July 9, 2001

Taxing Subject

The Gifted Child

Save on taxes while being a good guy

By JOSEPH F. GELBAND

The one constant on the changing economic scene seems to be the $10,000 annual gift-tax exclusion, which has remained frozen at that level since 1982, immune to the past 20 years of inflation. (It may be increased to $11,000 next year, depending on the consumer price index.)

The exclusion permits gifts of up to $10,000 to each of any number of recipients (a/k/a donees) each year without incurring the gift tax, and without counting against your lifetime gift-estate-tax exemption (now $675,000 and scheduled, under the new tax law, to hit $1 million next year).

Soaring educational and medical expenses have consistently outstripped the consumer price index; they can strain a family's finances to the breaking point. Often, grandparents or other older relatives are eager to help parents pay those expenses, but their generosity is dampened by gift-tax considerations.

If you have a donee in mind, but have already exhausted your $10,000 annual exclusion, you should know about section 2503(e) of the Tax Code, known as the "ed-med" provision.

This provision allows you an unlimited exclusion from the gift tax for certain "qualified" gifts for tuition and medical expenses for any number of donees. Such gifts are totally apart from your annual $10,000 exclusion, and don't encroach on your lifetime exemption.

The exclusion for tuition payments applies only to actual tuition charges -- it doesn't cover outlays for books, supplies, dorm fees, board or similar expenses. The educational institution can be anywhere from pre-K through graduate school, secular or religious -- and can be within the United States or abroad. The school qualifies as long as it maintains a faculty and curriculum, and has a regularly enrolled body of students registered in a consistent schedule of educational activities. (Hence, private tutoring doesn't qualify.) Your payment may be in behalf of a full-time or part-time student; but you must make it directly to the institution; don't give the money to the student.

And because the exclusion isn't limited to tuition for the current academic year or period, it can be stretched into a very effective estate-planning tool. For example, the IRS considered the case of a grandmother (since deceased) who arranged with a private elementary school, at which two of her grandchildren were enrolled, to prepay their tuition for several years in advance.

The agreement stipulated that the money she paid could be applied only as tuition for the designated grandchildren; any funds not so applied (if, for example, the grandchildren dropped out) would be forfeited to the school, and the students' father would pay any increase in the tuition charges. And because the grandmother had parted with the right to retrieve or control any part of the transferred funds, the entire amount was excluded from her estate.

At today's tuition charges, such an advance payment at a private elementary or prep school, or for students starting college or graduate school, can go a long way toward solving estate-tax concerns.

Meanwhile, the unlimited exclusion for medical-expense payments covers costs incurred "for the diagnosis, cure, mitigation, treatment or prevention of disease, or for the purpose of affecting any bodily structure or function," for transportation essential for medical care; and for medical insurance. Payments must be made directly to persons who provide the medical care, or to the insurance company.

While for income-tax purposes, the medical-expense deduction applies only to payments for yourself, your spouse or for certain dependents, the gift-tax exclusion is permitted without regard to your relationship to the beneficiary. (In fact, if the beneficiary happens to be your dependent, so much the better -- you can get the benefit of the income-tax deduction as well.)

The medical-expense exclusion also trims your estate by accelerating tax-free transfers to your eventual heirs. You could, for example, pay for your grandchildren's orthodontic work, or pay the premiums on the health or hospital insurance carried by your child, or any other costs of medical and nursing care, medication or treatment.

How about the generation-skipping tax? As its names implies, this is Uncle Sam's way of ensuring that he gets a bite out of your property -- once -- when you transfer it to your children (whether by gift or through your estate), and again when it passes from them to your grandchildren. The GST normally kicks in when you transfer property to or for persons more than one generation below yours, as discussed above. But gifts that are exempt from the gift tax are also out of reach of the GST.

One final caution: Again, your payment must be made directly to the educational institution, or to the provider of the medical service or insurance -- not to the beneficiary.

Joseph F. Gelband is a tax lawyer in Larchmont, New York.