Section 2503(e) of the Internal Revenue Code of 1986 provides for an unlimited gift tax exclusion for payments of tuition made directly to an educational institution on behalf of a student. This bypasses the annual gift tax exclusion limit for gifts made to the student. Taxpayers are eligible for this unlimited gift tax exclusion in addition to the annual gift tax exclusion. Taxpayers may give unlimited amounts of money for tuition costs directly to a student’s college or university without incurring a gift tax while also giving money to the student up to the annual gift tax exclusion.
Payments made directly to a college or university are normally treated as cash support, a form of untaxed income to the student, and should be reported as such on the Free Application for Federal Student Aid (FAFSA) and other financial aid forms such as the CSS/Financial Aid PROFILE. The U.S. Department of Education defines cash support in the Application and Verification Guide (a source of guidance to college financial aid offices) as including “money and gifts and housing, food, clothing, car payments or expenses, medical and dental care, college costs, and money paid to someone else on his behalf.” Payments by the parents of a dependent student do not count as cash support, except when the parents are divorced or separated and the payment is made by the non-custodial parent. Payments by grandparents, aunts, uncles and other third parties, however, will count as cash support. Eligibility for need-based student financial aid may be reduced by as much as half of the total income received by the student, including both taxed and untaxed income.
Some colleges, however, will treat such payments as a “resource” because section 2503(e) of the Internal Revenue Code of 1986 restricts the payment “as tuition” and the regulations at 34 CFR 673.5(c)(xiii) define estimated financial assistance as including “any educational benefits paid because of enrollment in a postsecondary education institution, or to cover postsecondary education expenses.” A resource reduces eligibility for need-based student financial aid dollar-for-dollar.
Either way, direct payments to a college under section 2503(e) of the Internal Revenue Code of 1986 will have a harsh impact on eligibility for need-based student financial aid. The unlimited gift tax exclusion should be used only if the student does not qualify for need-based financial aid.
If the college treats the payment as a resource, a mid-year payment may force a revision in the student’s financial aid package and may cause the student to owe a refund if the revision results in an overpayment. An overpayment occurs when a student receives student financial aid in excess of the student’s financial need. Otherwise, the amount of the gift will need to be reported as untaxed income on the subsequent year’s FAFSA. The latter provides an opportunity for a direct tuition payment to be made without affecting eligibility for need-based financial aid by making the payment on or after January 1 of the student’s junior year in college, when such payments will no longer affect amounts reported on the FAFSA for the senior year in college. (It is unclear whether the payment must be reported as untaxed income if the student files a FAFSA for graduate or professional school.)
To avoid hurting the student's eligibility for need-based financial aid, the person making the payment could give the money to the parents. Gifts to the parents do not get reported as untaxed income on the FAFSA. Such a gift will not benefit from the gift tax exclusion under IRC section 2503(e). However, most gifts fall under the annual gift tax exclusion, especially when given by a married couple, so the tuition gift tax exclusion is not necessary.
Another option is to wait until after the student files the FAFSA for his or her senior year in college, when there will be no subsequent year's FAFSA to be affected, assuming that the student is not immediately going to graduate school. But this will limit the use of the gift tax exclusion under IRC section 2503(e) to just that year's tuition.
There are no explicit coordination restrictions, other than a requirement that contributions to a 529 college savings plan or prepaid tuition plan are not considered eligible for the unlimited gift tax exclusion. Instead, such contributions are subject to the annual gift tax exclusion and eligible for five-year gift tax averaging. For example, if an uncle gives $30,000 to his nephew’s prepaid tuition plan, which is greater than the annual gift tax exclusion, it will be treated as though $6,000 were given for each of five consecutive tax years starting with the year of the gift. Even though the proceeds of the prepaid tuition plan are used to pay only for tuition, it is not eligible for the unlimited gift tax exclusion since the contribution is paid to the prepaid tuition plan and not directly to a college or university.
Payments that qualify for the unlimited gift tax exclusion do not appear to affect eligibility for education tax benefits that are restricted to tuition, such as the American Opportunity Tax Credit or the exclusion from income for qualified scholarships, even though the exclusions are restricted to tuition payments.
Taxpayers who use the unlimited gift tax exclusion cannot deduct the payment as a charitable contribution, since the funds are earmarked for the benefit of a specific individual.
The payments must be made directly to the educational institution to qualify for the gift tax exclusion. Indirect payments, such as reimbursement of tuition paid by someone else or transfers to a trust fund that is established to pay for tuition expenses, are not eligible for the gift tax exclusion.
The unlimited gift tax exclusion is limited to payments of tuition. (The law does not mention fees, so amounts paid for required fees might not be eligible for the unlimited gift tax exclusion.) Amounts paid for books, supplies, room and board are not eligible unless included in a comprehensive tuition fee.
The donor does not need to be related to the beneficiary of the gift. The student may be enrolled part-time or full-time.
The statute limits the gift tax exclusion to payments of tuition to an educational organization that “normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.” Foreign universities are eligible, as are unaccredited colleges.
There is no phaseout on eligibility for the gift tax exclusion.
The legislation authorizing the gift tax exclusion does not expire.
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