Low Interest Rates, Depressed Markets Present Estate Planning Opportunities  

We have all watched in dismay over the last several weeks as the coronavirus pandemic has wreaked havoc on our lives and the financial markets. Attempting to mitigate the economic downturn, the Federal Reserve has reduced interest rates to historic lows.  

Although, right now, your mind surely is on your health and portfolio, as it should be, we encourage you to direct a bit of your attention to one silver lining – techniques to minimize estate and gift taxes have never looked more attractive.  

Role of asset values and interest rates on estate planning

When it comes to investing, we all know the goal is to “buy low, sell high.” A similar concept applies in estate planning. When you transfer assets to family members, or to trusts for their benefit, you essentially “freeze” the value of those assets for estate and gift tax purposes.  

If the assets appreciate in value after being transferred, the appreciation generally escapes estate or gift tax, and your heirs benefit. Accordingly, if you transfer assets to family members when values are depressed, usually there is greater potential for a tax–free wealth transfer. 

For various wealth transfer techniques, the gift component, if any, is determined using current interest rates – specifically, the applicable federal rate (AFR) or the 7520 rate. For April 2020, the rates will be at or near all-time lows. If, going forward, investment returns outpace these rates, you can potentially transfer wealth to family members free of estate and gift tax. 

The following are some techniques that you should consider in the current environment. 

Gifts to family members and trusts

Gifts to family members and trusts continue to be popular, simple ways of sheltering future appreciation from estate and gift tax.  You can leverage gifts by using an “intentionally defective grantor trust” (IDGT). With an IDGT, as the trust assets generate taxable income, the grantor who created the trust, rather than the trust itself, 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 an additional wealth transfer to the trust’s beneficiaries, but the IRS does not consider the transfer to be a taxable gift. 

Whether or not the trust is structured as an IDGT, you can incorporate so-called dynasty trust provisions, allowing the trust to continue for the benefit of grandchildren and more remote descendants after your children pass away.  In fact, the trust can continue for as long as state law permits – in Florida, up to 360 years.  

Moreover, if you allocate generation-skipping transfer (GST) tax exemption to your gifts to the trust, the trust assets, including any future appreciation and income, will be free from estate tax for subsequent generations of beneficiaries. 

There is another reason to consider making substantial gifts now, unrelated to the current state of the markets. Although, currently, the estate, gift and GST tax exemptions are each $11.58 million per individual, the exemptions are scheduled, in 2026, to revert to between $6 million and $7  million each (the exact amount will be based on inflation adjustments). And, depending on the outcome of this November’s elections, a reduction of the exemptions could be voted into law even sooner.  

While we can’t predict what changes a new Congress or President may bring, you may want to get ahead of any changes by making large gifts now. The IRS has clarified that it won’t claw back gifts when or if the exemptions are reduced (either in 2026 or at any other time). Therefore, if the exemptions revert to lower levels, those who have not made large tax-free gifts will have missed an important opportunity. 

Intra-family loans

Making loans is another simple, yet effective way of shifting wealth to family members. Generally, if 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 (0.91% for April 2020) applies to loans less than three years, the mid-term AFR (0.99%) applies to loans between three and nine years, and the long-term AFR (1.44%) 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 estate or gift tax. 

Grantor retained annuity trust

With a grantor retained annuity trust (GRAT), a senior family member (the grantor) transfers assets to a trust, which pays him an annuity for a fixed number of years. After the GRAT makes the annuity payments, any property remaining in the GRAT passes to the beneficiaries, typically the grantor’s 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 (1.2% for April 2020) when the GRAT is created. Any income or appreciation on the trust assets in excess of the 7520 rate passes, at the end of the annuity term, to the beneficiaries gift and estate tax free. 

Sale to intentionally defective grantor trust

With this wealth transfer technique, the grantor sells assets to an IDGT in exchange for a promissory note, typically structured as interest-only with a balloon payment due upon maturity. The benefits of using an IDGT 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 discussed above, the grantor, rather than the trust, is responsible for paying any income taxes on trust’s earnings, allowing the trust to grow income tax free.  

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 or gift tax. 

Charitable lead trust

With a charitable lead trust (CLT), the grantor transfers assets to a trust, and the trust pays an annuity to one or more charities for a fixed number of years, or for the life or lives 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 the grantor’s children, either outright or in further trust. 

The value of the remainder interest is calculated using the 7520 rate from the month the CLT is created (or, if the grantor elects, either of the two preceding months). If, over the annuity term, the CLT generates returns higher than the 7520 rate, the excess return passes to the non-charitable beneficiaries free of estate and gift tax. 

A CLT may be structured to generate an income tax charitable deduction for the grantor in the year of its creation. The deduction is maximized when the 7520 rate is low. Each year, the grantor would be responsible for paying income taxes on the CLT’s earnings. 

Alternatively, the CLT can be structured to pay its own income taxes and to receive an annual deduction for the amount it pays to charity. In that case, the grantor would not be entitled to a deduction on his personal return. 

Now is the time

The current state of the financial markets, low interest rates and favorable transfer tax laws provide the perfect opportunity to use the forgoing techniques to shift wealth to family members at minimal estate and gift tax cost. Consider capitalizing on these techniques before the markets rebound, rates start rising and transfer tax exemptions are substantially reduced. 

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.