Interest rates remain at record lows, and while many experts believe they’ll begin to rise soon, it’s likely they’ll rise slowly. So it’s an ideal time to implement estate planning strategies that are most effective in a low-interest-rate environment.
Make family loans
Lending money to a family member is a simple but highly effective estate planning strategy. Although the IRS often scrutinizes these transactions to be sure they’re not disguised gifts, careful planning will help you avoid an IRS challenge. It’s important to treat the loan just like an arm’s-length transaction between unrelated parties. That means charging interest at or higher than the applicable federal rate (AFR), executing a written promissory note and taking steps to collect the payments.
The key to using a family loan to minimize transfer taxes is for the borrower to invest the funds in assets that outperform the AFR, which is more likely to happen when interest rates are low. Consider this example: Paul lends $1 million to his daughter, Mary, at a time when the AFR for long-term loans (more than nine years) is 3%. The transaction calls for Mary to make interest-only payments (at 3%) for 10 years, followed by a balloon payment at the end of year 10. Mary invests the funds in a business that earns a return of 7% per year. After paying back the loan, Mary ends up with a windfall of nearly $553,000. In a sense, therefore, the loan allows Paul to make a tax-free gift.
Consider a GRAT
A grantor retained annuity trust (GRAT) is an irrevocable trust that pays you (the grantor) an annuity for a term of years, after which it distributes its remaining assets to your children or other beneficiaries. When you contribute assets to a GRAT, you’re deemed to have made a taxable gift to the beneficiaries equal to the projected value of their remainder interests. That value is calculated by taking the value of your contributions and subtracting the present value of your annuity payments. The higher the annuity payments and the longer the trust term, the lower the present value and, therefore, the lower the gift-tax value.
Present value is based on the Section 7520 rate, a conservative, assumed rate of return published monthly by the IRS. To the extent that the trust’s investment returns outperform the Sec. 7520 rate (and provided you survive the trust’s term), your beneficiaries receive a tax-free windfall. And considering the fact that the Sec. 7520 rate has been in the neighborhood of 2% in recent months, that’s a relatively easy target to beat.
Make an installment sale to an IDGT
An intentionally defective grantor trust (IDGT) is an irrevocable trust designed so that contributions are considered completed gifts for gift tax purposes even though the trust is deemed to be a “grantor trust” for income tax purposes. An installment sale of assets to an IDGT is a particularly attractive strategy for transferring a family business to your children or other heirs because it enables you to minimize gift and estate taxes while retaining control over the business during the trust term.
By structuring the transaction as an installment sale for fair market value, you avoid gift taxes on the transfer. And designing the IDGT as a grantor trust ensures that you pay income taxes on the trust’s earnings, in effect making an additional tax-free gift to the beneficiaries. In addition, as grantor, any payments you receive from the trust are tax-free as well.
Typically, the grantor makes a taxable gift of “seed money” to the IDGT — usually 10% of the sale price. This ensures that the trust has sufficient economic substance to make the purchase. The success of a sale to an IDGT depends on the business generating enough income to make the note payments, which is easier to do when interest rates are low.
Lock in low rates
The strategies described above can also be effective when interest rates are high, but they’re most powerful when rates are low. If you’re considering one of these techniques, act quickly to lock in the lowest rate possible.
Sidebar: Strategies for the charitably inclined
If philanthropy is one of your estate planning goals, certain charitable giving strategies are most effective in a low-interest-rate environment. For example, a charitable lead annuity trust (CLAT) works best when interest rates are low. A CLAT works in essentially the same way as a grantor retained annuity trust (GRAT): You contribute assets to an irrevocable trust that transfers any remaining assets to your children or other beneficiaries at the end of the trust term. But while a GRAT pays an annuity to you as grantor, a CLAT pays an annuity to the charity, or charities, of your choice.
Like a GRAT, a CLAT generates a tax-free gift to your beneficiaries, so long as the trust assets outperform the Section 7520 rate. In addition, contributions to a CLAT that are structured as a grantor trust are eligible for charitable income-tax deductions. However, keep in mind that, if a CLAT is a grantor trust, you pay taxes on the trust’s income. If a CLAT is designed as a nongrantor trust, you lose the upfront charitable income tax deduction, but the trust pays tax on its income and enjoys a charitable deduction for amounts paid out to charity.
