Under the Internal Revenue Code, gifts from one individual to another are subject to gift tax, unless an exclusion or exemption applies. One such exclusion exists for a donor paying the tuition of another individual at a qualified school. Such qualified tuition payments are also excluded from generation skipping tax, if the transfer skips a generation (e.g., a grandfather pays the tuition of his grandchild).
What happens if the tuition paid does not relate to the current year, but is a prepayment of future tuition? Will the exclusion apply?
Yes, says the Internal Revenue Service. In Private Letter Ruling 200602002 (January 13, 2006), the IRS ruled that a grandparent's prepayment of tuition for a number of his grandchildren for multiple years through their graduation (grade 12) from the school, qualifies for both the gift tax and generation skipping tax exclusion.
As contrasted with the alternative of making a gift to a trust for education, or a transfer at death to a trust for education, both of which would be subject to estate or gift taxes (subject to available unified credit) - the prepayment during lifetime of tuition provides a useful mechanism for reducing transfer taxes if the applicable school is amendable to such arrangements.
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