Paying the College Directly to Avoid Gift Taxes
September 27, 2012
Under current IRS rules, a payment made directly to an educational institution to pay for the tuition of a student does not count as a gift to the student for gift tax purposes. For example, a grandparent can avoid gift taxes by writing a check to the college for their grandchild’s tuition instead of giving the money to the student or the student’s parents. But such a payment may result in a significant reduction in the student’s eligibility for need-based financial aid.
Accordingly, this strategy should be avoided if the student expects to qualify for need-based financial aid. In such a circumstance, a better strategy is to contribute the money to the student’s 529 college savings plan. One could also wait until after the student graduates from college and help the student pay down his or her student loans as a graduation gift.
Gift Tax Exclusion
Section 2503 of the Internal Revenue Code of 1986 discusses gift taxes. A donor may give gifts to any person without incurring gift taxes in any calendar year so long as the amount of the gift falls below the annual gift tax exclusion. The annual gift tax exclusion was $13,000 in 2012 and is indexed for inflation. If the transfer exceeds the annual gift tax exclusion, the donor may elect to use part of the donor’s lifetime gift tax exclusion instead of paying gift taxes. The gift tax exclusion is per donor, so a couple can together give twice the annual gift tax exclusion ($26,000) without incurring any gift tax liability.
In certain cases a transfer for the benefit of a person will not be considered a gift even if it exceeds the annual gift tax exclusion. In particular, section 2503(e) of the Internal Revenue Code of 1986 provides for the exclusion of payments for tuition and medical care from gift taxes.
Exclusion for certain transfers for educational expenses or medical expenses
(1) In general
Any qualified transfer shall not be treated as a transfer of property by gift for purposes of this chapter.
(2) Qualified transfer
For purposes of this subsection, the term “qualified transfer” means any amount paid on behalf of an individual —
(A) as tuition to an educational organization described in section 170(b)(1)(A)(ii) for the education or training of such individual, or
(B) to any person who provides medical care (as defined in section 213(d)) with respect to such individual as payment for such medical care.
Impact on Need-Based Financial Aid
However, while a payment directly to the college for tuition will avoid gift taxes, it may significantly reduce the student’s eligibility for need-based financial aid. There are three possible ways in which such a payment could be treated for student aid eligibility, each with a different impact on eligibility for need-based aid: (1) payment on account (no impact), (2) cash support (reduce aid by up to 50% of the amount paid) or (3) resource (reduce aid by 100% of the amount paid).
The tuition payment cannot be reported as a payment on the account because the source of the payment is someone other than the student or the student’s parents. The correct treatment is as cash support, which will be reported on the FAFSA as untaxed income to the student. This reduces aid eligibility by up to half of the payment. But some colleges adopt a harsher treatment, identifying the money as a resource. Resources reduce aid eligibility dollar for dollar.