When billionaire tech investor and philanthropist Robert F. Smith promised during a commencement address at Morehouse College in Atlanta on May 19, 2019 that he and his family would be paying off the student debt of every graduate in the Class of 2019, the announcement came as a resounding surprise not only to the approximately 400 graduating seniors who collectively stand to receive an estimated $40 million in financial assistance but also to Morehouse faculty and administrators, who learned of Smith’s intentions during his address, along with everybody else.
While the move has received widespread media attention for re-stimulating the national debate surrounding out-of-control increases in student loan debt, what has been less discussed are the potential tax consequences facing not only Smith and his family but also the Morehouse College graduates and their families, as well. Depending on how the plan is executed, it could have serious implications for Morehouse College, too.
As the saying goes, the devil is in the details, and with Smith having not yet come forward with his plan for how his gift will be executed, outside observers have begun to speculate about what form Smith’s gift might take and what the potential tax ramifications of each course might be.
“My first thought when I heard about this on the news was ‘How is this actually going to work?’” Scott Winkler, a Georgia-based CPA and certified financial planner told the Atlanta Journal-Constitution.
Whatever Smith and his team of financial and legal experts decide, with some graduates saying that their first student loan payments are due as early as June 2019, time is of the essence.
Option 1: Give The Money Directly To Students From Smith And His Family
Despite being perhaps the simplest and most obvious mechanism for fulfilling Smith’s pledge, most outside experts agree that simply giving the money directly to the students to pay off their debt is an unlikely choice for Smith and his family, if only because of the potential tax ramifications.
Under this direct-to-student scenario, the monetary transfer likely would be considered a gift and may trigger a gift tax. Despite its name, according to IRS rules, the gift tax applies to transfers of money or property between individuals (or from an individual to a trust) regardless of the donor’s intent.
“The gift tax is a tax on the transfer of property by one individual to another while receiving nothing, or less than full value, in return,” the IRS website states. “The tax applies whether the donor intends for the transfer to be a gift or not.”
Later, the IRS adds, “If you sell something at less than its full value or if you make an interest-free or reduced-interest loan, you may be making a gift.”
The federal gift tax works as follows: If a donor makes a gift to a person in excess of the IRS’ annual exclusion ($15,000 for tax years 2018 and 2019), the donor is required to file a gift tax return to report this excess amount. However, this does not automatically mean that a gift tax is due with the filing of the gift tax return. This is because the IRS also provides for a lifetime exemption of gift and estate taxes. As of 2019, the amount of this lifetime exemption is $11.4 million for gift and estate taxes. This means that, if a hypothetical donor were to die in 2019 and he or she has made less than $11.4 million worth of gifts over the applicable annual exclusions during his or her lifetime, the donor’s estate would not have to pay a gift tax.
The IRS has compiled and published comprehensive data that provides insight into how the gift tax is applied, and how gifts are used, in the United States. According to this data, most reported gifts are given to children and grandchildren and, because of the lifetime exemption referenced above, the vast majority of gift tax returns are nontaxable. For example, based on data from tax year 2009, that year saw 223,093 gift tax returns filed, of which 213,448, or 95.7%, were nontaxable.
The IRS data contains other interesting information about how gifts are made in the United States. For 2009, nearly two-thirds of the gifts, totaling $25.5 billion in value, were given directly to donees, while gifts given through trusts accounted for the other third. Nearly half (47.5%, totaling $18 billion in value) of all gifts were given in the form of cash, making it the most popular form of transfer on both taxable and nontaxable gift tax returns. Transfers of real estate were next most popular, representing 18.4% of all gifts, with gifts of stock accounting for 16.2%.
In any event, Smith’s pledge to cover the student loans of approximately 400 students is estimated to cost him roughly $40 million, for an average debt of $100,000 per student. This means that Smith would exceed the 2019 annual gift exemption by about $85,000 per individual, for a total of about $34 million counting toward his lifetime exemption.
Given the gift tax ramifications of fulfilling his pledge through direct-to-student payments, outside observers say such a scenario is an unlikely choice for Smith and his family. However, there are educational exclusions from the gift tax, including exclusions for tuition payments made by one individual on behalf of another. It is possible that Smith and his team may attempt to argue that payments of student loan debt fall under this exclusion and should not be subject to the gift tax. Still, experts consider this an unlikely option.
Option 2: Grant The Money To Morehouse College And Have Morehouse Distribute The Funds
A number of outside experts have noted Smith’s use of the word “grant” in describing his pledge to students. Using a grant to Morehouse College as the mechanism for distributing the funds would be a reasonable choice for a number of reasons, say outside experts such as Kelly Richmond Pope, a CPA who teaches at DePaul University, who also spoke to the Atlanta Journal-Constitution about the tax implications of Smith’s gift.
From a donor’s perspective, grants have the benefit of permitting greater control, allowing funds to be directed to a specific activity or purpose, such as paying off student loans. In theory, Smith could give the money to Morehouse College in the form of a grant, with Morehouse then using the funds to pay off the graduates’ student debt.
