Health And Education Exclusion Trusts

[Add your rating]

A client can make transfers, in unlimited amounts, to pay for any individual beneficiary’s tuition and medical care expenses, free of gift and generation-skipping transfer (“GST”) taxes, provided that such transfers are made directly to the educational institution or medical care provider. This exclusion is available in addition to the annual gift tax exclusion and applies without regard to the relationship between the client and the individual on whose behalf the payments are made.

A “health and education exclusion trust” (“HEET”) is a trust that, in addition to providing for mandatory payments to one or more specified charitable beneficiaries, authorizes the trustee to make payments directly to educational institutions or medical care providers on behalf of the individual’s grandchildren and more remote descendants, as tuition for their education or training or as payment for their medical care, until the corpus of the trust is exhausted or, if earlier, until the expiration of the maximum period allowed under applicable state law for the duration of trusts, without the payments being subject to gift or GST taxes. HEETs are particularly attractive to clients who are both philanthropic and desirous of providing for the health and educational needs of future generations, and who have fully utilized their GST tax exemptions or anticipate to do so for other future planning.

I. TAX ISSUES

A. Gift Tax

HEETs may be created during lifetime or incorporated into a client’s testamentary plan. Gift transfers to a HEET during the individual’s lifetime constitute taxable gifts to the extent not qualified for the gift-tax annual exclusion (currently $15,000 per individual donee in 2018). Funding the HEET with the remainder available upon expiration of a grantor retained annuity trust (“GRAT”) or charitable lead annuity trust (“CLAT”) is particularly attractive, as no taxable gift need be made. This is so because the present value of the remainder interest (i.e., the taxable gift) in a GRAT (or CLAT) is determined by subtracting the present value of the annuity payments to the client (or to the charitable beneficiary) from the value of the initial transfer to the GRAT (or CLAT). By increasing the value of the annuity payments, the value of the taxable gift (i.e., the remainder interest) may be reduced substantially (possibly to zero).

Alternatively, the client could create an irrevocable life insurance trust (“ILIT”) to acquire and hold insurance on the client’s life and collect and administer the policy proceeds as a HEET following the client’s death. Available gift-tax annual exclusions may minimize or eliminate gift tax on transfers made to the ILIT or, alternatively, the client could make loans to the ILIT for payment of policy premiums or otherwise enter into a split dollar or premium-finance life insurance arrangement for the payment of premiums.

B. GST Tax

The GST tax applies to outright distributions to skip persons (i.e., beneficiaries in the client’s grandchildren’s and more remote generations).

The GST tax also applies to transfers to trusts whose beneficiaries are all skip persons or if no person holds an interest in the trust and no distributions (other than a distribution the probability of which occurring is so remote as to be negligible, including distributions at the termination of the trust), may be made after the transfer to a person other than a skip person, unless the client’s GST exemption ($11,180,000 in 2018) is allocated so as to make the trust a GST exempt trust. If the trust is not GST exempt and its beneficiaries include both skip and non-skip persons, the GST tax will apply to distributions made to non-skip beneficiaries and upon the death of the last trust beneficiary who is a non-skip person (e.g., an individual in the client’s children’s generation). Any transfer which, if made by an individual during his or her lifetime would qualify for the gift-tax exclusion for tuition and medical care expenses is not subject to the GST tax.

1. GST Tax Generation Assignment
  
  The generation to which any person (other than the transferor) belongs is determined in accordance with certain prescribed rules for purposes of the GST tax. Certain charitable organizations and trusts and governmental entities are assigned to the transferor’s generation and are thus non-skip persons.
2. Charity’s Interest in the HEET
  
  A charity will be deemed to have an interest in the HEET if it has a present right to receive trust income or principal (i.e., a charity will not be considered to have an interest in the HEET if it is merely a permissible distributee of trust income and/or principal).The charity’s interest in the HEET will be disregarded in determining whether the HEET is a skip person, however, if that interest is “used primarily to postpone or avoid” the GST tax.This means that the charity must have a right to payments of trust income or principal (or both) and that the payments should be significant and indicative of true charitable intent (i.e., the HEET must provide for mandatory distributions to the charity and the charity should be a beneficiary from the HEET’s inception). The charity’s interest in the HEET must not be so transitory or de minimis that it should be ignored. Also, The charity’s interest must not be used for the primary purpose of avoiding or postponing the GST tax.
  
