Under IRC Sections 2503(e) (concerning gift taxes) and 2611(b)(1) (concerning generation skipping transfer ("GST") taxes) (hereafter the "IRC exclusion provisions") all "qualified transfers" for tuition or medical expenses are excluded from both gift and GST taxes - if they are paid directly to the educational institution or to the medical care provider. High net worth individuals commonly use IRC Section 2503(c) as a wealth transfer strategy. By paying their grandchildren's and great-grandchildren's tuition and medical bills, they are removing assets from their estate, both gift and GST tax free. Moreover, there are no limitations as to the amount that can be paid for such expenses. However, this strategy only works while the grandparents are alive.
For those grandparents who wish to pay for their descendants' education and medical bills while transferring significant assets out of their estates, a health and education exclusion trust, or "HEET", should be established. The grandparents can set up an inter vivos HEET using their $13,000 / $26,000 annual gift tax exclusion, their $1,000,000 / $2,000,000 gift tax exemption, or by naming the HEET as the remainder beneficiary of a zeroed-out grantor retained annuity trust or a zeroed-out charitable lead annuity trust (see below). Alternatively, a testamentary HEET can be established in the grandparent's Will or Living Trust and funded at death. An inter vivos HEET can be an irrevocable life insurance trust ("ILIT") drafted as a HEET. Assets used to fund a testamentary HEET (unless an ILIT is used) would be subject to estate taxes, but not the GST tax. However, by creating and funding an inter vivos HEET, the after-tax income and appreciation on the assets gifted to the HEET are removed from the grandparents' estate.
A key benefit of a HEET is that it gets around the onerous GST tax. The GST tax is 45% on the amount of a grandparent's gift (inter vivos or testamentary) to grandchildren (or more remote descendants) that exceeds (in 2009) $3,500,000, or $7,000,000 for married grandparents. To avoid the GST tax, the HEET must pay the educational or medical expenses directly to the provider, and the HEET must have a charity as a co-beneficiary. If the grandchildren (or more remote descendants) are the only beneficiaries of the HEET, transfers to it would be subject to the GST tax. Thus, a HEET is best suited for grandparents who have estates in excess of the $3,500,000 / $7,000,000 GST exemption and who have charitable goals.
A generation skipping transfer can occur in one of three ways: 1) a direct skip; 2) a taxable distribution; and 3) a taxable termination. The GST tax is calculated by multiplying the highest estate tax rate by the amount of the direct skip, taxable distribution, or taxable termination.
A transfer made directly to a skip person (i.e., grandchild), either during lifetime or at death, is a "direct skip." A transfer made to a trust in which all beneficiaries are "skip persons" is also a direct skip. However, because a HEET has a non-skip beneficiary (the charity), a transfer to a HEET is not a direct skip.
Transfers to trusts that have both skip and non-skip persons as beneficiaries do not pay the GST tax upon the funding of the trust. Instead, a GST tax is paid by the trustee when distributions are made to beneficiaries who are skip persons. However, because of the IRC exclusion provisions, distributions made from a HEET directly to providers of education and health care on behalf of a skip person are not subject to GST tax.
A taxable termination occurs when a trust loses its last non-skip person and, therefore, only skip persons remain as beneficiaries. Since a HEET will always have a non-skip person beneficiary - the charity - a taxable termination will never occur, nor the GST tax consequent to it. But, the charity's interest must be significant. Otherwise it will be ignored as being used "primarily to postpone or avoid" the GST tax. IRC Section 2652(c)(2).
To obtain the benefits of a HEET, careful drafting is required. First, the HEET should be established in a jurisdiction that allows for perpetual trusts. Second, to avoid GST taxes, the trustee must administer the HEET so that the distributions to the non-charitable beneficiaries constitute "qualified transfers" within the meaning of the IRC exclusion provisions (see below). Third, to maximize creditor protection, distributions to the non-charitable beneficiaries should be entirely discretionary, and an independent trustee or co-trustee should be named (see below). Fourth, to be assured that the HEET never loses its last non-skip person (thereby creating a taxable termination for GST tax purposes), the charitable beneficiary's interest must be significant. Finally, if the charity's interest is treated as a separate share, the HEET could be separated into two trusts - one exclusively for the charity and the other exclusively for the non-charitable beneficiaries - for GST tax purposes. IRC Section 2654(b).The effect of this division would be an eventual taxable termination with respect to most of the assets of the HEET. Perhaps the best way to assure that the charity's interest is both significant and not separate, is to give the trustee the discretion to make payments of income and principal to the charity, but with a definite "floor." Such uncertainty as to what the charity will receive should avoid the application of the separate share rule, while the floor assures the charity's interest is significant.
