Commencement speaker Robert Smith surprised the graduating seniors at Morehouse College in May when he announced that he would pay off all of their student loans. What are the tax implications of this magnanimous gesture?

Potential gift taxes

The value of Smith's gift has been estimated at $40 million, for some 400 graduating seniors, about $100,000 each. A simple transfer of $100,000 in cash to each student to retire the debt would create 400 taxable gifts for Smith. Each gift would be eligible for the $15,000 gift tax annual exclusion, which eliminates gift tax on $6 million. If Smith has made no other taxable gifts during his life, he has an $11.4 million federal gift tax exemption to use. The net taxable gift then comes to $22.6 million, which triggers a gift tax bill of $9.04 million.

Interestingly, the payment of someone's college tuition is exempt from federal gift tax when the payment is made directly to the education institution. The payoff of student loan debt is not similarly exempt, even if the loan proceeds were used to pay tuition.

Given the gift tax bite, a direct payment to the students seems an unlikely way to structure this gift. A better choice for Smith would be to make an restricted gift of $40 million to Morehouse College, and take a $40 million income tax deduction for the contribution. Morehouse, in turn, could apply the proceeds to retire the student debt.

Income tax potential

A direct gift to the students would not be taxable income for them. However, the forgiveness of their loans does create dollar-for-dollar taxable income. Many of the students are likely to be subject to the "kiddie tax," which was simplified in 2017. That means that they could face a tax rate of 37% on the amounts in excess of $10,000. In the aggregate, their income tax liability might approach $15 million, if the forgiveness happened all in one year.

No details on the structure of the gift have been released at this writing. However, this case shows that tax considerations are as important in philanthropy as they are in business and investment planning.

(June 2019)
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