Morehouse College’s graduating class got quite the surprise over the weekend, when their commencement speaker promised to pay off their outstanding student loans. But students aren’t totally out of the woods yet—they could still be liable for potentially thousands of dollars in taxes on their newly canceled debts.
The potential tax hit from billionaire Robert F. Smith’s pledge depends on how the transfer is structured, tax practitioners said. Smith, founder of Vista Equity Partners, vowed to pay an estimated $40 million for about 400 graduating seniors. In his remarks May 19 in Atlanta, Smith said the money would be made as a grant from his family.
“It’s a great idea, but the devil is in the details,” said Francine Lipman, a law professor at the University of Nevada Las Vegas.
Smith hasn’t explained how the gift will be structured. His announcement reverberated across higher education. It is said to be the largest gift ever made to a historically black college or university, according to the Chronicle of Higher Education. Vista Equity Partners didn’t return a request for comment.
Making a Charitable Donation
Lipman laid out one possible plan that could bring a tax break for Smith. If he donates the $40 million directly to Morehouse, he would be able to receive a tax deduction.
The school could then figure out exactly how much each student owes, and transfer the money to them. But taking that route could mean that the money would be considered income for the students, some of whom are likely still categorized as dependents for tax purposes. The money could potentially be taxed at a rate as high as 37%, the current rate on trusts, Lipman said.
“I’m sure Mr. Smith has fantastic lawyers and great CPAs, and the university is going to want to work with them to achieve a really good outcome for everyone,” Lipman said.
The “kiddie tax rate” was meant to deter rich parents from making generational transfers to children and lowering their tax bills. The New York Times recently reported that an error in the 2017 tax law means that rate is now applying to nontuition assistance for students. Lawmakers have introduced measures to fix the error, but only as it applies to survivor benefits for some military families.
Giving a Gift
If Smith passes on pursuing a charitable deduction, another route could mean he gives the money directly to the Morehouse students.
Recipients of a gift generally don’t owe income tax, according to tax code Section 102, because it is money that has already been subject to taxes in the hands of the donor, said Alexander Reid, a partner at Morgan Lewis & Bockius LLP. But the payments could also be treated as taxable income, because under Section 108, the students would be personally enriched by the canceled debt and thus must pay income tax, Reid said.
“Right now we don’t know for sure because we don’t have any details. Nobody knows for sure—except perhaps Mr. Smith and Morehouse!” Dorothy A. Brown, a law professor at Emory University School of Law, said in an email May 20.
Taxpayers “must report the canceled debt on your tax return for the year the cancellation occurs,” the Internal Revenue Service said on its website. But the agency also flags “amounts canceled as gifts, bequests, devises, or inheritances” as exceptions to the rule.
Taxes for Smith?
Smith could also face a tax consequence for his generosity. Smith has a net worth of $4.5 billion on the Bloomberg Billionaires Index, and is the richest black person in the U.S.
“Paying someone’s tuition as a gift is not subject to gift tax, but I don’t think paying off college loans would qualify for that exclusion,” said Lawrence A. Zelenak, a professor of law at Duke Law.
One potential workaround: Individuals can give a gift of up to $15,000 tax-free in 2019. Smith could structure the his loan payments in a way that would allow the gift tax exclusion to cover most of the money, Zelenak said.
“If he paid off the loans all at once, the exclusion wouldn’t cover the bulk of most of the gifts,” Zelenak said in an email. “But if he just made the loan payments as they became due, the exclusion would cover most or all of the payments.”