  Little IRS guidance is available on how significant the charity’s interest in the HEET must be.Some practitioners believe a 10% unitrust amount should be paid annually to charity in order for the interest to be substantial. Other practitioners believe that a 2% to 6% annual unitrust amount will constitute a meaningful interest. A present unitrust interest of 5% has variously been legally determined to be substantial or significant for other purposes. There are practitioners who believe that a mandatory annual distribution to charity as a percentage of trust income should be sufficient, while others note that there is no authority for such position and express a concern that an equivalent portion of the HEET may be deemed a separate “share” or trust. Such a determination would result in a GST tax with respect to the noncharitable share. It is generally thought that this “separate share” treatment should be avoided by, in addition to the required minimum annual distributions to the charity, granting the trustee discretion to distribute larger amounts to charity. Also, there is risk that providing for an annual distribution to charity of a percentage of trust income may be challenged as being so de minimis that it should be ignored, since such a provision could permit the trustee to invest the trust assets for growth and not income, thereby effectively reducing the charity’s interest.
  
  Ultimately, the test of whether an interest in a trust is used primarily to postpone or avoid the GST tax is subjective. The charity’s interest does not need to be insubstantial in order to be disregarded. The more significant the charity’s aggregate economic interests in the HEET, the greater the likelihood that it may be held to constitute a meaningful interest for GST tax purposes. Some degree of uncertainty will remain, however, until the IRS issues guidance.
  
  C. Income Tax
  
  If the HEET is structured as a “grantor trust” with respect to the client for federal income-tax purposes, so that the client would be liable for paying any tax on its income and gains during his or her life, amounts distributed by the HEET to its charitable beneficiary could entitle the client to a charitable contribution deduction (subject to any applicable percentage limitations on the client’s charitable deductions). Following the client’s death (i.e., when the trust is no longer a “grantor trust”) distribution of the trust’s “distributable net income” for an individual beneficiary’s tuition or medical care may result in income taxable to the beneficiary, unless the income is completely offset by the trust’s deductible distributions to charity. Any distribution from the HEET to cover the income-tax liability of an individual beneficiary who is a skip person would be subject to GST tax.
  
  II. Concerns Raised by Establishing a HEET
  
  Establishing a HEET may raise the following concerns:
  - There is little IRS guidance regarding HEETs;
  - A large annual payout to charity runs a real risk that the trust property will be significantly diminished over time;
  - Trust distributions other than directly to qualified educational institutions and persons who provide medical care for a beneficiary’s tuition or medical expenses are subject to GST tax (currently imposed at a 40% rate);
  - If the HEET is a “non-grantor trust,” distribution of the trust’s “distributable net income” for a beneficiary’s tuition or medical care may result in income taxable to the beneficiary, unless the income is completely offset by the trust’s deductible distributions to charity; and
  - HEETs may be subject to certain excise tax rules applicable to private foundations (e.g., self-dealing and excess business holdings), although the IRS has ruled privately that HEETs should not be subject to the private foundation excise tax rules.

III. Conclusion

HEETs are a useful vehicle for furthering a client’s charitable interests and providing for the education and health care needs of future generations in a tax- efficient manner. HEETs are particularly attractive for clients who have other property in their estates that can be sheltered from the GST tax by their GST exemptions.

