ESTATE PLANNING IN A LOW-INTEREST RATE ENVIRONMENT
Certain estate planning techniques are particularly effective in low interest rate environments, where current market interest rates are a factor in valuing the gift for federal gift tax purposes, and low market interest rates can reduce the value of the gift and thus reduce the amount of gift tax exemption required to be used (preserving more exemption for future gifts or to be used at death to reduce the estate’s exposure to estate tax).
Loans
One simple technique is to make a loan to family members (e.g. children, grandchildren, or a trust for any of them) and take back a promissory note at the prevailing interest rate. So long as the interest rate is at the prevailing rate reported monthly by the IRS, there is no gift to the family members. As the lender, you will get the amount loaned returned to you when the loan comes due, plus a return at today’s low rates. Your family members will be able to invest the funds at quite-possibly higher returns than the interest paid, and these earnings (less the interest paid) will belong to the family members, free of any gift or estate tax.
Grantor Retained Annuity Trust
Another option is to fund a grantor retained annuity trust (GRAT), which is an irrevocable trust that can result in the transfer of significant wealth to beneficiaries with no gift or estate tax. The GRAT provides that the grantor retains the right to receive annual fixed payments for a specified term of years. At the end of the term of years, the donor’s interest in the GRAT ends, and any remaining funds are held for the benefit of the donor’s chosen beneficiaries. The trust document specifies the amount of the annual payments retained by the donor, which we can compute to represent, on a present value basis, the full value of the assets that were contributed to the trust, meaning the present value of the remainder interest is zero, and no gift tax is due. In a low interest rate environment, smaller payments are required to return all value to the grantor, while higher interest rates would require larger payments in order to return all value to the grantor.
For example, if you contribute $100,000 to a two-year GRAT, and if the required IRS interest factor for the month of your contribution is 1.2% percent (which is the rate for April 2020), we know that if the trust directs that $50,901 will be paid to you at the end of year 1 and again at the end of year 2, the present value of your retained payments is $100,000 and the present value of any remaining assets at the end of year 2 is zero. So for gift tax purposes, the value of the gift to be reported to the IRS is zero. Of course if the trust actually earns exactly 1.2% percent during the two years, there will be nothing left to pass to your beneficiaries at the end of year 2. But if the trust can outperform the required IRS interest factor, there will in fact be funds remaining in the trust at the end of year 2 to pass to your beneficiaries, free of any gift tax. In a low interest rate environment, investment returns for assets in the GRAT can more easily outpace the IRS-specified interest rate.
Sale to Grantor Trust
A technique similar to funding a GRAT is for a donor to sell assets to a trust for the benefit of beneficiaries, and take back an interest-bearing promissory note that requires the trust to make payments to the donor in installments over a term of years. Like with a GRAT, the donor retains the present value of the assets transferred (in the form of the promissory note), plus an interest factor at prevailing rates, so that there is no gift; and the trust for beneficiaries ends up (after making the required note payments) with any growth in the value of the asset beyond the required interest factor.
One advantage over a GRAT is that the minimum required interest rate for the note (known as the “applicable federal rate,” it varies depending on whether the note is short term, midterm, or long term, and whether interest compounds annually, quarterly, or monthly) is usually less than the IRS interest factor for a GRAT (125% of the average federal midterm rate over the prior three years). So outperforming the stated rate can be easier with a sale.
Perhaps the main disadvantage of the sale technique is that the tax law and IRS have not explicitly accepted its validity. Indeed the IRS has argued in some cases that the donor’s retained interest was not a fixed debt instrument but instead an equity interest in the trust’s assets. To counter that argument, most practitioners advise that, prior to the sale, the trust should have assets equal to at least 10% of the value of the assets that will be sold, so that at least 10% of the amount due under the promissory note can come from assets other than the assets sold. It is recommended that the donor transfer the initial assets to the trust at least one tax year prior to the intended sale.
The trust is structured as a “grantor trust,” so that during the donor’s lifetime he or she is considered the owner of the trust for income tax purposes. This has the result that the sale of assets to the trust does not give rise to capital gains tax, and the trust’s payment of interest to the donor is not taxable. And if trust assets are sold to third parties during the donor’s life, the donor will be responsible for paying the capital gains tax rather than the trust, this preserving more assets for the trust beneficiaries.
Charitable Lead Annuity Trust
A charitable lead annuity trust (CLAT) is quite similar to a GRAT, except one or more charities receives annuity payments from the GRAT for a term of years, rather than the grantor retaining such payments. After the trust term ends, the remaining trust property (i.e., any outperformance in assets above the IRS-specified interest rate) passes to the donor’s beneficiaries free of any gift or estate tax. Also, if the CLAT is structured so that the donor is taxed on trust income, the donor receive an up-front income tax charitable deduction for the gift of the annuity interest. Like with a GRAT, the lower the IRS interest rate, the more effective this technique can be.