Rev. Rul. 72-2

Advice has been requested as to the Federal income tax consequences arising out of a tuition postponement plan established by a university.

The university established a tuition postponement plan to enable certain qualified students who could not otherwise afford the cost of securing a higher education the opportunity of attending the school. Under the plan a student may defer payment of part of his tuition plus a limited amount of other charges imposed by the university until his later working years. In return for the privilege of deferring these charges the student obligates himself to pay the university a percentage of his income each year for a period up to 35 years or at least until the amount deferred has been repaid. Payments are to be made on a semiannual basis beginning with the year after the student completes or discontinues his education.

The amount the student is required to pay each year is computed by applying to a repayment base, calculated by reference to his income, a percentage determined by the amount deferred with a specified minimum amount.

Each student participating in the plan is assigned to a repayment group composed of other students with similar payment terms. By applying the repayment on a group basis those members of the group who realize high incomes will repay larger amounts, while those who experience low incomes will repay relatively smaller amounts. The participant's obligation to make payments can therefore terminate before the expiration of the 35 year payment term if the payments by all members of the repayment group of which he is a member equal the amount deferred by all participants in the group plus interest and the participant has paid at least the amount he originally deferred without interest. In the event a participant has not repaid an amount equal to the principal of his deferred amount at the time of group termination, he is obligated to pay the unpaid balance plus interest, in equal installments over the remainder of his payment term.

A participant's obligation to make payments will also terminate before repayment of the required amount by his group if he repays 150 percent of the amount he originally deferred plus interest on that amount.

The university maintains a policy of insurance on the life of each participant in an amount equal to the balance in his account, the premiums on which are payable by the participant.

The plan provides that each payment to the university will be first applied to principal until such amount is paid in full and then to the payment of the life insurance premiums and the balance, if any, to the payment of interest. Payments not made when due accrue interest and payments thereafter received are applied to discharge the obligation to pay overdue installments with interest thereon, in the order of their maturity.

Question (1)

Will participants under the tuition postponement plan realize taxable income as a result of the deferral?

Answer

Section 61 of the Internal Revenue Code of 1954 defines gross income as all income from whatever source derived, except as specifically excluded. However, money received as a loan under ordinary circumstances does not come within the meaning of the term income and is not taxable for Federal income tax purposes. Under the tuition postponement plan the participant has an unconditional and legally enforceable obligation to make certain payments to the university. Therefore, the amount deferred represents a debt of the participant to the university, and he will not realize taxable income as a result of the deferral.

Question (2)

Will the method of allocating payments made to the university by each participant first to repayment of the deferred amount, then to insurance premiums with the balance, if any, allocated to interest, be accepted for Federal income tax purposes?

Answer

Section 163(a) of the Code provides there shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness. A loan can be so arranged that payments will be allocated to principal first and then to interest. In an arm's length agreement the parties have the right to earmark the payments by the debtor to principal. See Huntington-Redondo Company v. Commissioner, 36 B.T.A. 116 (1937), acquiescence, C.B. 1937-2, 14, George S. Groves v. Commissioner, 38 B.T.A. 727 (1938), acquiescence, C.B. 1939-1 (Part 1) 15. Therefore, the method of allocating the payments first to principal will be accepted for Federal income tax purposes. Also see Revenue Ruling 63-57, C.B. 1963-1, 103.

Question (3)

Are payments made to the university by the participant that are allocated to repayment of the deferred amount and to insurance premiums deductible?

Answer

Section 262 of the Code provides that no deduction shall be allowed except as otherwise expressly provided, for personal, living, or family expenses. Repayment of a principal amount of an indebtedness is not an allowable deduction. Life insurance premiums paid by reason of the indebtedness are not allowable deductions. Therefore, no deduction will be allowable for amounts paid by the participant that are allocated to repayment of the deferred amount and insurance premiums.

Question (4)

Will payments made to the university by the participant in excess of the amounts allocated to repayment of the deferred amount and to insurance premiums be treated as interest and deductible under section 163 of the Code?

Answer

Section 163(a) of the Code, and the regulations thereunder, provide that all interest paid or accrued within the taxable year on indebtedness shall be allowed as a deduction in computing taxable income. For income tax purposes, interest has been defined by the Supreme Court of the United States as the amount one has contracted to pay for the use of borrowed money, and as the compensation paid for the use or forbearance of money. See Old Colony Railroad Co. v. Commissioner, 284 U.S. 552 (1932), Ct. D. 456, C.B. XI-1, 274 (1932); Pearl E. Deputy, Administratrix, et. al. v. Pierre S. duPont, 308 U.S. 488 (1940), Ct. D. 1435, C.B. 1940-1, 118. It is not necessary that the lender charge as interest a percentage of the sum loaned. Interest, in order to be deductible need not be computed at a rigid stated rate. All that is required is that a sum definitely ascertainable be paid for the use of borrowed money, pursuant to the agreement of the lender and the borrower. See Kena, Inc. v. Commissioner, 44 B.T.A. 217 (1941). Therefore, the amounts paid by each participant in excess of the amount allocated to principal and insurance premiums is interest and deductible under the provisions of section 163(a) of the Code.

Question (5)

Will a participant be in receipt of taxable income on account of any payment made to the university by another participant in his repayment group?

Answer

The discharge of an obligation by a third party generally will result in income to the party whose obligation is satisfied. Under the tuition postponement plan each participant has an individual obligation to pay the university his deferred amount. However, no participant has a fixed obligation to pay the university interest on such deferred amount since it is possible in some instances due to various circumstances of payments by other members of the participant's repayment group that the amount an individual participant must repay to discharge his indebtedness will not include an interest charge. The obligation that each participant has to pay the university his deferred amount is an unconditional one and survives group termination. Therefore, since a payment made to the university by another participant in his repayment group will not relieve an individual participant of his obligation to the university for the deferred amount, the individual participant will not be in receipt of taxable income on account of such payment.