With interest rates still low there are substantial wealth transfer opportunities available for parents, grandparents and others who wish to transfer assets to the next generation or beyond and, in the process, minimize or eliminate transfer taxes, whether they be gift or estate taxes. Current economic conditions have resulted in depressed asset values, but when combined with the attractive growth shielding tools discussed in this article, now is the time to be calling your estate planning attorney. As Steven Leimberg, a nationally recognized estate planner, wrote in his April 2009 newsletter, estate planners are witnessing a “rare convergence” of events favorable to their clients. These events include depressed value of assets, low AFR rates, and significant valuation discount techniques. As with many issues surrounding tax-centered estate planning, however, these factors are vulnerable to economic and legislative change. It is therefore important to take advantage of these opportunities while they are available.
The Applicable Federal Rates (“AFR”), established by the Internal Revenue Service (“IRS”), have a substantial impact on various gift and estate planning strategies. Each month the IRS determines the interest rate which must be used to measure the present value of annuities, income interests, and remainder interests for gift tax purposes. This is known as the “Section 7520 rate”. Low AFR rates are particularly beneficial to certain gift and estate tax planning strategies, and thus create opportunities for transferring assets to the next generation without or with less gift and estate tax consequences. This article discusses strategies for realizing these benefits.
Intra-Family Loans
An example of an intra-family loan is when a parent loans money to a child and the child issues the parent a promissory note evidencing the loan. The then applicable AFR rate is the minimum interest rate the parent must charge on such a loan to avoid potential gift tax problems. Another example is a similarly structured loan from a grandparent to a grandchild. However, with respect to the intra-family loans, it is important that the payments required under the note actually be paid to the lender. Moreover, any forgiveness of debt by the lender will constitute a gift to the borrower, which could lead to gift or income tax consequences.
Generally, the loan proceeds are invested by the borrower with the expectation that the return on those invested assets will be greater than the interest rate on the promissory note. Thus, the net effect of such a loan should be that the future appreciation of the invested assets in excess of the interest rate on the promissory note will go to the borrower as a tax-free gift.
One would ask why would a parent or other relative charge interest on such a loan to a family member. If the interest rate is not at least based on the minimum AFR rate, then the lender is actually making a gift of the foregone interest.
Loan to Grantor Trust
A loan by a parent, for example, to an irrevocable trust that the parent established is also very effective. However, such a trust should have some other assets to repay the loan that is made to the trust. Otherwise, the IRS might contend that the lender retained an interest in the trust for estate tax purposes.
If it is a “grantor trust,” it will provide even greater benefits. If the trust is properly drafted and administered, the trust assets will not be subject to estate taxes upon the death of the grantor. Additionally, because of grantor trust status, all the net taxable income of the trust is reported by the grantor on his or her own personal income tax return. This results in the trust being able to grow faster since the income taxes attributable to the trust taxable income are paid by the grantor and not by the trust.
From an income tax point of view, it’s as if the grantor made the loan to himself. The intra-family loan to the grantor trust should have no income tax consequences since the interest is not taxable to the grantor. The tax laws do not treat the income tax payment made by the grantor as an indirect gift to the trust. The promissory note from the trustee of the trust should use the minimum AFR rate.
Sale to Grantor Trust
Another type of intra-family loan involves the sale of appreciated assets to a grantor trust in exchange for a promissory note from the trustee of the trust using the minimum AFR rate (unless the lender wants a higher rate). Because of the grantor trust status, there is no income tax on the difference between the value of the asset sold to the trust and its cost basis. The payment of interest by the trust to the grantor has no income tax consequences. It is neither deductible by the trust nor treated as interest income by the grantor. With respect to this type of sale, it is very important, however, that the promissory note be paid in full to the grantor before his or her death. Otherwise, the non-recognized gain at the time of the original sale to the trust might be recognized in the event that the trust still has a debt to the grantor at the time of his or her death.
This type of sale can be leveraged if the sale involves a fractional interest in an asset rather than the entire asset. The value of a fractional interest in an asset should be less than its percentage value of the entire asset because a bona fide purchaser would insist on a discount for purchasing a fractional interest.
However, at the time of the sale to the trust, it is important that the trust have some other assets. Otherwise, there is a risk that the IRS might contend that the sale is not based on a bona fide installment sale, but rather a transfer of assets to the trust with the grantor retaining an interest in the trust assets. If the Service prevails, then at the time of the grantor’s death, there may be an estate tax based on the then value of the trust assets.
