays the rent and the student’s name is on the lease, the rent paid on his behalf counts as cash support because he is responsible for payments that his friend is making. Note that this item does not appear in the parents’ question-only the student reports this information.
As the last sentence in this paragraph suggests, a possible workaround is for the grandparent or other third party to give the money to the parents, who can then use to the money to pay the college bills without having to report it as cash support on the FAFSA. There is no similar question about cash support for parents on the FAFSA because the definition of “Untaxed income and benefits” in the Higher Education Act of 1965 [20 USC 1087vv(b)(1)(F)] is restricted to funds paid to the student or on the student’s behalf, and does not include funds paid to the student’s parents:
(F) cash support or any money paid on the student’s behalf, except, for dependent students, funds provided by the student’s parents;
Cash support provided to or on behalf of the student will reduce need-based aid eligibility by up to half of the amount of the support. Some colleges, however, will treat a direct payment by the grandparent or another third party to the college to pay for tuition as a resource, instead of cash support. This is a harsher treatment, which reduces need-based aid dollar for dollar. This interpretation is a consequence of the IRS gift tax rules for qualified transfers. Since the gift tax exclusion depends on the funds being restricted for tuition, the colleges argue that the payment satisfies the requirements to be considered a resource. The regulations at 34 CFR 673.5(c)(1)(xiii) specify that resources (also described as “estimated financial assistance”) include “Any educational benefits paid because of enrollment in a postsecondary education institution, or to cover postsecondary education expenses.” However, a payment by a grandparent or other relative is not considered an educational benefit, and as such is not considered a resource. Instead, it should be treated as cash support.