Direct payments for tuition and medical care

In short

A friend of mine once wrote a check for his granddaughter's college bill and then fretted for a month over whether he had made a taxable gift. If you are holding a similar worry, here is the good news. The federal tax code lets a person pay tuition or medical bills for someone else without it counting as a gift. The payment must go straight to the school or the provider. It must not pass through the student or the patient first. It covers tuition only, not room, board, books, or fees. It covers medical care, including the cost of insurance. And it sits apart from the yearly gift limit of the current figure, which the official source publishes each year. Pay the right way, and your lifetime exemption stays untouched.

The whole of it

What it is

I once watched an old rancher hand a neighbor a sack of seed and say, "No strings, and no paperwork." The tax law has a rule a bit like that, though it does come with a few strings. Section 2503(e) of the Internal Revenue Code says that certain payments are not treated as taxable gifts at all. Two kinds of payment qualify. One is tuition paid to a school for a student's education. The other is money paid to a medical provider for someone's care.

This is different from the yearly gift exclusion, which is the amount a person may give to any one individual each year without filing a gift tax return. The direct payment rule is a second door. You can walk through it in addition to the yearly exclusion, and neither one uses up the other.

For families with very large estates, that matters a great deal. Every dollar that passes through this door leaves the estate without touching the lifetime exemption, which is the total a person may give away during life or at death before federal transfer tax applies. That exemption is the current figure, which the official source publishes each year for this year. The direct payment rule does not count against it.

How it works

If you have ever paid a bill for someone you love, you know the question is always the same. Who gets the check? Under this rule, the answer has to be the institution. The donor must pay the school or the medical provider directly. If the donor hands the money to a grandchild and the grandchild pays the bill, the rule is lost. The transfer is then an ordinary gift.

The recipient can be anyone. A child, a grandchild, a niece, a friend, or a stranger all qualify. No family tie is required. The donor may also be generous across many people in the same year, and there is no cap on the amount.

Tuition has a narrow meaning here. It means the charge for enrollment at a school that has a regular faculty, a regular curriculum, and a body of students in attendance. Room and board do not count. Books and supplies do not count. Required fees that are not tuition do not count. A student activity fee, for example, falls outside the rule.

Medical care has a wider meaning. It follows the definition used for the medical expense deduction in section 213 of the Internal Revenue Code. That includes diagnosis, treatment, and prevention of disease. It includes hospital stays, surgery, and prescription drugs. It includes medical insurance premiums paid directly to the insurer. It includes certain transport costs for care. It does not include costs the recipient's insurance has already repaid. If a plan reimburses the patient, the donor's payment for that same bill does not qualify.

Timing is a point families miss. Some donors prepay several years of tuition in one lump sum. A friend of mine once prepaid several years of tuition and then learned the school's refund policy mattered. The statute names only tuition paid directly to the school, and it says nothing plain about prepayments. The IRS pages on gifts do not clearly say how a prepayment is treated when the school may hand money back. A tax professional can say how the rule applies to a given school's refund policy, and the IRS pages on gifts are the place to read what the agency says.

The numbers, and where to find yours

Here is where I tip my hat to the honest limits of a short guide. Three figures matter, and each one changes on a schedule set by law. The yearly gift exclusion is the current figure, which the official source publishes each year. The lifetime exemption is the current figure, which the official source publishes each year. The top federal rate on transfers above the exemption is the current figure, which the official source publishes each year.

Do not trust a figure on a napkin, and do not trust one from a friend at the club. The IRS publishes these on its own pages. Look at the instructions for Form 709, the United States Gift and Generation Skipping Transfer Tax Return, and at the IRS page titled Estate Tax. Those pages carry the current numbers and the year they apply to.

Notice something about the direct payment rule itself. It has no dollar limit to look up. That is its charm. A donor can pay a large tuition bill or a large hospital bill, and the amount does not matter to the gift tax.

A worked example

Let me tell you about a woman I will call Margaret Ellison. She is seventy two and a widow, and her estate is worth about $48,000,000. She has three grandchildren. Her grandson Daniel is at a private university where tuition is $62,000 a year. Her granddaughter Claire needs a surgery that costs $38,000 after insurance has paid its share.

Margaret first thinks of writing checks to the grandchildren. That would be a gift. Say she sent Daniel $62,000. Subtract the yearly exclusion, which we will call $19,000 for the sake of this story only, and $43,000 remains as a taxable gift. Claire's $38,000 would leave $19,000 taxable. Together, $43,000 plus $19,000 is $62,000 that she must report on Form 709. That amount would reduce her lifetime exemption.

Now watch what happens when Margaret pays the right way. She sends $62,000 to the university's bursar. She sends $38,000 to the hospital. Neither payment is a taxable gift. Her lifetime exemption is not reduced by even one dollar. Better still, she can still give each grandchild the full yearly exclusion on top of that. If she gives each of the three grandchildren $19,000, that is 3 times $19,000, which equals $57,000 more, all tax free under the yearly rule.

So in one year Margaret moves $62,000 plus $38,000 plus $57,000 out of her estate. That total is $157,000. None of it counts against her lifetime exemption. At a top rate we will call 40 percent for the sake of the story, a $157,000 transfer that might have been taxed would have cost up to $62,800 in tax. Here the tax cost is $0.

Where it goes wrong

I have seen smart people trip on small things. The commonest slip is the check made out to the wrong party. If the donor pays the student, the rule fails. Keep the payment on the institution's letterhead and name the institution as the payee.

A second slip is mixing up tuition with the rest of the bill. A school statement may list tuition, housing, a meal plan, and fees. Only the tuition line qualifies. The family should ask the school to split the bill so that the donor pays only the qualifying piece.

A third slip is paying a medical bill that insurance has already covered or will cover. The rule does not reach amounts that a plan repays. Wait for the insurer to finish, then pay what is left.

A fourth slip is the paperwork. These payments generally do not need to be reported on Form 709. Even so, a donor who also makes taxable gifts that year will file a return. Keep the receipts, the invoices, and proof of payment in a folder. A trustee, an accountant, or an estate attorney will thank you later.

A fifth slip is a trust. Money paid out of a trust is not the same as money paid by a person. The trust document and the tax rules for that trust decide the outcome, and a lawyer should look at it first. Likewise, generation skipping transfer tax has its own exclusion for these payments, and a professional should confirm how it applies.

Questions to answer before you leave this page

Have you asked the school or the clinic to send you a bill that shows only the qualifying charge? Do you know the exact legal name of the payee, so the check or wire goes to the institution and not to the family member? Has the insurer finished paying, so that you are not covering a cost that will be reimbursed? Are you holding the receipts, the invoices, and the proof of payment in one place? Have you looked up the current yearly exclusion and the lifetime exemption on the IRS pages for Form 709 and the Estate Tax? And have you sat down with your estate attorney or tax adviser to make sure the plan fits your whole family?