Elevating Estate Planning with Health and Education Exclusion Trusts (HEETs)

Understanding HEETs and Their Tax Advantages

Health and Education Exclusion Trusts (HEETs) are a strategic tool for high-net-worth individuals aiming to support their descendants' education and healthcare expenses while also engaging in philanthropy. Under Internal Revenue Code (IRC) Sections 2503(e) and 2611(b)(1), "qualified transfers" made directly to educational institutions or medical care providers for tuition or medical expenses are exempt from both gift and generation-skipping transfer (GST) taxes. This provision is a popular wealth transfer strategy among affluent families, allowing them to pay for their grandchildren's and great-grandchildren's education and medical bills without incurring gift or GST taxes, and without any cap on the amount that can be paid for these expenses. However, this benefit is only applicable during the lifetime of the grandparents.

For those seeking to extend this support beyond their lifetime and transfer significant assets out of their estates, establishing a HEET is an effective solution. HEETs can be set up during the lifetime of the grandparents (inter vivos) using their annual gift tax exclusion, their lifetime gift tax exemption, or by designating the HEET as the remainder beneficiary of certain types of trusts. Alternatively, a testamentary HEET can be created through a Will or Living Trust and funded upon death. Funding a testamentary HEET may result in estate taxes, but not GST taxes. By creating and funding an inter vivos HEET, the income and appreciation of the assets gifted to the HEET are removed from the grandparents' estate.

Generation-Skipping Tax Considerations

A significant advantage of a HEET is its ability to circumvent the burdensome GST tax, which in 2009 was set at 45% for transfers to grandchildren that exceeded $3.5 million for individuals or $7 million for married couples. To avoid GST taxes, the HEET must directly pay educational or medical expenses and include a charity as a co-beneficiary. If only descendants are beneficiaries, the HEET would be subject to GST taxes. Therefore, HEETs are particularly suitable for grandparents with estates exceeding the GST exemption and who have charitable intentions.

A generation-skipping transfer can occur in three ways: direct skips, taxable distributions, and taxable terminations. The GST tax is calculated by applying the highest estate tax rate to the amount of the transfer. However, because a HEET includes a non-skip beneficiary (the charity), transfers to a HEET are not considered direct skips. Trusts with both skip and non-skip beneficiaries do not incur GST taxes upon funding. Instead, GST taxes are paid when distributions are made to skip-person beneficiaries. Due to the IRC exclusion provisions, distributions from a HEET for education and healthcare are not subject to GST taxes. Since a HEET always includes a non-skip beneficiary, a taxable termination, and consequently GST taxes, will never occur.

Crafting a HEET with Precision

To reap the benefits of a HEET, meticulous drafting is essential. The trust should be established in a jurisdiction that permits perpetual trusts. The trustee must manage the HEET to ensure distributions to non-charitable beneficiaries are "qualified transfers" as defined by the IRC exclusion provisions. For optimal creditor protection, distributions should be discretionary, and an independent trustee or co-trustee should be appointed. The charitable beneficiary's interest must be significant to prevent a taxable termination for GST tax purposes. If the charity's interest is treated as a separate share, the HEET could be divided into two trusts for GST tax purposes, potentially leading to a taxable termination for most of the HEET's assets. To avoid this, the trustee could be given discretion to make payments to the charity with a definite "floor," ensuring the charity's interest is significant without triggering the separate share rule.

The Significance of the Charitable Interest

The charitable interest in a HEET must be substantial for the IRS to recognize the charity as a bona fide perpetual non-skip person beneficiary. The more meaningful the charity's interest, the more likely the IRS will respect it. However, a larger payout to the charity means less property for non-charitable beneficiaries. While there is limited guidance on the required significance, some practitioners suggest an annual unitrust amount of 4% to 6%, or even 10% to 50% of the HEET's income, plus a percentage of the trust principal. Various IRC sections imply that a 5% or greater economic interest is significant, but until the IRS provides clear guidance, uncertainty persists.

Charitable Deductions and Trust Taxation

When establishing an inter vivos HEET, there is no immediate income or gift-tax charitable deduction available. Similarly, assets funding a testamentary HEET do not qualify for an estate tax charitable deduction. An inter vivos HEET is often structured as a "grantor trust," allowing the grantor to claim an annual charitable income tax deduction for distributions made to charity. Since the grantor pays the tax on the HEET's income, the trust's growth is not reduced by income taxes. After the grantor's death, the HEET will be taxed as a complex trust and will file its own Form 1041, with the trust itself deducting income distributions to the charitable beneficiary. Trusts can deduct charitable contributions up to 100% of trust income, unlike individuals who are limited to a 50% of AGI ceiling.

Qualified Transfers and Creditor Protection

Qualified transfers include tuition payments to both domestic and foreign institutions, but not costs for books or room and board. To cover additional college expenses, grandparents may also fund IRC Section 529 plans. Qualifying medical expenses encompass a wide range of services, including hospital services, nursing care, medical laboratory, surgical, dental, and other diagnostic services, x-rays, medicine and drugs, artificial teeth and limbs, and ambulance services. Elective surgeries are not covered. HEETs can also provide medical and long-term care insurance for beneficiaries.

To maximize creditor protection, the trustee should have broad discretion to distribute among a class of beneficiaries. An independent trustee or co-trustee is preferred for optimal asset protection. The grantor and/or beneficiaries can have the power to remove and replace the independent trustee without adverse estate tax consequences, provided any successor trustee is not related or subordinate to the grantor or beneficiary exercising the removal power.

Practical Applications of HEETs

HEETs are often used in testamentary plans for assets exceeding the GST exemption. After allocating the GST exemption to a Dynasty Trust, a portion of the remaining estate could be allocated to a HEET. Those wishing to make a large charitable bequest might split the charitable portion of their estate between a family foundation and a HEET, with the foundation serving as the charitable beneficiary of the HEET. A direct bequest to charity has the advantage of avoiding estate taxes on assets passing to the HEET.

A HEET can also be named as the remainder beneficiary of a grantor retained annuity trust (GRAT) or a charitable lead annuity trust (CLAT). With a GRAT, GST exemption cannot be allocated until the end of the GRAT term, potentially subjecting the appreciation to GST taxes if the remainder beneficiaries are skip persons. A HEET as the remainder beneficiary eliminates the need for GST exemption. Similarly, with a CLAT, only the present value of the remainder interest is subject to transfer taxes, and a "zeroed-out" CLAT can result in a tax-free transfer. A HEET as the remainder beneficiary addresses GST exemption concerns.

Please note that this article is for informational purposes only and is not intended as legal or tax advice. Taxpayers should consult their own legal and tax advisors for advice specific to their situation.

Internal Revenue Service IRC Section 2503(e) IRC Section 529 Plans