It’s hard to look anywhere these days without seeing something about interest rates or inflation. All of us know that inflation hovers at a forty-year high and we feel that impact every time we go to the grocery store or gas pump. While these represent direct ways that interest rates impact us, interest rates have an indirect impact on Estate Planning practitioners as well. Many advanced Estate Planning techniques derive their value from the prevailing interest rate. Certain techniques work best in a low-interest rate environment, while others produce better results in a high-interest rate environment. This first part of a two-part series will examine which techniques work best in a low-interest rate environment. The second part will detail which techniques work best in a high-interest rate environment.
As the opening paragraph indicated, the techniques that we recommend need to change based on the prevailing interest rate. To fully understand the impact that interest rates have on Estate Planning, it’s important to understand a bit about interest rates. Each month, the Internal Revenue Service publishes the Applicable Federal Rate (“AFR”) under Internal Revenue Code §1274 for short-term loans (0-3 years), mid-term loans (3-9 years), and long-term loans (more than 9 years) along with the §7520 rate which is 120% of the mid-term AFR rounded to the nearest 2/10ths. Practitioners use the §7520 rate to calculate annual payments for certain estate planning techniques. Use of the appropriate AFR on a loan between related parties prevents imputed income or gift taxes. Note that if the IRS considers the loan a gift, the lender/donor still may apply their annual per donee exclusion (currently $16,000) to the gift as well as using any portion of their applicable exclusion amount (currently $12.06 million) to cover the gift. Use of the appropriate AFR prevents use of the annual per donee exclusion or applicable exclusion amount.
Planning during periods of low-interest rates often involves a lending strategy used to leverage the interest rates and transfer wealth with little or no gift tax. Parents or grandparents may make loans to children, grandchildren, or any other related party at the appropriate AFR for the desired loan term. This allows the younger generation to invest the loan proceeds and if the investment produces returns that exceed the AFR, the borrower keeps that excess value free of gift tax consequences. The borrower may use the funds for anything, such as purchasing a home or starting a business. If the lender feels generous, or simply wanted to gift the funds, but lacked sufficient applicable exclusion amount, the lender could forgive up to the annual per donee exclusion amount each year, reducing or eliminating entirely, the amount returned to the lender. Of course, if the lender had sufficient applicable exclusion amount, then they could forgive the loan at any time. In the right situation, the intra-family loan benefits both the lender and the borrower.
Similar to the intra-family loan, a sale to an Intentionally Defective Grantor Trust (“IDGT”) presents another great technique for use in a low-interest rate environment. Here, the grantor sells a highly appreciating asset to the IDGT. The grantor creates the IDGT and funds it with “seed money,” usually at least 10% of the value of the asset which the grantor intends to sell to the IDGT. The IDGT purchases the asset with a note. The IDGT then uses income received from the appreciating asset to make the interest payments on the note. The IDGT qualifies as a “grantor trust,” which means the lender/grantor reports the income and capital gains incurred by the trust on his or her individual tax return. This allows the assets to grow inside the IDGT on a tax-free basis. In addition, any appreciation of the assets above the AFR accrues to the beneficiaries free of gift tax.
A Grantor Retained Annuity Trust (“GRAT”), much like the sale to IDGT, allows for the transfer of significant assets to beneficiaries with little or no gift or estate tax consequences. The grantor establishes the trust and funds it with assets expected to appreciate. The grantor receives annuity payments for the GRAT term. The total value of all annuity payments will equal (or exceed) the initial value of the asset plus interest based on the §7520 rate. A lower §7520 rate means a lower bar for success. If the GRAT was structured as a zeroed-out GRAT, then any assets or appreciation remaining in the trust at the end of the GRAT term passes to the beneficiaries free of gift tax. Even if the assets in the GRAT fail to outperform the §7520 rate, the grantor suffers no adverse tax consequences.
The final technique that works well in a low-interest rate environment, the Charitable Lead Annuity Trust (“CLAT”) resembles the GRAT, except the Trust makes the annuity payments to a charity rather than the grantor. This entitles the grantor to a charitable deduction for the projected actuarial percentage passing to charity. The grantor makes a gift of the assets projected to pass to the non-charitable beneficiaries at the end of the CLAT term. Like the GRAT, the drafting attorney may structure both the CLAT to “zero-out” meaning that the grantor will incur no gift tax upon creation of the entity. Like a GRAT, a CLAT works best in a low-interest rate environment because any investment performance above the §7520 rate passes tax free to the beneficiary or beneficiaries at the end of the trust’s term. The lower the rate, the larger the potential tax-free transfer.
Many of the above techniques worked great in recent years while the interest rates were historically low. Some strategies like Tenancy in Common Fractionalization and Family Limited Partnerships or Family Limited Liability Companies do not depend upon rates at all. This makes these techniques important regardless of interest rates. In light of the recent rise in interest rates, the next part of the series will examine techniques like a Charitable Remainder Annuity Trust (“CRAT”) and a Qualified Personal Residence Trust (“QPRT”) that work best with higher interest rates.
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