With all the uncertainty of our current times, it may not feel like the right time to make a substantial transfer of wealth. However, for individuals who are projected to have a large federally taxable estate and desire to gift assets to heirs, now may be exactly the right time. When interest rates are low, there are some really great planning techniques that should be considered. As of August 2020, interest rates aren’t just low, the rates the IRS uses to calculate minimum interest rates to apply to loans (AFR) and the discount rate applied to remainder interest and life estates (Section 7520 rate) are the lowest rates ever published. The August Section 7520 rate is just 0.4%; 2 years ago that same rate was 3.4%. The historically low rate leaves a lot of room for taxpayers to do some high impact planning.
Grantor Retained Annuity Trust
A Grantor Retained Annuity Trust (“GRAT”) is an irrevocable trust in which assets are transferred to and the grantor retains the right to receive an annuity payment for a specified term of years. The assets remaining at the end of the term are distributed to the remainder beneficiaries, usually the grantor’s children or grandchildren. The reason a GRAT is such a powerful planning technique when interest rates are low is because of the leverage it can provide. If the trust assets realize a return greater than the assumed rate (0.4% in August 2020), all of that appreciation is transferred to the beneficiary and is not included in the value of the gift. In addition, as long as the grantor survives for the term of the trust, the gifted assets are excluded from the grantor’s gross estate.
The key aspects of the GRAT are funding the trust with assets that are expected to appreciate or provide income that will fund the annuity payment to the grantor, determining the desired annuity payment amount and minimizing the gift tax impact of the transfer of the remainder interest to beneficiaries after the annuity term expires. The GRAT term is selected by the grantor but should be reasonable to provide the best opportunity for the grantor to survive the term and not have the assets pulled back into the grantor’s estate.
The following example of funding under the current Section 7520 rate (0.4% in August 2020) illustrates the importance of funding the trust with assets expected to appreciate:
A parent funds a GRAT with $1,000,000 of securities with a 5-year term and a grandchild is the remainder beneficiary. If the trust provides an annuity payment of 5% ($50,000 paid to grantor each year), the present value of the remainder interest is currently calculated to be $752,970. This is the amount of the taxable gift used against the grantor’s lifetime exemption on the transfer to the trust.
The key to making this beneficial is funding the trust with assets that will appreciate at a greater rate than 0.4%. If the assets in the trust only provide a 2% annual rate of return the actual amount projected available for the remaining trust beneficiary is $844,000 but if those same assets grow at 5% annually, there will be $1,000,000 remaining in the trust. The larger the difference between the Section 7520 rate and the actual return on the investments the better the outcome for wealth transfer. As long as the parent outlives the term of the GRAT, the trust assets and additional appreciation escape estate tax inclusion in the parent’s estate. This allows the grantor to lock in the value of the gift at funding, but provide for a potentially larger actual gift.
GRAT funding can also be useful for individuals that don’t want to use their lifetime exemption amount for gifts during their lifetime and for clients that have already exhausted their lifetime exemption. Assume the same GRAT funding above with a couple of minor changes:
The trust annuity payment increases to a $204,000 annual payment to the grantor. This reduces the present value of the remainder interest to zero. There is no gift tax exclusion amount used for this transfer. Assuming a 5% return as above, the remaining assets after the 5-year term are projected to be $150,000.
While a tax-free transfer of $150,000 may not seem like enough to bother with funding a trust and paying the annuity for 5 years, we can increase the funding amount to increase the benefit. Funding the trust with $10,000,000 in assets would result in $1,500,000 being transferred tax free at the end of the term. In addition, by naming a grandchild as the trust beneficiary, the assets will also be excluded from the next generation’s estate, which can facilitate an increased multi-generational wealth transfer.
Intentionally Defective Grantor Trusts
Another opportunity to consider is the transfer of a family business to a trust in order to freeze the value of the asset for estate tax purposes. This allows future growth in value to occur outside of the grantor’s estate while the grantor maintains some control over the assets. This technique, like the GRAT, can be especially advantageous right now given the low-interest rates. The basic premise of an Intentionally Defective Grantor Trust (“IDGT”) is that assets are moved outside of the grantor’s estate and the value of the gift is established. The grantor will pay tax on the trust income, but the appreciation in the asset is not included in the value of the gift and therefore doesn’t use more of the grantor’s lifetime exemption. The value ‘freeze’ happens when the asset is sold to the trust on an installment note and is used with the goal of shifting income and appreciation in excess of a favorable interest rate to the IDGT. Such a shift only occurs if the rate of return actually realized by the trust asset exceeds the interest on the installment note. That’s where the low-interest rate comes into play. The current long term rates applicable to an installment note, the Applicable Federal Rate (“AFR”) is only 1.12%.
Let’s look at an example that mirrors the GRAT example:
The grantor has a closely held business currently valued at $1,000,000. The business is sold to an IDGT on an installment sale basis. Assuming the term of the note is 10 years, annual note payments, based on an interest rate of 1.12%, are $106,000. At the end of the 10-year term, if the annual return of the assets in the trust has been 5%, the additional assets transferred to the trust beneficiary are valued at $290,000.
This type of sale only works if the business assets create sufficient liquidity inside the trust to make the required annual note payments.
Just 2 years ago the interest rate applied to this same installment sale scenario was 2.95%, which makes the current environment an excellent time to consider this type of wealth transfer. Under these lower rates, the value transferred tax free is double what it was in 2018.
Not all high impact planning needs to be complicated. With historically low-interest rates we’ve all heard we should refinance our mortgage but there are other loan strategies to consider as well. Related party loans are an excellent tool for some families to transfer wealth and retain some control. In order for loans to family members to avoid gift tax treatment, there must be interest charged, and the minimum rate is the AFR rate discussed above (August 2020 rate 1.12%). A parent can make a loan to their adult child at 1.12% and save the child significant interest they might otherwise have to pay to a non-related lender. In addition, the parent can forgive principal amounts of the loan each year using annual gift exclusion amounts (currently $15,000/year per recipient). Many families like to use loans as a wealth transfer planning strategy as it allows the parent to decide each year how much loan forgiveness they want to provide and provides peace of mind for families that like to maintain some control. Also, for families already using these loans as a planning tool now is an excellent time to consider a ‘refinance’ of those loans at this new lower rate.
These rates change monthly. We may not have the opportunity to utilize them for long, which makes now the perfect time to consider your planning options.
These strategies provide a unique opportunity to transfer significant wealth more tax efficiently than at any other time. If you are interested in exploring any of them, please contact your Aldrich advisor. We can provide you with an analysis of the available options and help you determine which strategy may be most appropriate.
MEET THE EXPERT
Senior Tax Manager
Joylyn Ankeney, CPA
Aldrich CPAs + Advisors
Joylyn has been assisting clients with estate and trust planning and compliance since 1999. She focuses on helping her clients by providing tax planning strategies for families with a focus on wealth transfer planning. Her background working with charitable organizations helps her find creative solutions to help clients optimize their charitable goals. By regularly attending…
- Trusts and estates
- Charitable planning
- Strategic tax planning and compliance
- Wealth transfer strategies
- Certified Public Accountant serving high net worth individuals