Gideon Rothschild, Esq., partner, now retired, with the New York City law firm Moses & Singer LLP. He is a past chair of the Real Property Trust & Estate Law Section of the American Bar Association. MosesSinger.com/gideon-rothschild
Every month, the Internal Revenue Service issues its “Applicable Federal Rates” for the following month. These rates are a key component in many estate-planning strategies. As a general rule, lower rates provide for significant opportunities to shift wealth to junior generations. The Applicable Federal Rates have been approaching historic lows recently. The rate for a long-term loan (more than nine years to maturity) is a mere 1.86% for October!
What do these low interest rates mean for you? It means that now may be the time to…
By way of brief background, a grantor retained annuity trust (or “GRAT”) is a statutorily sanctioned type of trust whereby the grantor transfers property in trust but retains the right to receive payments from the trust for a predetermined period of years. Most commonly, the payments are structured such that, after accounting for a federally mandated rate of return on the property transferred into the GRAT (called the “§7520 Rate” and based on the Applicable Federal Rates for the month in question), the present value of the payments will equal the value of the property transferred into the GRAT. When the annuity payments are structured in this manner, the GRAT is often referred to as being “zeroed-out” because the remainder interest has no value for gift tax purposes—thus, no gift tax is payable and no gift tax exemption is used in connection with the funding of the GRAT. To the extent that the investment return on the GRAT property exceeds the §7520 Rate, value will remain in the trust after all annuity payments are made, thereby effecting a tax-free gift of the excess return.1 The §7520 Rate for October is just 1.8%. Accordingly, to the extent that an investment return in excess of 1.8% is achieved, there will be a tax-free transfer of assets to the ultimate beneficiaries of the GRAT (typically the grantor’s spouse and/or children).
As a result of the low interest rates, it’s also a good time to loan money to younger family members. To the extent that the loan recipients are able to invest the borrowed funds and generate a return greater than the minimum interest rate, wealth will have been successfully transferred without any gift tax.
By way of example, if a loan of $1 million were made to a child for 10 years at 1.8% and the child invests the proceeds in an investment earning 5% after taxes, the excess after 10 years of $433,593 will have been transferred to the child gift- tax-free.
Instead of making loans directly to family members, another option is to make loans to a “grantor trust” for their benefit. A grantor trust is a type of trust in which all income is taxable to the grantor individually. This in effect permits additional “gifts” to the beneficiaries (in an amount equal to the income tax) without the grantor being considered to have made any further taxable gifts. Furthermore, a trust can be structured to be generation-skipping exempt, which means that the assets can benefit not only the child’s generation but also more remote descendants without any further wealth transfer tax. The assets will also remain protected from creditors and possible divorce claims.
Similarly, it may also be appropriate to sell assets to a grantor trust in exchange for a promissory note. Again, assuming the assets that are sold to the trust appreciate at a rate that exceeds the Applicable Federal Rate, wealth will be passed on to the next generation without the imposition of a gift tax.
If you currently hold an outstanding promissory note from a family member or grantor trust that has an interest rate higher than current interest rates, it may be possible to refinance that note now for a longer term and a lower rate.
1Note, however, that the grantor’s death during the annuity payment period will cause all of the GRAT property to be included in the grantor’s estate for tax purposes.