Estate Planning in a Low Interest Rate Environment
A few weeks ago, we wrote about how the dramatic reduction in interest rates presented planning opportunities. Each month, the IRS announces the minimum interest rate required to be charged for loans in order to avoid a gift (known as the applicable federal rate). This rate is determined based upon Treasury Bill rates. As we wrote, the April 2020 applicable federal rates had fallen to rates not seen for many years.
Incredibly, the IRS has announced that the May and June 2020 rates are even lower than the April 2020 rates. For example, the May 2020 rate for loans of three years or less is only 0.25% and for loans of more than three years but not more than nine years is only 0.58%. Moreover, the June 2020 rate will be only 0.18% and 0.43%, respectively (The corresponding rates in March 2020 were 1.50% and 1.53%, respectively, and in April 2020 were 0.91% and 0.99%, respectively.)
Thus, May and June 2020 are an ideal time to consider the following techniques in order to transfer wealth to younger generations:
- +Making loans to family members or trusts for their benefit to permit the borrowers to invest the loan proceeds.
- +Selling assets to trusts in exchange for a promissory note (as discussed below).
- +Refinancing existing loans that were made at a much higher interest rate than the current applicable federal rate.
A grantor may sell assets to a trust in exchange for a promissory note. (As a rule of thumb, the trust should have assets equal to at least 10% of the value of the assets sold.) Typically, the promissory note provides for interest with the principal payable at the end of the loan term. Thus, the assets need to merely grow at a rate in excess of the applicable federal rate. Further, the grantor may allocate GST exemption to the assets transferred to the trust so that the trust may be a dynasty trust continuing on for generations transfer-tax free.
Moreover, the trust may be designed as a “grantor trust” so that the trust is treated the same as the grantor for federal income tax purposes. Thus, the grantor is taxed on all of the income and gains and transactions between the grantor and the trust do not cause gain recognition. Effectively, when the grantor pays the income tax on the trust’s income and gains, the grantor is making a “tax-free” gift to the trust, thereby increasing the potential to transfer wealth.
A grantor retained annuity trust or GRAT is a technique that allows the grantor to transfer substantial value to a trust with little (or no) immediate gift tax consequences by retaining the irrevocable right to receive a fixed annuity amount payable for a term of years (the “Annuity Payment”). The estate tax benefit of the GRAT is that any appreciation above the “Section 7520 Rate” on the assets transferred to the GRAT, passes to the remainder beneficiaries free of additional gift or estate taxes. The Section 7520 rate is calculated based upon 120% of the applicable federal rate for a nine-year loan discussed above. For May 2020, the Section 7520 rate is a mere 0.8% and for June is an even lower 0.6%. This means that, in order for the GRAT technique to be successful for a GRAT created in June, the earnings on the GRAT assets must only exceed 0.6%. This is the lowest Section 7520 rate in history.
The GRAT technique is particularly attractive when the value of assets has been depressed, assuming that there is an expectation of appreciation. Thus, the significant drop in stock prices over the last two months and the effect of current market conditions in valuing non-controlling interests in business entities, including family limited partnerships, may present opportunities to pass significant wealth. (Moreover, if the IRS were ever to successfully challenge the value of a business interest, the GRAT automatically adjusts the annuity amount without any adverse gift tax consequences.) Finally, even if the GRAT technique fails because the assets do not appreciate in value, the grantor will receive back all of the assets in satisfaction of the annuity payments without significant gift tax consequences.