Act Now to Save on Estate, Gift Taxes Before Interest Rates Rise

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Whether or not the Federal Reserve will actually raise interest rates before the end of the year is anyone’s guess, but with the central bank on the fence about an increase, now is the time to act to save on estate and gift taxes.

Federal Reserve Chair Janet Yellen was recently quoted as saying that she and her fellow Federal Open Market Committee members anticipate increasing interest rates later this year, followed by additional, gradual increases thereafter. Her remarks were quickly followed by other Fed officials expressing doubts about a rate hike. Ever since then, the media, investors, business leaders and professional organizations have been speculating about if and when rates will rise.

4 estate planning techniques

One thing’s for certain: low interest rates provide a fantastic opportunity to shift wealth to family members at minimal tax cost. If history is any indication, interest rates won’t stay low forever, so now is an optimal time to consider estate planning techniques to take advantage of currently low rates.

For various wealth transfer techniques, the taxable gift component, if any, is determined using current interest rates. If investment returns outpace these rates, you can transfer wealth to family members free of estate and gift tax.

For some techniques, the relevant interest rate is the applicable federal rate (AFR).  For others, it’s the so-called “7520 rate.” These rates are currently near all-time lows.

Below are four techniques that you should consider before rates begin to rise.

  1. Intra-family loans

Making loans is a simple, yet effective way of shifting wealth to family members. Generally, as long as the interest rate on the loan is at least equal to the AFR, the IRS will not treat the loan as a gift.

The appropriate AFR depends on the length of the loan. The short-term AFR (0.49% for November) applies to loans less than three years, the mid-term AFR (1.59%) applies to loans between three and nine years, and the long-term AFR (2.57%) applies to loans longer than nine years.

To avoid reclassification as a gift, the loan should be evidenced by a written promissory note, and the borrower should make any required interest and principal payments on time. If the borrowed funds are invested and generate a return in excess of the required interest payments, the borrower retains the excess return, free of any gift or estate tax.

  1. Grantor retained annuity trust

With a grantor retained annuity trust (GRAT), a senior family member (grantor) transfers assets to a trust, which pays him an annuity for a fixed number of years. The annuity can be structured to be the same amount each year or to increase by as much as 20% annually. After the GRAT makes all of the annuity payments, any property remaining in the GRAT passes to the beneficiaries, typically children, either outright or in further trust.

The creation of a GRAT constitutes a gift to the beneficiaries equal to the initial value of the trust assets, reduced by the present value of the annuity to be paid to the grantor. The most popular type of GRAT is the “zeroed-out” GRAT, for which the annuity is structured to produce no gift or only a nominal gift. The present value calculation is based, in part, upon the 7520 rate when the GRAT is created. Any income or appreciation on the trust assets in excess of the 7520 rate – currently, just 2.0% – passes, at the end of the annuity term, to the beneficiaries gift tax free.

  1. Charitable lead trust

With a charitable lead trust (CLT), a senior family member (grantor) transfers assets to a trust, and the trust pays an annuity to one or more charities for a fixed number of years. Alternatively, the CLT may be structured to last for the life of the grantor or for the joint lifetimes of the grantor and his spouse. At the end of the annuity term, the assets remaining in the trust pass to one or more non-charitable beneficiaries, typically children, either outright or in further trust.

When the grantor creates a CLT, he makes a gift equal to the present value of the remainder interest that will pass to the non-charitable beneficiaries. Like zeroing out a GRAT, a CLT can be structured so that the taxable gift will be small or nonexistent. The value of the remainder interest is calculated using the 7520 rate. For CLTs, the grantor may choose the lowest 7520 rate from the month in which he creates the CLT and the two preceding months. If, over the annuity term, the CLT generates returns higher than the chosen 7520 rate, the excess return passes to the non-charitable beneficiaries free of estate and gift tax.

A CLT may be structured as a “grantor trust” for income tax purposes, in which case the trust’s income is taxed to the grantor. With a grantor CLT, the grantor receives an income tax charitable deduction equal to the present value of the charity’s interest. Because the calculation of the deduction is based, in part, on the 7520 rate, the deduction is maximized when interest rates are low.

Alternatively, if the CLT is structured as a non-grantor trust, the grantor is not entitled to an income tax deduction; however, the CLT is responsible for paying its own income taxes, and the CLT receives a deduction for the annual amount paid to charity.

  1. Sale to intentionally defective grantor trust

In this wealth transfer technique, a senior family member (grantor) creates an irrevocable trust for the benefit of junior family members. The trust is structured to intentionally cause it to be treated as a grantor trust for income tax purposes. The grantor then sells the assets to the trust in exchange for an interest-only promissory note with a balloon payment due upon maturity.

The benefits of using a grantor trust are two-fold. First, the sale is ignored for income tax purposes. Therefore, no gain is recognized, and the interest payments on the note are not included in the grantor’s taxable income. Second, as the trust assets generate income, the grantor, rather than the trust, is responsible for paying any income taxes. Thus, the trust grows income tax free, while the grantor’s estate is reduced by the taxes he pays. This results in a transfer of wealth to the beneficiaries, but the IRS does not consider the transfer to be a taxable gift.

When the note matures, the trust must repay the principal by distributing cash or other assets back to the grantor. If the grantor dies before the note matures, the remaining value of the note is included in his estate for estate tax purposes. Either way, the trust assets, including all post-sale income and appreciation in excess of the interest payments, are not subject to estate tax.

Last chance for low interest rates?

The current low interest rate environment provides fertile ground for using the forgoing techniques to shift wealth to family members. Consider capitalizing on these techniques before rates start rising.

Contact me or another member of Kaufman Rossin’s estate and trust team for help with planning your estate and minimizing tax for your heirs.


John Anzivino, CPA, FICPA, AICPA, is a Estate & Trust Principal Emeritus at Kaufman Rossin, one of the Top 100 CPA and advisory firms in the U.S.

Scott Goldberger, JD, is a Estate & Trust Principal at Kaufman Rossin, one of the Top 100 CPA and advisory firms in the U.S.

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