Notes

The unlimited exclusion is available for tuition expenses of a full-time or part-time student paid directly to a qualifying educational organization for the student’s education or training. Amounts paid for books, supplies, dormitory fees, board, or other similar expenses which do not constitute direct tuition costs do not qualify for the unlimited exclusion. Treas. Reg. § 25.2503-6(b)(1)(i), -6(b)(2).
Qualifying medical expenses are limited to those expenses defined in Section 213(d) and include expenses incurred 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. In addition, the unlimited exclusion includes amounts paid for medical insurance on behalf of any individual. Treas. Reg. § 25.2503-6(b)(3), -6(c) Example (3). It does not apply, however, to amounts paid for medical care that are reimbursed by the donee’s insurance. Thus, if payment for a medical expense is reimbursed by the donee’s insurance company, the donor’s payment for that expense, to the extent of the reimbursed amount, is not eligible for the unlimited exclusion and is treated as having been made on the date the reimbursement is received by the donee. Treas. Reg. § 25.2503-6(b)(3), -6(c) Example (4).
A qualifying educational organization is one which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on. Treas. Reg. § 25.2503-6(b)(2), -6(c) Example (2). See IRC § 170(b)(1)(A)(ii) and the regulations thereunder.
IRC §§ 2503(e) and 2611(b)(1).
The gift-tax annual exclusion will be generally available with respect to gifts to the trust over which the individual beneficiaries have a present interest in the gifted amounts. See IRC § 2503(b); Treas. Reg. § 25.2503-2(a).
In order to qualify for the gift-tax exclusion provided in Section 2503(e), transfers must be made directly to a qualified educational institution or medical care provider. Therefore, the initial gift transfer to the HEET is not exempt from gift tax under IRC § 2503(e). Treas. Reg. § 25.2503-6(c) Example (2).
Treas. Regs. § 26.2612-1(d)(2).
IRC § 2651(f)(3). Any organization described in IRC § 511(a)(2), charitable trust described in IRC § 511(b)(2), and governmental entity is assigned to the transferor’s generation.
IRC § 2652(c)(1)(A); Treas. Reg. § 26.2612-1(e)(1)(i). A charity also has an interest in a trust if it is the remainder beneficiary of a qualified charitable remainder trust or a pooled income fund. IRC § 2652(c)(1)(C); Treas. Reg. § 26.2612-1(e)(1)(iii). Note, however, that an individual has an “interest” in property held in trust if he or she has a present right to receive income or corpus from the trust or is a permissible current recipient of income or corpus from the trust (but not if he or she has a right to future income or principal distributions). IRC § 2652(c)(1)(A), (B); Treas. Reg. § 26.2612-1(e)(1)(i), -1(e)(1)(ii).
IRC § 2652(c)(2).
Treas. Reg. § 26.2612-1(e)(2)(ii) takes the position that if a significant purpose for the creation of the HEET is to postpone or avoid GST tax, the charity’s interest will be disregarded. Treas. Reg. § 26.2612- 1(e)(2)(ii) appears to have adopted a less stringent standard – significant, rather than primarily – for disregarding an interest. There is no apparent authority in the statute for the position taken by the regulations. See IRC § 2652(c)(2).
Private Letter Rulings 9109032 and 9823006 are informative with regard to the taxation of HEETs, although neither of the trusts at issue was a HEET. In Private Letter Ruling 9109032, the charities did not have a present right to receive trust income or principal of the trust. The trust in PLR 9823006 did not have either a current or contingent charitable beneficiary.
Private Letter Ruling 200714025. Under the facts of Private Letter Ruling 200714025, the trustees have the power under the terms of the trust instrument to distribute part or all of the trust’s income to charitable organizations, as selected by its trustees. The trustees proposed distributing the trust’s income for charitable purposes. The IRS ruled that the trust was not a “split-interest” trust under IRC § 4947(a)(2) and that, as a result, the trust would not be subject to the private foundation excise tax rules, including the prohibitions against self-dealing and excess business holdings. A “split-interest” trust is a trust that (i) is not exempt from tax under IRC § 501(a), (ii) has some unexpired interests that are devoted to purposes other than religious, charitable, or similar purposes described in IRC § 170(c)(2)(b), and (iii) has amounts transferred in trust after May 26, 1969, for which a deduction was allowed under one of the sections listed in IRC § 4947(a)(2). See IRC § 4947(a)(2).