While the IRS defines “grants” as including “[s]cholarships, fellowships, internships, prizes, and awards”, what is somewhat unique about Smith’s pledge is that, unlike a traditional scholarship, it is retroactive in nature. That is, instead of promising in advance to pay a student’s tuition, Smith has promised to pay off debt that already has been incurred.
Grants generally are considered taxable expenditures by the IRS unless certain specific criteria are met. For grants to individuals to be considered nontaxable expenditures, the grant must be “awarded on an objective and nondiscriminatory basis under a procedure approved in advance” by the IRS and it must consist of “a scholarship or fellowship” at an established educational institution. However, “grant recipients need not be limited to degree candidates, nor must the grant be limited to tuition, fees, and course-required books, supplies and equipment.”
While this language does provide Smith and his team some wiggle room, again, it is the retroactive nature of Smith’s promise to pay that makes the situation somewhat unique from a taxation standpoint.
Though avoiding the gift tax implications of the first scenario, the grant approach would raise issues of its own. For example, some say that paying off student debt may call into question Morehouse College’s status as a 501(c)(3) nonprofit institution.
“Would Morehouse be able to legally pay off the debt that is under the Social Security number of a student?” asked Barron Barnes, another Georgia-based CPA who spoke to the Journal-Constitution. “I think that would be a violation of what they are allowed to do as an institution with a 501(c)(3) tax-exempt status.”
Despite the legal questions raised, many outside observers believe that some form of grant is the most likely mechanism Smith and his family will use to execute his pledge.
Option 3: Create A Private Equity Fund To Distribute Funds
According to the Georgia CPA Winkler, another option for Smith and his family would be to set up a private equity fund from which money could be dispersed to pay off the graduates’ debt. However, as Winkler himself has acknowledged, such a fund would take at least a year to create, meaning that, unless Smith and his team have been in the process of establishing a fund in the lead up to his announcement, it is an unlikely choice, if only for timing considerations.
As to which option Smith and his family will choose, we will just have to wait and see how the logistics play out. As stated, one of the few hints that Smith himself gave in his announcement was his use of the term “grant” to describe his pledge. Some experts say a grant would make the most sense from a tax-planning point of view, as well, making it the most likely option in the eyes of many tax professionals.
Tax Implications For The Graduates And Their Families
One of the issues common to all of the plans discussed above is that they each raise potential tax consequences for the graduates and their families. However, highlighting the complexity of the situation from a taxation perspective, experts are not in agreement on what the IRS’ tax treatment of students will be.
Barron Barnes, one of the Georgia-based CPAs who spoke to the Journal-Constitution, told that publication that if the students were to have their loans paid off by Morehouse College via a Smith-funded grant, then the students likely would receive an IRS Form 1099-C for cancellation of the debt, which treats the balance of the paid-off student loan as income to the graduate.
However, other professionals have reached a different conclusion.
“The lender did not forgive the debt, so there is no cancellation of indebtedness income,” Bill Smith, Managing Director at CBIZ MHM’s National Tax Office, told FOX Business.
Information provided by the IRS supports the latter conclusion. Form 1099-C is intended to be filed by a financial institution that has canceled the debt of a borrower. For example, if a borrower receives a loan from a lender, and the borrower later is unable to repay, the lender may agree to settle the debt for less than the full amount owed.
The logic is as follows: When a borrower receives a loan, the money is not considered taxable as income because of the contractual obligation for the money to be repaid. However, if all or a portion of that indebtedness later is cancelled by the lender, what was originally considered a loan essentially converts to taxable income for the borrower, at least in the eyes of the IRS.
“File this form [1099-C] for each debtor for whom you cancelled $600 or more of debt owed to you if…you are an applicable financial entity, and an identifiable event has occurred,” the IRS website states.
As neither Smith nor Morehouse College qualifies as an applicable financial entity, it is unlikely either would be required to file a Form 1099-C for each student whose loans are paid off. Also, because the loans presumably would be paid off in full by an outside source rather than forgiven by the lender, the financial institution holding the student debt would not be required to file a Form 1099-C, either.
Whatever the ultimate tax implications may be for Morehouse College graduates and their families, as some observers have pointed out, the financial liability is certain to be significantly less than their student debt.
Given the pros and cons of each option from a tax-planning standpoint, it is not clear exactly which avenue Smith and his team of professionals will pursue in fulfilling his pledge to pay off the student debt for each member of Morehouse College’s 2019 graduating class. With Smith having explicitly pushed for his fellow alumni to follow in his footsteps, whatever mechanism Smith chooses, not only his pledge but also the means by which he implements it likely will become a model for future philanthropists to follow.
In any event, the tax complications underlying what is at once both a generous gesture and a powerful statement by Smith demonstrate once again the importance of incorporating thoughtful tax strategies into all of your wealth-management decisions.
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