FAQs on the Use of the Gift Tax Medical and Tuition Expense Exclusion

They still have options: they can make tax-free transfers for qualifying educational or medical expenses. But these transfers are subject to their own set of rules. Tom Abendroth, of ArentFox Schiff’s Private Clients practice, answers some frequently asked questions below.

What is the gift tax exclusion for payment of medical and tuition expenses?

Under Section 2503(e) of the Internal Revenue Code (the “Code”), tuition payments made directly to an educational organization on behalf of a person, and payments for a person’s medical care made directly to the provider are not treated as taxable gifts. This can be an important exclusion for planning purposes. For example, grandparents who already take full advantage of the annual exclusion for gifts to grandchildren can make additional tax-free transfers by paying their grandchildren’s tuition for private school or college.

What education expenses besides tuition fall under the exclusion?

The education expense exclusion is limited to tuition. Tuition means the amount of money required for enrollment. It includes tuition for part-time students. It does not cover books, supplies, room and board or similar expenses. See Treas. Reg. §25.2503- 6(b)(2)(3). One issue, on which there appears to be no guidance, concerns institutions such as boarding schools which do not break out their fees between teaching expenses and room and board and instead charge one tuition fee. The commonly accepted practice is to claim the full fee charged by such an institution as qualifying for the Section 2503(e) exclusion. The IRS, at some point in the future, could challenge this.

Are there limits on the types of schools or educational organizations that qualify?

To qualify for the exclusion, the payment of tuition must be to an educational organization of the type described in Section 170(b)(1)(A)(ii). See IRC § 2503(e)(2)(A). Section 170(b)(1)(A)(ii) defines an educational organization as one that normally maintains a regular faculty and curriculum and has a regularly enrolled body of students in attendance at the place where the educational activities are being carried on. Treas. Reg. § 1.170A-9(b)(1). The presentation of formal instruction must be the primary function of the organization.

Do private primary and secondary schools qualify? What about pre-schools?

The regulations under Section 170 specify that primary, secondary, preparatory schools, high schools, colleges, and universities all are considered “educational organizations”. The gray area addressed in IRS rulings concerns nursery or pre-schools and schools in other instructional areas. The inquiry is a fact-specific one. There is guidance in the form of public and private rulings. The public rulings address qualification as an educational organization for purposes of qualifying for exemptions from other federal taxes, such as fuels or communications taxes, and not the application of Section 2503(e). Nevertheless, they are instructive since the definition of educational organization is the same.

In Revenue Ruling 78-446, 1978-2 C.B. 257, the IRS ruled that a children’s daycare center satisfied the definition of educational organization for purposes of exemption from certain taxes because it had a regular enrollment, planned educational activities, and instruction from a staff of teachers and assistants. Another daycare program was found not to have educational activities as its primary purpose, where its function was more custodial in nature. Revenue Ruling 78-446.

Other providers of educational activities that have been found to qualify as educational organizations include a martial arts school, an instruction academy for yoga, and a wilderness camping and survival program. The IRS concluded that the martial arts school’s primary function was the presentation of formal instruction, its courses were interrelated and given in a regular and continuous manner, thereby constituting a curriculum, it maintained a regular faculty, and had a regularly enrolled body of students. Rev. Rul. 78-309, 1978-2 C.B. 123.

For the organization providing yoga instruction and promoting the practice of yoga, the IRS was careful to distinguish its program of eight-week yoga courses, which did qualify, and its other activities, which did not. Rev. Rul. 79-130, 1979-1 C. B. 332. Payment for the eight-week course presumably would qualify as a direct payment of tuition.

Payment for individual classes or other activities would not. In Revenue Ruling 83-140, 1983-2 C. B. 185, the IRS approved a wilderness company program for adolescents with emotional and behavioral problems. While this program lacked a traditional classroom setting, it had qualified instructors and an organized plan of instruction, which was taught during 26-day hiking and camping trips, repeated 10 months of the year. Based on this ruling, payments for certain types of summer camps, such as music, art, or computer camps, also might qualify.

Does the exclusion apply to tuition payments to a religious school or to a school in a foreign country?

Yes, if the school otherwise qualifies as an educational organization.

Do you lose the exclusion if the school is watch- listed under the no child left behind legislation?

No. And do not even whisper the thought anywhere near Washington DC.

What medical expenses qualify for the exclusion?

Qualifying medical expenses are defined by reference to Code Section 213(d). See IRC § 2503(e)(2)(B). The exclusion applies to payments for (i) the diagnosis, cure, mitigation, treatment or prevention of disease, (ii) the purpose of affecting any structure or function of the body, or (iii) transportation primary for and essential to medical care. Treas. Reg. § 25.2503-6(b)(3). Payments for medical insurance are covered. The Section 213(d) definition of medical care is extremely broad. It also covers long-term care services, such as the costs of nursing homes or assisted living facilities, if provided by a licensed health care provider. The most notable area it does not cover is cosmetic surgery, unless to correct a birth defect or disfigurement from injury or disease. See IRC § 213(d)(9)(A).

What if the expenses subsequently are paid by health insurance?

If a donee’s medical expenses are subsequently reimbursed by insurance, the donor’s payment does not qualify for the exclusion. Treas. Reg. § 25.2503- 6(b)(3). The donee must reimburse the donor. If he or she does not, the donor’s payment will be treated as a taxable gift. The annual exclusion would apply to it if otherwise available.

Can I pay tuition or a doctor’s bill for a child or other relative by giving that person the money?

In the case of both educational and medical expenses, the payment must be made directly to the provider. This is a key element of the exclusion. If an individual gives her grandchild $5,000 to pay medical expenses, the gift does not qualify under Section 2503(e), even if the grandchild in fact uses the $5,000 for that purpose.

Can I give a check to my child and let him or her use it to pay the expense?

Yes you can, if the check is made payable to the educational organization or medical service provider. You cannot make the check payable to the child and let him or her endorse it over.

How can I reduce the hassle of making payments directly?

For a taxpayer who wishes to take full advantage of this exclusion, the direct payment requirement does create administrative challenges. One solution is for the taxpayer to create an account, in the taxpayer’s own name, for each child, and give the child check- writing authority as agent. It also may be possible to provide a credit card to the child tied to the account. The child then can directly pay medical or educational expenses for the child and his or her descendants from the account. Since the account is in the donor’s name, and the child is acting only as agent, the direct payment requirement is satisfied.

Can I prepay several years of tuition?