How significant must the charitable interest be for the IRS to respect the charity as a bona fide perpetual "non-skip person" beneficiary? The more meaningful the charity's interest, the greater the likelihood the IRS will respect it. But, the larger the payout to charity, the less property is available for the non-charitable beneficiaries. Unfortunately, there is little guidance in this area. Some practitioners believe a 10% unitrust amount must be paid annually to the charity. Others believe that a 4% - 6% annual unitrust amount is significant and cannot be ignored as de minimis. Still others believe that 10% - 50% of the HEET's income should be paid to the charity annually, plus a percentage of trust principal. Perhaps guidance can be found under several Internal Revenue Code sections where a 5% or greater economic interest is deemed to be significant: IRC Section 4942 (minimum distribution amount for private foundations); IRC Section 664 (minimum distribution amount for charitable remainder trusts); IRC Section 2041(b)(2) (lapse of power of appointment); and IRC Section 147 (private activity bonds). Until the IRS provides guidance on this issue, uncertainty will remain.
There is no up-front income or gift-tax charitable deduction available when a grantor establishes an inter vivos HEET. Nor is there an estate tax charitable deduction available for assets funding a testamentary HEET. An inter vivos HEET should probably be drafted as a "grantor trust" so that, when the HEET makes distributions to charity, the grantor will be entitled to an annual charitable income tax deduction for same. Since the grantor of the HEET pays the tax on the HEET's income, a grantor HEET also benefits the beneficiaries, because the growth of the HEET's corpus is not diminished by income taxes.
A testamentary HEET, an inter vivos non-grantor HEET, and an inter vivos grantor HEET after the grantor's death, will all be taxed as complex trusts and will file their own Form 1041. In such case, the trust itself will deduct distributions of income to the charitable beneficiary. IRC Section 642(c). And unlike individuals whose charitable contribution deductions are limited by a 50% of AGI ceiling (at best), a trust can deduct its charitable contributions up to 100% of trust income.
Among those distributions that constitute a "qualified transfer" are tuition payments for full or part-time students to both domestic and foreign institutions. However, the costs of books and room and board do not qualify. To cover room and board, books and other college expenses, the grandparents may also want to fund IRC Section 529 plans. Qualifying medical expenses include expenses paid on behalf of a beneficiary to any person who provides services for the "diagnosis, cure, mitigation, treatment or prevention of disease or for the purpose of affecting any structure or function of the body or for transportation primarily for and essential to medical care." Treas. Reg. Section 25.2503-6(b)(3). Covered are payments for hospital services, nursing care, medical laboratory, surgical, dental and other diagnostic services, x-rays, medicine and drugs (whether or not requiring a prescription), artificial teeth and limbs, and ambulance. Not covered are payments for elective surgery. Finally, the HEET can be used to provide medical and long-term care insurance for its beneficiaries.
To maximize creditor protection, the trustee of the HEET should be given broad discretion to make distributions among a class of beneficiaries. While a beneficiary may be a trustee, for optimal protection of assets, it is preferable to assign all distribution powers to an independent trustee or co-trustee. The grantor and/or the beneficiaries can be given the power to remove and replace the independent trustee without adverse estate tax consequences, as long as any successor trustee so appointed is not "related or subordinate" (within the meaning of IRC Section 672(d)) to the grantor or beneficiary exercising the removal power.
A HEET is most commonly used as part of the grantor's testamentary plan for assets in excess of the GST exemption. For example, after the decedent's GST exemption is allocated to a Dynasty Trust, a portion of the remaining estate could be allocated to a HEET. Those who want to make a large bequest to charity might divide the charitable portion of their estate between a family foundation and a HEET. The family foundation could also serve as the charitable beneficiary of the HEET. Of course, the advantage of a direct bequest to charity over a HEET is that estate taxes have to be paid on the assets passing to the HEET.
Another planning opportunity is to name a HEET the remainder beneficiary of a grantor retained annuity trust ("GRAT"). Because of the estate tax inclusion period ("ETIP") rules, GST exemption cannot effectively be allocated to a GRAT until the end of the GRAT term. Thus, if the GRAT increases in value as planned, that appreciation would be partially subject to GST taxes if the remainder beneficiaries were skip persons. However, by making a HEET the GRAT's remainder beneficiary, the need for GST exemption is obviated.
Similar to the situation with a GRAT, a HEET can also be used in conjunction with a charitable lead annuity trust ("CLAT"). With a CLAT, charity receives an annuity for a fixed term of years, and the donor's heirs receive the assets remaining in the CLAT at the end of the fixed term. Only the present value of the CLAT's remainder interest is subject to transfer taxes. However, it is possible to set the annuity and term to arrive at a tax-free transfer. This is referred to as a "zeroed-out" CLAT (just as GRATs can be zeroed-out). But, while the rules for allocating GST exemption to a CLAT differ from the ETIP rules for a GRAT, they still prevent a grantor from allocating GST exemption based on the value of the remainder interest at the time the CLAT was created. As with the GRAT situation, a HEET remainder beneficiary does away with the GST exemption concern.
In summary, affluent individuals who want to secure their descendants' education and health care, who have otherwise exhausted their GST exemption, and who have an interest in charity should examine the many uses and benefits of a HEET.