The Basics:
An important estate planning goal is to find procedures to share your wealth with your heirs without incurring transfer taxes or depleting your exemptions.  One way to accomplish this is to take advantage of the annual gift tax exclusion, which allows you to transfer up to $12,000 per recipient tax-free. The problem with this approach is that it can take years to transfer a meaningful amount of wealth.  A taxpayer can give more, however, by paying tuition or medical expenses on behalf of your children or other heirs.  If the payments are made directly to the school or health care provider, they are exempt from gift tax without consuming any of the individual’s exemptions or annual exclusions.

The strategy approved by the Internal Revenue Service Private Letter Ruling allowed the taxpayer to accelerate the process by paying tuition in advance.  The taxpayer who requested the ruling planned to enter into separate written agreements with the school for each of his six grandchildren.  Under the agreements, the taxpayer would prepay the total annual tuition for each grandchild through 12th grade. The amounts would be based on the school’s current tuition rates, and the grandfather or the children’s parents would agree to pay any tuition increases in subsequent years.

The prepayments would nonrefundable – they would be forfeited to the school in the event a grandchild drops out or transfers to another school. The Internal Revenue Service ruled that, under the facts presented, prepaid tuition was exempt from Gift and Generation Skipping Taxation taxes. The ruling has significant implications for people who want to remove large amounts of assets from their estates tax-free but do not have the time they need to accomplish this through annual exclusion gifts.

The main disadvantage of the technique approved in the Private Letter Ruling is that the taxpayer had to make nonrefundable payments to a specific school on behalf of a designated student.  Unlike other educational savings vehicles, such as Section 529 college savings plans, you can not transfer the funds to another school or another person if the student transfers or drops out. 

In conclusion, if you are looking for a procedure to shield large amounts of wealth from gift and estate taxes, the prepaid tuition strategy is worth further study.