Interest rates are at a historic low, creating an array of estate planning opportunities for the forward-thinking client. Additionally, the financial markets have experienced significant declines due to the current pandemic. Proactive wealth transfer planning in today’s economic environment can lock in substantial benefits and tax savings for future generations.
Intra-family loans are often used as an estate planning strategy to benefit family members by allowing for financing at below-market rates. The minimum interest rate required to avoid gift tax consequences is the Applicable Federal Rate (AFR), which is published monthly by the IRS. The current AFR for an intra-family loan compounded annually is 0.25 percent, 0.58 percent or 1.15 percent, depending on the duration of the loan. If you have a promissory note in place as a result of a loan between family members or entities, the current low interest rates provide the opportunity to reduce the required annual payments through a note refinancing. For example, if a note was issued as a 9-year note in May 2017, the AFR would have been 2.04 percent. The rate for May 2020 is 0.58 percent. On a US$1 million loan, a refinancing would reduce the annual payment from US$20,400 to US$5,800, and given the appropriate circumstances, the interest payment can be forgiven as part of an annual exclusion gift. Refinancing the note would therefore shift more value to the borrower, and reduce the lender’s taxable estate.
Sale to grantor trust
Another estate-planning strategy to take advantage of low interest rates is to sell assets to a grantor trust. In a typical transaction, the grantor sells assets to a grantor trust (with no income or loss recognition) in full or partial exchange for a promissory note. The value of the assets are “frozen” as of the date of the sale. If the assets sold to the trust generate income at a rate greater than the loan interest rate, the additional appreciation shifts to the benefit of the trust beneficiaries. Given the current low interest rates, significant estate and gift tax savings can be achieved by a seller-financed sale to a grantor trust.
For sales that have taken place in prior years, a loan refinancing in today’s environment would effectively allow for a gift tax free transfer of value to the trust beneficiaries by lowering the annual payments that are required to be made by the trust to the grantor. For example, assume a US$10 million promissory note that was issued in May 2017 for a duration of 9 years in a sale to a grantor trust. Again, May 2017 had a 2.04 percent AFR resulting in annual interest payments of US$204,000. If the note is refinanced in May 2020, the annual interest payment can be reduced to US$58,000. Lower interest payments result in the grantor receiving lower annual payments as well as the grantor holding a less valuable note—both of these results reduce the grantor’s taxable estate.
Establishing a Grantor Retained Annuity Trust (GRAT) is an especially effective strategy to transfer assets to the next generation while minimizing estate and gift tax consequences. When creating a GRAT, the Grantor transfers to the GRAT assets that are expected to appreciate over the duration of the GRAT term (a GRAT term typically ranges from two to five years) in exchange for an annuity. The annuity amount is computed based on: (i) the initial value of the transferred assets; and (ii) the Internal Revenue Code Section 7520 rate (published monthly by the IRS). The Section 7520 rate for May 2020 is 0.8 percent (as compared to the May 2017 rate of 2.4 percent). If the assets transferred to a properly structured “zeroed-out” GRAT appreciate more than the applicable Section 7520 rate and the Grantor outlives the term of the GRAT, all excess appreciation is then transferred to the beneficiaries of the GRAT at the end of the GRAT term, without estate or gift tax consequences.
Gifting assets with depressed values
Assets which currently have a low valuation, but are expected to appreciate, can be transferred to the next generation using trusts. Although the transfer will utilize a portion of the transferor’s gift tax exemption, this amount is based on the current valuation on the date of the transfer. Once the asset is transferred to a separate individual or entity, the appreciation that the asset accrues is no longer taxable to the transferor’s estate. Assets such as marketable securities that have significantly declined during this period should be gifted now to take advantage of the low values.
Actions to consider
Those interested in exploring the possibility of capitalizing on the historically low rates and values in the current economic environment may want to:
- Review their prior loan and sale transactions to determine how a note refinancing may confer tax benefits; and
- Consider gifting and/or selling assets that have declined in value but are expected to appreciate in the long term to trusts for the benefit of intended beneficiaries.
Please feel free to contact us if you would like to discuss estate planning strategies for your assets.