Wealth Transfer Strategies: Strike while interest rates are low
Estate, Gift, & Trust Planning
By Paul Karlitz ChFC®, CLU®, CLTC, LUTCF - Partner
Low interest rates create attractive opportunities to transfer wealth to younger generations in a tax-advantaged way. Shifting wealth may seem less urgent now that the federal gift and estate tax exemption and the generation-skipping transfer (GST) tax exemption amounts are both $11.58 million in 2020 ($23.16 million, effectively, for married couples). But these exemptions are scheduled to revert to previously lower levels in 2026 — or earlier if a new administration or Congress decides to reduce them sooner.
The future of federal transfer taxes and the fact that this is an election year suggest that you might want to consider gifting strategies that lock in current exemption amounts. Another advantage of acting now is that certain estate planning strategies benefit from the current low interest rate environment. We discuss several general strategies you might consider with your professional advisors.
A properly structured grantor retained annuity trust (GRAT) can be a powerful tool for transferring wealth to your loved ones with little or no taxes while continuing to enjoy an income stream for a period of years. It’s particularly effective if done when interest rates are low.
A GRAT is an irrevocable trust that pays you, as grantor, an annuity (a periodic fixed dollar amount) for a term of years and then distributes the remaining assets to your beneficiaries. When you transfer assets to a GRAT, the value of the gift to your beneficiaries is equal to the projected value of their remainder interests. Under IRS rules, that value is calculated by assuming the GRAT assets will grow at a certain rate of return — known as the “Section 7520” rate — regardless of their projected or actual growth rate. Assuming you survive the GRAT’s term, any appreciation in asset values beyond the Section 7520 rate (also known as the “hurdle” rate) is transferred to your beneficiaries free of gift and estate taxes.
The hurdle rate for a GRAT is the published Sec. 7520 rate for the month in which the GRAT is established. In recent months that rate has dropped to well under 1%. The lower the rate, the more likely the GRAT will outperform it and, therefore, the larger the potential tax-free gift. An additional benefit of a GRAT is that it’s considered a “grantor trust” — that is, you as grantor are treated as its owner for income tax purposes. By paying the trust’s income taxes, rather than having them come out of the trust’s earnings, you essentially make additional tax-free gifts to your beneficiaries. Note that, if the grantor dies during the GRAT term, the assets will be included in the grantor’s estate for estate tax purposes.
A charitable lead annuity trust (CLAT) works like a GRAT, except that the annuity payments are made to a charity rather than to you. Like a GRAT, a CLAT transfers assets remaining at the end of the trust term to your children or other noncharitable beneficiaries, and the value of the gift is determined in much the same way. So the lower the hurdle rate, the larger the potential tax-free gift.
The income tax treatment of a CLAT depends on whether it’s structured as a grantor or nongrantor trust. If it’s a grantor trust, you’re entitled to a charitable deduction up front based on the present value of the annuity payments. But this deduction is essentially recaptured in future years as you pay taxes on the CLAT’s income. For this reason, CLATs are typically structured as nongrantor trusts, in which the trusts themselves are taxed on their income but also enjoy deductions for the amounts paid to charity.
Loaning money to a family member is another possible option. To avoid future conflicts or misunderstandings — not to mention negative tax consequences — make sure you document these loans.
So long as your loan is structured carefully and you charge at least the applicable federal rate (AFR) of interest, it’ll generally be respected by the IRS. If your borrower earns a rate of return on the borrowed funds that’s higher than the AFR you charge, then the difference between those returns and the interest paid to you constitutes a tax-free gift.
An ideal time
Current conditions make it an ideal time to take advantage of GRATs, CLATs and intrafamily loans, but it’s important to act soon. If interest rates rebound, these strategies may become less effective.
Sidenote: Selling a business to an IDGT
Do you own a business? Selling it to a properly structured intentionally defective grantor trust (IDGT) for the benefit of the younger generation may enable you to retain control of the company while taking advantage of low interest rates. An IDGT is an irrevocable trust structured so that contributions are treated as completed gifts for gift tax purposes even though the trust is considered a grantor trust for income tax purposes.
So long as the transaction is structured as an installment sale for fair market value, transferring your business to the trust doesn’t trigger gift taxes. Typically, at least 10% of the sale price is provided as “seed” money to the IDGT. If your business generates a higher rate of return than the interest payments on the installment sale, that excess constitutes a tax-free transfer to the trust.
Securities and investment advisory services offered through qualified registered representatives of MML Investors Services, LLC,90 Park Ave. 17th Floor, New York, NY 10016, 212.536.6000. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Lenox Advisor, Inc., its employees, or representatives are not authorized to give legal or tax advice. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal tax or legal counsel. CRN202301-276478