Low Interest Rates Create Planning Opportunities

The IRS has issued a low deemed interest rate for intra-family transactions. For May they are assuming an unprecedented .8 percent rate of interest for these transactions, which may include family loans, grantor-retained annuity trusts (“GRATs”), and other similar methods to shift wealth to future generations.

Every month the IRS issues a “7520 Rate” (named after the section of the Internal Revenue Code to which it relates), also known as one of the “Applicable Federal Rates” or “AFR,” which are used as assumed rates of return to measure the values of gifts in certain advanced estate planning techniques. Many estate planning techniques succeed when assets transferred outperform the 7520 Rate or another federal rate such as the AFR, and, therefore, when the rates are low, there is more opportunity to beat the 7520 Rate. Some strategies to consider include creating or refinancing intra-family loans, selling assets to grantor trusts, or creating GRATs. We discuss those strategies in a short summary below, but please let us know if you would like to discuss any of these strategies in more depth.

Grantor Trusts

A grantor trust is one in which the person contributing assets to a trust is still deemed to be the owner for income tax purposes. An individual can sell or exchange personal assets with grantor trust assets without recognizing capital gains. This tax treatment gives the grantor enormous flexibility in dealing with trust assets. For example, if the grantor establishes a trust for the grantor’s children with certain assets that the grantor later wants back, the grantor can swap personal assets with trust assets of an equal value with no income tax, gift tax, or estate tax consequences.

The tax treatment also presents opportunities for creative estate tax planning. The grantor trust is particularly well suited to estate “freeze” techniques that limit the growth of a client’s estate. These techniques typically involve the sale of property by the grantor to the trust for consideration of an installment note with regular interest-only payments, then a balloon payment at the end of the note term. A promissory note may also be designed as “self-canceling,” that is, a note that terminates by its terms upon the grantor’s death or as a probate annuity. These types of notes are subject to numerous rules and constraints, which should be discussed with us.

The benefit of using installment notes is that the taxpayer may use the AFR as the note rate. If this rate is lower than the rate of growth (including income) from the transferred property, the taxpayer has effectively reduced the growth of his or her estate. Installment note sales are typically used for transfers of highly appreciating assets, assuming the property generates sufficient income to make the note payments or can be converted to cash in order to do so. The balloon payment may be made with a portion of the property transferred to the trust if cash is insufficient (with no tax consequences if the trust is a grantor trust, i.e., if the payment is made before the grantor’s death). For example, if the value of the property has doubled subsequent to the sale to the trust, only one-half of the property need be returned to the grantor for the balloon payment. If possible, the balloon payment should be made before the grantor’s death. The grantor will pay the tax on income generated by the trust assets, as if the trust were the grantor’s own revocable trust.

A drawback of using the installment note method is that the note, or the cash or property used to pay off the note, is included in the grantor’s estate. A second drawback is the uncertain income tax consequences if the grantor dies while the note is outstanding. A possible result is that the death will cause a stepped-up basis in the note but no change in the trust’s basis in the property.

GRATs

A GRAT is a vehicle used to transfer assets to children or grandchildren at a reduced gift tax cost. This technique is likely more successful when interest rates are low.

To create a GRAT, an individual contributes assets to an irrevocable trust under which he or she retains the right to a specified annuity payment for a fixed term of years. At the end of the term of years, the annuity payments to the individual end and the beneficiaries designated in the trust agreement receive the remaining trust assets. For gift tax purposes, upon contributing assets to the trust the value of the gift is equal to the actuarial value of the beneficiaries’ remainder interest in the trust assets. The gift made is usually substantially less than the assets’ current value. If the grantor survives the trust’s fixed term and the trust assets appreciate at a rate faster than the AFR that is in effect at the time the trust is funded, the “excess return” is shifted to the remainder beneficiaries free of gift tax at the end of the fixed term.

GRATs are usually scheduled to end well within an individual’s normal life expectancy because if the grantor does not survive the term of years, most, if not all, of the trust assets revert to his or her estate. The annuity amount may be fixed as a dollar amount or as a percentage of the value of the trust assets on the date they are transferred to the trust. The annuity amount must actually be paid to or for the grantor’s benefit; it is not sufficient that the grantor has the right to withdraw this amount from the trust. The annuity cannot be paid by means of a promissory note.

Charitable Lead Trust

A charitable lead trust (“CLT”) makes payments to charity as long as a person lives or for another specified period. At the end of that period, the property remaining in the trust is transferred to a noncharitable beneficiary. Generally, CLTs are used by wealthy individuals as a way to leave an inheritance to children that the children cannot use for a specified number of years.

Because payments are made to charity during those years, the donor is allowed to pass a portion of the inheritance to the children with a reduced estate tax. CLTs can make effective gifts in years that the donor is in a much higher income tax bracket than the donor is expected to be in the following year. CLTs work particularly well in periods of low interest rates.

Although not everyone will need to use techniques such as a GRAT or a CLT, the current situation presents opportunities to individuals of varying economic circumstances to address intra-family loans and wealth transfer that may not have been considered previously.

Review of Current Estate Planning Documents

The COVID-19 pandemic and its impacts have made clear the importance of an up-to-date estate plan. We are working daily to review and update or prepare important documents such as wills, trusts, durable powers of attorney, health care directives, and beneficiary designations for life insurance and retirement accounts. We are working with clients remotely, and they have been able to gain peace of mind by knowing they have up-to-date documents in place that capture their intent. We have also been able to assist clients in the execution of documents while complying with social distancing and safety restrictions. Please let us know if you would like us to review your estate planning documents.