This article is part of an expanded web version of “Tuition Magicians”, which appears in the January edition of CFO magazine.

With the cost of a college education soaring, more grandparents are volunteering to help pay for their grandchildren’s college tuitions. In fact, a widely-referenced survey sponsored by AIG SunAmerica Mutual Funds revealed that, out of 1,000 grandparents polled in 2003, more than 54 percent plan to contribute to their grandchildren’s college education. Twenty percent said they intend to pay 75 percent of the cost, while one-quarter expect to chip in between 25 percent and 50 percent.

What’s more, grandparents can count on the Internal Revenue Service to help keep the full value of their largesse intact as long as they’re alive. The IRS allows any taxpayer to transfer tuition money directly to a school for the benefit of a student without incurring a tax on the transaction. Unfortunately, if a grandparent dies before the payment is made, the rules change. Any assets distributed from a grandparent’s estate or trust that are transferred to a grandchild may be subject to estate taxes. The legacy could also be subject to a transfer-tax known as a generation-skipping tax (GST) that can run as high as 45 percent of the transfer amount.

Since the GST doesn’t kick in on the first $2 million transferred to grandchildren, however, it usually affects only taxpayers in the higher brackets. But the estates of wealthier grandparents—including funds set aside for educational expenses—could be significantly reduced by the GST. To cope with that situation, they might want to consider installing a health and education exclusion trust (HEET), says Virgilia Bryant of PricewaterhouseCoopers’ Private Company Services division.

If structured properly, a HEET takes advantage of the IRS’s tuition gift-tax exclusion and, by extension, avoids the GST, says Bryant. However, counsels Bryant, to garner the tax break, grandparents must be willing to give up some money to charity. That means that along with grandchildren and great-grandchildren, the trust must also name a qualified charity as one of its beneficiaries.

By structuring the HEET so a charity is able to receive disbursements, a grandparent can make sure that a grandchild, or “skip person,” will never be the only beneficiary of the trust. (A skip person is someone that’s two or more generations removed from the original grantor.) That’s important, because the IRS won’t exempt trusts from the GST if only skip persons are named as beneficiaries. Further, although there’s no bright-line tax rule to follow, the charity must have a “meaningful interest” in the income and principle of the trust to avoid being taxed separately, or viewed as a tax dodge.

Any asset can be transferred to a HEET, but all disbursements must be in cash. Also, the initial transfer of cash into a HEET may be taxable. One way around that is if the grantor is living, the transfer could take advantage of each person’s $12,000 annual gift tax exclusion—and again, by extension, the GST tax exclusion.

Cash disbursed from a HEET is somewhat restricted, too—it can only be used for tuition. But tax-qualified tuition payments can be for any level of schooling or formal instruction, says Bryant. That includes pre-school, undergraduate and graduate programs, and technical and vocational training. The student can be enrolled part-time or full-time, and can attend programs in the United States or overseas. Qualified medical expenses can also be paid with HEET disbursements made directly to the provider.

Some families use HEETs to supplement state-sponsored 529 Plans, the college- savings vehicles that allow after-tax dollars to accumulate tax-free. While HEETs can only be used for tuition and qualified medical expenses, 529 Plans disbursements can be used to pay for tuition, plus room and board, books, computers, and other qualified college fees and expenses.

Still, HEETs aren’t for everybody. Bryant explains that they’re complicated structures that require time, money, and expertise to set up. Nevertheless, as an estate-planning tool, they may grandparents help their grandchildren make the grade.