by Julia L. Cronin
Many of our clients are first generation wealth builders with a passionate commitment to providing funds for the education of family members and pride in their ability to create a healthcare safety net for generations to come.
During his or her lifetime, a client may make unlimited tuition payments directly to an educational institution to pay for a student’s enrollment, and/or make payments directly to a healthcare provider for a person’s qualifying medical expenses. Internal Revenue Code section 2503(e) excludes these “qualified transfers” for tuition and medical expenses from gift taxes, without regard to the relationship between the donor and the donee.[1] Internal Revenue Code sections 2611(b)(1) and 2642(c)(3) also exclude payments made directly to educational institutions or healthcare providers from generation skipping transfer tax (“GSTT”), which ordinarily otherwise imposes a tax on gifts for the benefit of a “skip-person,” that is, related persons who are more than one generation younger than the donor, such as grandchildren, or unrelated persons who are more than 37.5 years younger than the donor.[2] [3] [4]
There are no limitations as to the amounts that can be paid for qualifying educational and healthcare expenses during a client’s lifetime, so our clients frequently make such gift and generation skipping transfer tax free payments for their grandchildren and great-grandchildren.
But this strategy only works while the client is alive.
What happens if a client wants to create a trust to provide for the education and healthcare needs of generations to come, even after the client’s passing?
“Qualified transfers” made directly to educational institutions or healthcare providers are excluded from GSTT whether the payment is made by an individual or by the trustee of a (carefully designed) trust.
In fact, specifically designed irrevocable dynasty trusts, known as a “Health and Education Exclusion Trust” or “HEET,” permit clients to make such “qualified transfers” to pay medical and educational expenses of the HEET’s beneficiaries – be they nieces and nephews, grandchildren or great grandchildren, or more remote descendants of the client – for generations to come.
Transfers to a HEET created during a client’s lifetime (an “inter vivos” HEET) are completed gifts for federal gift tax purposes.[5] Unlike the unlimited amounts that can be paid for qualifying educational and healthcare expenses during a client’s lifetime, completed gifts to an inter vivos HEET are limited to a client’s lifetime gift and estate tax exclusion amount. But, a completed gift to a HEET will remove assets from the client’s estate and create a tax-efficient pool of funds to accomplish the client’s education and healthcare safety net goals where GSTT would otherwise significantly reduce the funds some beneficiaries ultimately receive.
Clients who have already used their lifetime gift exemption can make tax free contributions to a HEET with annual exclusion gifts ($17,000 per beneficiary in 2023) and GSTT will not diminish distributions made on behalf of skip beneficiaries in the future.[6] Some clients choose to make a HEET the remainder beneficiary of a testamentary charitable lead annuity trust (“T-CLAT”), or a grantor retained annuity trust (“GRAT”). Ordinarily, such remainders do not have GST exemption allocated to them, so having a HEET as a remainder beneficiary could significantly compound the value of a reminder for a client’s beneficiaries.
A HEET can help accomplish a client’s education and healthcare objectives in a powerful way, but to obtain the benefits, a HEET must be very precisely drafted. For example, HEET must have a “non-skip” beneficiary – a charity – as a co-beneficiary with “skip” beneficiaries such as grandchildren and/or more remote descendants to qualify for exemption from GST. This is only one of several very technical drafting requirements.
As with many favorable strategies, HEETs may be on the “endangered strategies” list. Legislation was proposed in 2013 to effectively eliminate HEETs, by “modifying” the exclusion definition under Internal Revenue Code § 2611(b)(1) to subject transfers to a HEET to GSTT upon funding or when distributions are made to non-charitable beneficiaries. If enacted, the change would effectively eliminate the use of HEET trusts on a going-forward basis, and it is unclear if existing HEET trusts would be able to continue to make distributions for non-charitable beneficiaries without negative tax consequences.
A HEET is best suited for clients who have federally taxable estates and who have charitable goals as well as goals to provide for the health and education of beneficiaries long into the future. As always, we never recommend one strategy in isolation. Rather, we work closely with our clients to identify their goals and objectives, and then model combinations of strategies to develop a bespoke recommendation intended to accomplish the client’s planning objectives with maximum impact.
[1]See Internal Revenue Code § 2503(e) and Treas. Reg. §§ 25.2503-6(a), 25.2503-6(b)(2) and 25.2503-6(b)(3).
[2]See Internal Revenue Code §§ 2611 and 2613.
[3] A generation skipping transfer can occur in one of three ways. (1) A transfer to a skip person – such as from a grandparent to a grandchild. This is a “direct skip.” (2) A “taxable distribution” from a trust to a skip person – such as from a trust created by a grandparent to a grandchild. (3) A “taxable termination” – such as when a trust loses its last non-skip person and only skip persons remain as beneficiaries. See Internal Revenue Code § 2611(a).
[4] The GSTT is equal to the highest estate tax rate on any transfer to a skip person – currently, 40% – on the amount of the gift that exceeds the federal gift, estate, and GSTT exemption, $12.92 million as of 2023.
[5]See Treas. Reg. § 25.2503-6(c), Example 2.
[6] I.R.C. § 2503 establishes annual exclusion gifts. The annual exclusion is available only for gifts of a present interest in the property, defined in Treas. Reg. §§ 25.2503-3(b) as “[a]n unrestricted right to the immediate use, possession, or enjoyment of property or the income from property.” Accordingly, the trust instrument must give the beneficiaries of the trust to demand immediate possession and enjoyment of principal or income of the trust. This is known as a “Crummey power” after the case in which the device was first approved, Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968).