Introduction
The favorable tax treatment provided by the Tax Cuts and Jobs Act, combined with historically low interest rates during the COVID-19 pandemic, has resulted in tremendous wealth transfer planning opportunities.
Increased Lifetime Exemption
In December 2017, the Tax Cuts and Jobs Act (“TCJA”) was signed into law. The TCJA made substantial changes to the federal gift and estate tax landscape. Prior to the TCJA, an individual could transfer, during life and at death, $5 million (as adjusted for inflation for years after 2011) free from gift and estate tax. The TCJA doubled the lifetime gift and estate tax exemption (the “lifetime exemption”) from $5 million to $10 million (as adjusted for inflation for years after 2011). As of 2020, an individual can now transfer $11.58 million (or $23.16 million for a married couple) free from gift and estate tax.
The lifetime exemption for 2020 is the highest it has ever been. In comparison, in the year 2000, the lifetime exemption was only $675,000. Now is a unique time to transfer wealth and take advantage of the large lifetime exemption. The benefits of the TCJA, however, do have an expiration date. On Jan. 1, 2026, the lifetime exemption will revert back to $5 million (as adjusted for inflation for years after 2011), if the TCJA is not repealed earlier by a change in the law.
Furthermore, for individuals who utilize their entire $11.58 million lifetime exemption, the IRS has issued regulations that ensure the benefit of the higher lifetime exemption will not be retroactively eliminated when the lifetime exemption reverts back to $5 million.[i]
Low Interest Rates
In addition to the benefits of the higher lifetime exemption afforded by the TCJA, the economic downturn has presented further wealth transfer planning opportunities. Every month, the IRS issues an Applicable Federal Rate (“AFR” or “AFRs”). The AFR is determined from the average of market yields from certain government debt obligations. When that yield drops, so does the AFR. The AFR is often a critical component of wealth transfer strategies, as it creates a threshold interest rate that must be charged for private loans. In connection with the AFR, the IRS also issues a Section 7520 rate. Under the Internal Revenue Code, the Section 7520 rate is 120% of the midterm AFR. The relevance of the Section 7520 rate is that it is the interest rate that must be used to value life estates, remainder interests or interests for a term of years.
For May 2020, the short-term AFR (zero to three years) is 0.25%, the midterm AFR (more than three to nine years) is 0.58% and the long-term AFR (more than nine years) is 1.15%. In addition, the Section 7520 rate for May 2020 is 0.80%. The May 2020 AFRs and Section 7520 rate are some of the lowest ever published. The combination of the historically low rates and an all-time high lifetime exemption presents a variety of wealth transfer planning opportunities.
Wealth transfer strategies that may be beneficial during this time include (i) low-interest intra-family loans, (ii) refinancing intra-family loans, (iii) sales to grantor trusts, (iv) grantor retained annuity trusts (“GRATs”) and (v) charitable lead annuity trusts (“CLATs”).
Intra-family Loans
An intra-family loan may be a valuable way to provide liquidity to the next generation. The lending family member will have the ability to determine repayment terms, including interest rate, loan duration, timing of payments, and whether payments consist of both interest and principal or are interest only with the balance due at maturity. If an intra-family loan is utilized, the loan must charge, at a minimum, the AFR. The failure to charge a minimum interest rate at the AFR would result in adverse gift tax consequences. However, the AFR is typically a much lower rate than that charged by a commercial lender.
If an individual makes a nine-year loan to a family member or to a trust in May 2020, the minimum interest rate he or she will be required to charge on the loan is only 0.58%. However, notwithstanding the historically low AFR, due to the large lifetime exemption, it may make more sense to make a gift instead of a loan.
One of the biggest advantages of an intra-family loan is the arbitrage. If the borrower, by means of the loan, acquires assets that will produce income and appreciation exceeding a rate of return equal to the interest rate charged on the loan, such excess would accrue to the benefit of the borrower without gift or estate tax implications.
Refinancing Intra-family Loans
If an individual currently has an intra-family loan outstanding, either to a family member or to a trust, May 2020 is an optimal time to refinance the loan to take advantage of the historically low AFR. For example, an outstanding intra-family loan originated in May 2000 with interest charged at the long-term AFR of 6.20% can be refinanced in May 2020 into a new loan arrangement with a long-term AFR of 1.15%. The refinance occurs with the borrower renegotiating the existing loan to be payable with a new loan. The substantially reduced interest rate would provide a great benefit to the borrower. To provide consideration to the lender for the borrower’s lower interest rate, the borrower should make a down payment of the outstanding principal amount, shorten the maturity date, pledge additional collateral or provide some other additional benefit to the lender under the terms of the new loan arrangement.
