Estate Planner July-August 2006
For many people, the $2 million estate tax exemption (up this year from $1.5 million) and the $1 million lifetime gift tax exemption are more than enough to shield their assets from estate tax. But if the value of your estate exceeds the exemption amounts, you’ll need some creative strategies to preserve your wealth for future generations.
In a recent private letter ruling (PLR) No. 200602002, the IRS gave its blessing to a planning technique that allows you to remove significant amounts of wealth from your estate tax-free, without using up your exemptions.
The ruling permits a taxpayer to prepay tuition for his six grandchildren through 12th grade, without triggering estate, gift or generation-skipping transfer (GST) taxes. Bear in mind that a PLR applies only to the taxpayer who requested it and sets no legal precedent. But it does provide valuable guidance on how the IRS may rule in similar cases.
An important estate planning goal is to find ways to share your wealth with your heirs without incurring transfer taxes or depleting your exemptions. One way to accomplish this is to take advantage of the annual gift tax exclusion, which allows you to transfer up to $12,000 per recipient tax-free (up this year from $11,000). If you elect to split gifts with your spouse, you can give up to $24,000 per recipient.
The problem with this approach is that it can take years to transfer a meaningful amount of wealth. You can give more, however, by paying tuition or medical expenses on behalf of your children or other heirs. As long as you make the payments directly to the school or health care provider, they’re exempt from gift tax without consuming any of your exemptions or annual exclusions.
For example, each year, Tom and Mary give $24,000 to their granddaughter, Alice, to help pay for her $20,000 tuition and other education expenses. They would like to help out even more, but if they make additional gifts they’ll have to pay gift taxes at rates as high as 46% or use their gift tax exemptions. But if Tom and Mary pay Alice’s tuition directly to her school, they can still use their annual exclusion to give Alice up to $24,000, for a total tax-free gift of $44,000.
An accelerated program
The strategy approved in the PLR allows you to accelerate the process by paying tuition in advance. The taxpayer who requested the ruling planned to enter into separate written agreements with the school for each of his six grandchildren. Under the agreements, he would prepay the total annual tuition for each grandchild through 12th grade. The amounts would be based on the school’s current tuition rates, and the grandfather or the children’s parents would agree to pay any tuition increases in subsequent years.
The prepaid tuition would not guarantee enrollment or afford the grandchildren any additional rights or privileges over other students. Also, the prepayments would be nonrefundable – that is, they would be forfeited to the school in the event a grandchild drops out or transfers to another school.
The IRS ruled that, under the facts presented, prepaid tuition was exempt from gift and GST taxes. The ruling has significant implications for people who want to remove large amounts of assets from their estates tax-free but don’t have the time they need to accomplish this through annual exclusion gifts.
The PLR doesn’t mention the ages of the six grandchildren or the school’s tuition rates. But it’s likely that the dollar amounts involved are substantial. Suppose the grandchildren are in grades 2, 3, 4, 5, 6 and 7 and that the average tuition is $15,000 per year. The grandfather could transfer $765,000 without paying gift, estate or GST taxes or using any of his exemption amounts. Plus, he would still be able to use the annual exclusion to make additional gifts to his grandchildren.
Study before choosing a strategy
The main disadvantage of the technique approved in the PLR is that you have to make nonrefundable payments to a specific school on behalf of a designated student. Unlike other educational savings vehicles, such as Section 529 college savings plans, you can’t transfer the funds to another school or another person if the student transfers or drops out.
The most tax-efficient way to finance educational expenses is to start contributing early to a Section 529 plan, a Coverdell Education Savings Account, a tax-advantaged educational trust or some combination of these vehicles. These tools offer greater flexibility and less risk than the technique described in the PLR, but they also require more lead time because of contribution limits and the need to use your annual exclusion to avoid gift tax. But if you don’t have the luxury of time, and you’re looking for ways to shield large amounts of wealth from gift and estate taxes, the prepaid tuition strategy is worth further study.