Current interest rates, which remain near historic lows, present several income, estate and gift tax planning opportunities. A number of estate planning techniques, including a grantor retained annuity trust (“GRAT”), an intra-family loan, an installment sale of a closely-held family business interest and a charitable lead annuity trust (“CLAT”), are more beneficial during periods of low interest rates.
A GRAT remains a viable estate planning technique
A GRAT allows the transfer of property with appreciation potential to an irrevocable trust whereby the grantor retains the right to receive a fixed annual annuity payable for a term. At the end of the annuity term, the trust property passes to the trust’s beneficiaries. If the grantor survives the term, the value of the trust assets are not included in the grantor’s gross estate for estate tax purposes.
The IRS requires the use of published interest rates to value the annuity and remainder interests. Under Section 7520 of the Internal Revenue Code, the IRS uses a rate based on 120 percent of the Mid-Term Applicable Federal Rate (“AFR”) to discount the value of an annuity, an income interest for life or a term of years, or a remainder or reversionary interest in a trust to present value (the “7520 Rate”). The 7520 Rate (which varies from month to month) for June, 2016 is 1.8%. When the value of the trust property transferred to a GRAT appreciates at a rate exceeding the 7520 Rate the grantor will have successfully passed wealth to the GRAT’s beneficiaries outside the transfer tax system.
The transfer of the property to the GRAT is a gift for gift tax purposes to the extent that the initial value of the trust property exceeds the present value of the grantor’s retained annuity interest for the month the GRAT is created. A “Walton” GRAT is a technique that effectively permits the grantor to “zero-out” the gift to the GRAT. This technique is often used when a grantor has fully utilized his or her lifetime gift tax exemption.
The Department of the Treasury’s Green Book for Fiscal Year 2017, which provides explanations of the President’s budget proposals, attempts to impose some downside risk in the use of a GRAT. For example, a proposal would require that a GRAT have a minimum term of ten years and a maximum term of the life expectancy of the annuitant plus ten years. The administration has long targeted GRATs, and it is important that the legislative landscape be monitored in this regard to ensure the GRAT remains a viable estate planning technique.
Intra-family loans remain attractive planning tools
Consideration should also be given to the making or renegotiation of existing intra-family loans. Utilizing the current low interest rates in connection with an intra-family loan, a borrower can effectively retain the earnings on the borrowed funds which exceed the interest due on the debt.
Note that in order to avoid assessment of “imputed income,” the Code requires that the borrower pay interest on the loan. In order to avoid imputed interest on an intra-family loan, interest must be paid at the AFR. In June, 2016, the AFR for Short-Term Loans (3 years or less) is .64%; 1.41% for a Mid-Term Loan (greater than 3 years but less than 9 years); and 2.24% for Long-Term Loans (greater than 9 years). A demand loan which is payable in full at any time on demand of the lender typically requires an interest rate equal to the Short-Term AFR, compounded semiannually, for the period during which the loan is outstanding.
Consider an installment sale of a closely-held family business interest
Another estate planning technique which can afford a significant opportunity to transfer wealth outside the transfer tax system involves the sale of a closely-held business or family partnership which has appreciation potential to a family member under an installment sale. The sale is generally made in exchange for a promissory note which bears interest over a term of years at the current AFR. In many instances, the note requires an annual interest payment with a balloon payment due at the end of the term.
This technique effectively permits the seller to “freeze” the value of the asset sold at the balance due under the promissory note. Future appreciation in the asset’s fair market value above the note and interest due is not includable in the seller’s taxable estate. This technique works especially well when a low interest rate environment coincides with favorably low valuation of the business or family partnership – either due to current market conditions or a temporary decrease in fair market value. In addition, when an installment sale is made pursuant to a transaction involving a grantor trust, capital gains tax on the interest sold can be avoided and if the trust is properly structured, the future appreciation in value occurs outside the transfer tax system.
Charitable planning opportunities exist
For individuals who are charitably inclined, a CLAT can also perform well in a low interest rate environment. Under the terms of a CLAT, a charity receives annuity payments for a stated term. At the end of the trust term, the property remaining in the CLAT passes to one or more non-charitable beneficiaries (typically the children of the donor). Note that there are Generation-Skipping Transfer Tax implications if the non-charitable beneficiaries of a CLAT include grandchildren of the donor.
The annuity amount is valued by assuming that the charity’s interest will earn a rate equal to the 7520 Rate for the month the donor establishes the CLAT. If the growth of the trust property outpaces the 7520 Rate, the growth inures to the benefit of the trust’s remainder beneficiaries outside of the donor’s taxable estate.
Donors can obtain significant tax benefits utilizing a CLAT, including an upfront income tax deduction if the CLAT is structured as a “grantor trust” and the gift and estate tax laws allow a deduction for the actuarial value of the annuity interest committed to charity.