Sales to Grantor Trusts
A sale to a grantor trust is a more advanced way to utilize an intra-family loan. Under this scenario, an individual creates (or maybe has already created) a trust for his or her children and grandchildren (if desired, the trust creator’s spouse can also be a beneficiary of the trust). The trust is treated as a “grantor trust,” meaning that the creating individual is responsible for any ongoing income tax obligations of the trust. The trust creator then sells an asset (such as a partial interest in a closely held business) to the trust in exchange for a promissory note. An asset sold to the trust in May 2020 in exchange for a nine-year promissory note would only need to charge interest at a rate of 0.58%. If a closely held business interest is sold to the trust, and the business interest sold has combined income and appreciation exceeding the rate of interest charged on the note, such excess will accrue to the benefit of the trust without any gift or estate tax implications. Furthermore, since the trust is structured as a grantor trust, the sale to the trust as well as the interest payments made to the trust creator from the trust would not result in any taxable income.
Generally, in order to sell an asset, such as a partial interest in a closely held business, to a trust in exchange for a promissory note, the trust should be “seeded” prior to the sale. With the incredibly large lifetime exemption of $11.58 million for 2020, an individual could leverage his or her lifetime exemption and gift a partial interest in a closely held business worth $11.58 million to the trust, followed by a sale to that trust of a partial interest in the closely held business worth $115.80 million (total transfer to the trust equals $127.38 million).[ii] If the $115.80 million loan was structured as a nine-year obligation, the interest charged on the loan in May 2020 would be only 0.58%. The historically low AFR combined with the all-time high lifetime exemption provides for this extraordinary wealth transfer opportunity.
Grantor Retained Annuity Trusts
The implementation of a GRAT is another wealth transfer planning strategy that is beneficial in a low-interest-rate environment. A GRAT is somewhat similar to the sale to a grantor trust; however, instead of selling assets to a trust in exchange for a note, an individual transfers assets to a trust in exchange for an annuity for a specified number of years. At the end of the specified annuity term, the GRAT will terminate and the assets remaining in the trust will pass to the GRAT remainder beneficiaries (either outright or in further trust).
The initial transfer of assets to a GRAT creates a taxable gift equal to the value of the remainder interest passing to the GRAT beneficiaries at the end of the annuity term. The value of the remainder interest depends on the amount transferred, the duration and value of the annuity, and the Section 7520 rate. Often, the annuity is structured so that the value of the remainder interest is “zeroed out” and there is no taxable gift (or a very low taxable gift). This is referred to as a zeroed-out GRAT. The GRAT is zeroed out because the annuity payments that the trust creator receives from the GRAT equal the amount of assets that he or she contributes to the GRAT plus a rate of return, that is equal to the Section 7520 rate. A zeroed-out GRAT is successful when the income and appreciation from the assets contributed to the GRAT grow at a rate higher than the Section 7520 rate because such excess will transfer to the GRAT remainder beneficiaries free from gift and estate tax implications. If a GRAT is established in May 2020, the assets contributed to the GRAT need to exceed only a 0.80% rate of return for the GRAT to be successful. If the assets do not appreciate at a rate that exceeds the Section 7520 rate, then all of the GRAT assets revert back to the trust creator as if nothing ever happened.
Not only is a GRAT a favorable strategy in the current low-interest-rate environment but also the existing market conditions make a GRAT appealing. During the current market upheaval, the value of certain asset classes have moved to lower territory. Some of these losses have partially recovered, and based on historical figures, remaining losses could recover in the next two or three years.
Funding a GRAT in May 2020 with marketable securities will be successful if the income and appreciation from the securities have a rate of return that exceeds the May 2020 Section 7520 rate of 0.80%. This appears to be a good bet. Additionally, if marketable securities are used to fund a GRAT, the need for an expensive appraisal will be avoided. With the historically low AFR and the current market conditions, the implementation of a GRAT is a great wealth transfer planning opportunity.
Charitable Lead Annuity Trusts
If an individual is charitably inclined, a CLAT would be an effective wealth transfer planning opportunity. Similar to a GRAT, annuity payments are made during the term of the CLAT. However, instead of the trust creator being the recipient of the annuity payments, the annuity payments are made to a charitable beneficiary of the trust creator’s choice. Any assets contributed to the CLAT with income and appreciation exceeding a rate of return equal to the Section 7520 rate (0.80% for May 2020) pass to the CLAT remainder beneficiaries (who are usually individual family members) following the end of the annuity term, free from gift and estate tax implications. Furthermore, depending on the structure of the CLAT, the trust creator may be entitled to a charitable income tax deduction upon its creation.
Conclusion
The combination of an all-time high lifetime exemption and a historically low AFR and Section 7520 rate has presented estate planning lawyers and their clients with several very favorable wealth transfer strategies to consider.
[i] Treas. Reg. § 20.2010-1(c).
[ii] For married couples, the gift and sale amounts can be doubled.