Self-Canceling Installment Note
A Self-Canceling Installment Note (“SCIN”) is similar to a sale of an asset and payment by a note. However, if the selling party dies holding a regular note, the unpaid value of that note is considered an asset of the deceased seller’s estate for estate tax purposes. The use of a SCIN should avoid that result since the SCIN is automatically cancelled upon the seller’s death. However, there will be certain income tax consequences due to the cancellation of the note at the time of death. For the note to be properly structured and thus avoid possible gift tax issues, the SCIN must have a higher interest rate and/or additional principal added to the face amount of the note to compensate for the self-cancellation feature. A SCIN may work particularly well if the person issuing the note is not of good health. With interest rates low to start with, a higher interest rate used for the SCIN may not be significant.
Grantor Retained Annuity Trust
A Grantor Retained Annuity Trust (“GRAT”) provides an excellent opportunity for someone who wants to pass wealth to his or her next generation and minimize transfer taxes (e.g., gift or estate taxes). The GRAT is an irrevocable trust for a term of years to which the grantor makes a one-time transfer of property. The grantor retains the right to receive a fixed payment at least annually from the GRAT for the specified term of years. At the time of the transfer, the grantor makes a gift calculated on the present value of the remainder interest. At the end of the term of years, the trust property is distributed to or held for the benefit of the remainder persons named in the trust.
The grantor-beneficiary of the trust must outlive the term of years in order for the GRAT to remove the trust assets from the grantor’s estate. As with many of the techniques, the successful use of a GRAT calls for a balance of factors. The longer the term and the larger the annual payment, the lesser is the amount of the gift that reverts to the next generation. On the other hand, the longer the term, the greater is the risk that the grantor-beneficiary of the trust will predecease that term, in which case the then value of the GRAT is includable in the deceased grantor’s estate. However, if the grantor dies during the term of the GRAT, the estate of the deceased grantor is no worse off than if that grantor had never used the GRAT (except for the cost of having set up the GRAT).
The “present value of the remainder interest” is the value of the trust assets transferred to the trust reduced by the value of the annuity income retained by the grantor-beneficiary. A low AFR rate at the time of transfer results in a larger present value for the retained annuity which then reduces the present value of the gift of the remainder interest. A properly planned GRAT can minimize or even avoid gift tax consequences at the time of funding. These benefits can be leveraged if the grantor uses fractional interests to fund a GRAT.
The use of the GRAT, assuming the grantor survives the fixed term of years, permits all future growth and appreciation of the trust assets to avoid future gift and estate taxes. There are certainly other matters to discuss with respect to GRATs which are not necessarily affected by low interest rates, such as the concepts of a parallel, rolling or short term GRATs and zeroed-out GRATs.
A different version of the GRAT is a grantor retained unitrust (“GRUT”). Whereas the GRAT provides a fixed percentage payment to the grantor-beneficiary each year based on the original value of the asset contributed to the trust, a GRUT pays a fixed percentage based on the annual value of the trust assets. A low AFR rate does not affect the determination of the gift of the remainder interest and thus the AFR rate is not a factor with a GRUT.
Private Annuity
Private Annuities provide various tax advantages. In a typical transaction, a parent transfers property to his or her child and the child gives an unsecured promise to pay the parent a fixed amount of periodic income for life. To avoid a gift, it is important to structure the private annuity so that the value of the assets transferred to the child equals the present value of the annuity to be paid. With a lower AFR rate, the amount the child has to pay as an annuity to his/her parent is less. The private annuity is a good strategy where the parent has a short life expectancy. This is due to the fact that the Private Annuity automatically terminates upon the annuitant’s death. If the parent is deemed to be “terminally ill”, then the mortality component of the IRS valuation tables cannot be used to determine the present value of the annuity. A person is deemed to be terminally ill if there is at least a 50% probability that he/she will die within one year.
However, a Private Annuity certainly becomes disadvantageous if the annuitant lives beyond his or her lifetime since the payments must be made for the annuitant’s lifetime. Moreover, it is important to note that the payor of the Private Annuity does not get a tax deduction for any of the payments made, which would be the case if the transaction had instead involved a loan by the parent.
A previous advantage of a Private Annuity was the ability to transfer highly appreciated assets and be able to defer the taxable gain on that appreciation and allocate it over the various years during which the annuity payments were received. Unfortunately, in 2006, the IRS issued regulations which prohibit this income tax advantage.
Charitable Gift Annuities
An increasingly popular method of benefiting a charity, but with the donor receiving from the charity regular payments, is through a charitable gift annuity. Many charities offer these annuity opportunities. With a low AFR rate the potential income tax charitable deduction for the gift annuity will be less, but a lower AFR rate permits a higher portion of the annuity payments to be received income tax free. This would be particularly valuable to an individual who does not itemize his or her deductions.
