Making Estate Planning Lemonade – Part II Opportunities in a Low Interest Rate Environment
We have previously discussed gifting as a way to make estate planning lemonade out of low asset value lemons.
Today's focus is on how the pandemic-related, historically-low interest rates – in addition to low asset values – create a perfect storm of estate and business planning opportunities.
How Low Can Interest Rates Go?
IRS Revenue Ruling 2020-9 recently released the applicable federal rates ("AFRs") (annual compounding shown below) and "Section 7520 rate" for April 2020:
Long-term AFR: 1.44%
Mid-term AFR: 0.99%
Short-term AFR: 0.91%
Section 7520 rate: 1.2%
Practically speaking, the AFRs are "safe harbor" minimum interest rates used for loans between related parties. The Section 7520 rate is the AFR for determining the present value of an annuity, a life interest for a term of years, or a remainder or reversionary interest.
Given these low federal interest rates and the long-term positive outlook for marketable securities and private ownership interests, it makes sense to review a few excellent estate and business planning opportunities. This is especially important in light of the high estate, lifetime gift, and generation-skipping transfer tax exemption available under current law ($11.58 million per person), which will remain in effect until the sooner of 2026 or an intervening change by Congress.
Grantor Retained Annuity Trusts
A grantor retained annuity trust ("GRAT") is an irrevocable trust to which a grantor gifts property and from which the grantor retains the right to receive annuity payments for a term of years. At the end of the term, the trust property passes to other beneficiaries (or trusts for their benefit). The annuity payments made to the grantor reduce the value of the gift of the remainder interest when the GRAT is established so that only the net present value of the remainder interest is subject to federal gift tax. The GRAT yields estate and gift tax savings if the grantor survives the term and the trust property generates a total net return (net income and appreciation) in excess of the Section 7520 rate (1.2% for April 2020).
Accordingly, gifting lower-value property now (e.g., marketable securities) to a longer-term (versus a shorter-term) GRAT could yield a return in excess of 1.2%, commonly known as the "hurdle rate." At the end of the term, assuming the grantor survives, the value of the GRAT property passing to the beneficiaries would exceed the net present value of the remainder interest reported for federal gift tax purposes upon creation of the GRAT. That excess amount would pass to the GRAT beneficiaries free of federal estate or gift tax.
Charitable Lead Annuity Trusts
The needs of tax-exempt charitable organizations are significant in light of the current pandemic. The charitable lead annuity trust ("CLAT") is a useful technique that – when interest rates are low – meets the grantor's current philanthropic goals and achieves an additional goal of transferring wealth to the non-charitable remainder beneficiaries free of estate and gift tax.
The CLAT is similar to a GRAT, except a charity, not the grantor, receives the annuity. The value of the annuity is determined based on the value of the property gifted to the CLAT and the 7520 rate at that time. At the end of the term, the appreciation in the value of the CLAT property in excess of the 7520 rate at the time of the gift passes to the CLAT beneficiaries free of federal estate or gift tax.
Sales to Grantor Trusts
A common closely-held business succession planning technique is the installment sale of discounted business interests to an irrevocable grantor trust in exchange for a promissory note. The trust is designed as a separate entity for federal estate and gift tax purposes, but the trust income is taxed to the grantor for income tax purposes. The AFRs typically used are the mid-term rate (loan term of nine years or less) (currently under 1%) and the long-term rate (loan term of more than nine years) (currently 1.44%). Post-sale appreciation in the value of transferred assets passes to the trust beneficiaries outside the grantor's taxable estate free of federal estate or gift tax.
Accordingly, sales to newly-established irrevocable grantor trusts using current AFRs or refinancing existing promissory notes are attractive estate and gift tax planning opportunities.
The historically-low interest rates also make new or refinanced intrafamily loans attractive. A senior generation family member can lend assets at a frozen value to junior family members at the appropriate AFR. Intrafamily loan payment terms must be honored as if the loan were between unrelated parties. If the assets appreciate in value significantly over the course of the intrafamily loan, then the return in excess of the "hurdle rate" benefits the junior family member borrower and is outside the senior family member lender's taxable estate.