Paying the College Directly to Avoid Gift Taxes
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By The Fastweb Team
September 11, 2017
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 $14,000 in 2017 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 ($28,000) 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.
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 2017-18 FAFSA, this would appear in the answer to question 45j: “Money received, or paid on your behalf (e.g., bills), not reported elsewhere on this form.”
The subregulatory guidance of the 2017-18 Application and Verification Guide confirms this interpretation:
j. Money received (45 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.
Easy for Colleges to Detect Such Cash Support
It is easy enough for a college to detect such tuition payments because the check that is applied to the student’s account will be written by a payor whose name is different than the names of the student and parents as listed on the FAFSA and other applications. (Note that in a divorce case, only one parent’s name will be listed on the FAFSA. But the noncustodial parent is not considered a parent for federal student aid purposes.)
Some institutional financial aid applications also ask explicitly about contributions from relatives. For example, the CSS/Financial Aid PROFILE form has a question that asks about other resources: “Amounts expected from relatives, spouse’s parents and all other sources.” There’s also a question about contributions from the noncustodial parent: “How much does the noncustodial parent plan to contribute to the student’s education for the ####-## school year?”
Other Benefits of Making Direct Tuition Payments
Sometimes there are other benefits of making a payment directly to the college that will offset some or all of the loss in eligibility for need-based financial aid. For example, a few colleges provide a discount for prepayment of multiple year’s worth of tuition, such as allowing the donor to pay for subsequent year’s tuition at current rates. This can yield significant savings, since tuition rates tend to increase each year, yielding senior year tuition rates that are about one fifth higher than tuition rates during the freshman year.
Direct Payments are Not Charitable Contributions
Note that direct payment of tuition to a college or other educational organizations does not count as a charitable contribution because the payment is earmarked for a particular student.
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