Charitable Lead Trust (CLT)
A charitable lead trust (“CLT”) is a trust that pays income to a charity for a period of years after which the trust assets revert back to the grantor. If the CLT is established upon the grantor’s death, then the reversion would be to the individuals and/or trust designated to receive the trust assets upon the expiration of the time period. If the CLT is set up as a grantor trust, the grantor will be taxed on the trust income each year but will receive in the first year that the trust is funded a charitable deduction for the present value of the charity’s interest over the specified period of years. A low AFR rate results in a lower present value of the reversionary interest to the grantor or other beneficiaries and thus increases the grantor’s charitable deduction.
Using a non-grantor CLT, there is no initial charitable deduction, but the grantor is not taxed on the CLT income each year. Instead of the trust assets at the end of the term reverting to the grantor, the assets are distributed to named family members, other third persons, or trusts. The low AFR rate increases the present value of the charitable interest and thus reduces the value of the remainder interest for determining if there is (1) a gift subject to a gift tax (if the CLT was funded during the grantor’s lifetime) or (2) the value of the remainder interest subject to an estate tax (if the CLT was funded upon the grantor’s death). The most important advantage of the non-grantor CLT is that all of the appreciation in the value of the trust assets during the trust term will ultimately pass to the family members, other third persons or trusts without a gift or estate tax on such appreciation.
A non-grantor CLT is also most beneficial for an older grantor who wants to support a charity and/or reduce his or her estate taxes. A non-grantor CLT may be established at the time of the grantor’s death. With a low AFR rate, there is a larger estate tax charitable deduction, thus reducing estate taxes at his or her death. Note that the longer is the term of the lead trust, the greater is the estate tax charitable deduction. However, it also translates into the non-charitable beneficiaries having to wait much longer to receive the trust assets at the end of the CLT term. This would be particularly beneficial if the rate of the appreciation of the assets invested in the CLT is greater than the AFR initially used.
Charitable Remainder Interest In Personal Residence
An individual can make an outright gift of his personal residence to charity but retain a life estate to continue to use and occupy the personal residence during his or her lifetime. The residence may be the primary or secondary residence. When a low AFR rate is applied, the present value of the charity’s remainder interest is higher and thus the donor receives a larger income tax charitable deduction.
WHEN A LOW AFR IS DETRIMENTAL
Charitable Remainder Trust
A low AFR rate makes it more difficult to properly structure a charitable remainder trust (“CRT”). The typical CRT is funded by the grantor and provides for a fixed percentage payment each year to the grantor during the grantor’s lifetime or for a specific term of years. On the grantor’s death or the expiration of the term of years the CRT’s assets are distributed to charity. The grantor should get a partial income tax charitable deduction when he or she funds the CRT. Additionally, appreciated assets can be used to fund a CRT and the trust in turn can then sell the assets without any tax on the gain. If the payout rate to the beneficiary is greater than the income of the CRT, however, then some of that non-taxed gain will be considered distributed to the beneficiary for that year and thus taxable to the recipient as a capital gain.
A low AFR rate complicates the use of a CRT because it is more difficult to satisfy two of the code requirements for the CRT to be qualified. One requires that the remainder interest to the charity cannot be less than 10% of the initial value of the assets transferred to the trust. Second, the possibility for exhausting the CRT assets before the end of the CRT cannot be more than a 5% probability at the time the trust is funded. Despite these difficulties, there are certain ways to design a CRT to be able to satisfy these percentage requirements even when there is a low AFR rate applied.
Qualified Personal Residence Trust
A qualified personal residence trust (“QPRT”) generally involves an individual transferring his or her personal residence (either a primary or secondary residence) to a trust for a fixed term of years. The consequences are similar to that of a GRAT discussed above. If the grantor survives the term of years, then the residence in the QPRT is transferred to the designated beneficiaries. If the grantor does not survive the term of years, then the value of the residence is includable in his or her estate for estate tax purposes.
When the QPRT receives the residential property, a gift to the remainder beneficiary is deemed to have occurred. The value of that gift is based on the value of the retained right to occupy the residence by the grantor during the term of years, the applicable AFR rate, and also the age of the grantor. With a low AFR rate, the value of the retained right to occupy is lower, thus increasing the present value of the gifted remainder interest for gift tax purposes.
Nevertheless, the use of a QPRT can be an effective way to transfer a residence with a lower gift value then an outright gift of the property to that remainder beneficiary. This can be especially effective if the gift involves a fractional interest in the residential property.
If the grantor does not survive the term of years, as discussed above, there is a reversion to his estate. The reversion value is also a factor for determining the amount of the present value of the gift at the time the QPRT receives the residential property. The higher the value of the potential reversion interest, the lower is the present gift value. A low AFR rate does not affect the reversion value as much as the age of the grantor does. The older the grantor is, the higher is the reversion value. For an older grantor, a QPRT may still be an effective gifting vehicle even with a low AFR rate.
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