IRC §2503(E) Exclusions: Powerful Tools for Tax-Free Education and Medical Giving

The Internal Revenue Code provides several valuable opportunities under IRC §2503 for making transfers that are excluded from gift tax. These exclusions include special rules for certain payments of educational and medical expenses under IRC §2503(e). The beauty of these provisions is that the amounts that can be transferred are unlimited, and the transfers can benefit any number of individuals. Because such transfers are not treated as taxable gifts, they typically do not need to be reported on a Form 709 Gift Tax Return.

IRC §2503(e) provides an especially powerful exclusion for transfers made directly for educational or medical expenses. This provision covers two types of “qualified transfers”: (1) amounts paid directly to an educational institution for tuition, and (2) amounts paid directly to medical providers or insurers for medical care. Because these transfers are not considered gifts, there is no limit to the amount that can be paid, and no reporting requirement applies. Payments may be made for anyone, not just family members, and to as many people as desired.

Education Expenses

Under IRC §2503(e)(2)(A), qualified tuition payments include amounts paid on behalf of an individual as tuition to an educational organization for that individual’s education or training. This exclusion is in addition to the annual exclusion under IRC §2503(b). To qualify, the payment must be made directly to the institution, not to the individual, for reimbursement. Treasury Regulation §25.2503-6(b)(2) clarifies that reimbursing someone who paid tuition or student loans will not qualify for the exclusion. The institution must also meet the definition of an “educational organization” under IRC §170(b)(1)(A)(ii), meaning it maintains a faculty, a regular curriculum, and a regularly enrolled body of students. This definition is broad enough to include specialized programs such as ballet schools or martial arts academies (Rev. Rul. 67-447 and Rev. Rul. 78-82). The exclusion applies to both part-time and foreign schools under Reg. §25.2503-6(b) and (c). Importantly, only tuition itself qualifies for this exclusion; payments for books, supplies, room, and board do not. Some clients choose to combine an IRC §2503(e) strategy with contributions to a 529 plan, since 529 funds can be used for broader educational expenses, including room and board, books, and supplies.[1]

Medical Expenses

IRC §2503(e)(2)(B) provides that any amount paid on behalf of an individual as payment for unreimbursed medical care expenses is not treated as a gift for gift tax purposes, provided the payment is made directly to the provider and not to the patient, as explained in Reg. §25.2503-6(b)(2). “Medical care” is defined broadly under IRC §213(d) to include most medical and dental services, hospital and nursing care, prescription drugs, and diagnostic services. To illustrate the breadth of the definition, health insurance premiums are specifically included under Reg. §25.2503-6(b)(3)[2], and certain medically related costs—such as meals and lodging, and even medically necessary home improvements like installing a wheelchair ramp—may also qualify within specific limitations. However, there are medically adjacent expenses that will not be included in the definition of “medical care” for purposes of this exclusion. For example, elective cosmetic surgery and general wellness expenses, such as gym memberships, are generally not a qualified medical expense unless prescribed by a physician for a specific medical condition and meeting the requirements of IRC §213(d).

GST Tax Exclusion for Qualified Transfers

For high net worth clients who have already used their generation-skipping transfer (“GST”) tax exemption—or prefer not to allocate it to a trust limited to education and health expenses—but still want to benefit grandchildren or future generations, planners sometimes recommend a Health and Education Exclusion Trust (“HEET”). This type of trust is primarily a GST-tax savings vehicle that takes advantage of IRC §2503(e). Under IRC §2611(b)(1), transfers that qualify under IRC §2503(e)(2)(B) are excluded from GST tax, meaning that distributions from a non-GST-exempt trust directly to educational or medical institutions for skip persons (like grandchildren) are not subject to GST tax. However, if every beneficiary of the trust is a skip person, the trust itself becomes a skip person, and the contribution to the trust would be subject to GST tax. To avoid that outcome, practitioners typically add a charitable beneficiary with a “meaningful interest” in the trust. The law is unsettled on what constitutes a meaningful interest, but the charitable beneficiary’s interest should be substantial, ongoing, and not merely nominal or easily severable. The key is that the trust should be structured to avoid the appearance that the charitable interest exists solely to avoid GST tax.

In sum, the IRC §2503 exclusions offer exceptional flexibility for transferring wealth free of gift tax. Payments made directly to educational or medical institutions are unlimited in amount, benefit an unrestricted number of individuals, and generally do not require gift tax reporting. And, for clients with significant wealth and GST-planning considerations, the HEET provides another option to preserve family benefits in a tax-efficient manner.

[1] 529 plans are treated as completed gifts and are subject to the annual exclusion amount under IRC §2503(b). Thus, planners sometimes recommend that clients use a combination of direct tuition payments (for the unlimited exclusion) and 529 plan contributions (for broader expenses) to maximize tax savings.

[2] If health insurance later reimburses the donee for an expense that was already paid directly by another person, it may be possible to sign over the reimbursement check to that person to eliminate any unintended taxable gift. Reg. §25.2503-6(b).