Although the current uncertain environment may—understandably—cause many persons to hesitate to engage in a substantial family gifting program, these economic conditions, such as the current depressed financial markets and historically low interest rates, present a unique opportunity for families to pass a significant amount of wealth to younger generations with minimal transfer tax exposure. Clients should review their balance sheets and discuss with their attorneys and financial advisors the planning techniques described below to determine which techniques may provide the most viable opportunity for the client’s particular circumstances.
The primary goal of this article is to provide a high-level discussion of those estate planning techniques that present the greatest potential for upside when implemented during a state of declining financial markets combined with the historically low interest rates, including:
- Grantor Retained Annuity Trusts
- Sales to a Grantor Trust
- Intrafamily Loans
- Charitable Lead Trusts
- Generation-Skipping Transfer Tax Planning.
As a general reminder, in 2020, each individual has a combined federal estate and gift tax exemption of $11.58 million, and each married couple has a combined exemption of $23.16 million. Subject to annual inflation adjustments, this exemption will remain in place through 2025, after which time it will be reduced to approximately one-half of its value. Of course, the results of the 2020 elections and mounting federal deficits may result in an earlier and possibly more dramatic reduction in the exemption before that date.
The Applicable Federal Rate and the Section 7520 Rate
Each month, the IRS publishes certain market-based interest rates. These rates include the applicable federal rates (AFRs) and the Section 7520 rate.
For many estate planning techniques, the AFR for any given month is the lowest amount of interest that may be charged between related parties in a loan transaction without triggering imputed income or a gift. A different AFR applies depending on the term of the loan, with the short-term AFR applying to loan terms shorter than three years, the mid-term AFR applying to loan terms three years or longer but less than nine years, and the long-term AFR applying to loan terms that are nine years or longer.
The Section 7520 rate is the rate used to calculate annuity payments and the value of life estates and remainder interests for certain estate planning techniques, such as Grantor Retained Annuity Trusts (GRATs) or Charitable Lead Trusts (CLTs), discussed below.
On July16, 2020, the IRS released the AFRs and the Section 7520 rate for August 2020 (Rev. Rul. 2020-15). These rates represent historic lows, with the Section 7520 rate being 0.4 percent, and the long-term, mid-term, and short-term AFRs being set at 1.12 percent, 0.41 percent, and 0.17 percent, respectively.
By comparison, during the 2008-2009 financial crisis, the AFRs and Section 7520 rate reached their lowest point in February 2009, when the Section 7520 rate was 2.0 percent, and the long-term, mid-term, and short-term AFRs were 2.96 percent, 1.65 percent, and 0.60 percent, respectively.
For perspective, the bottom of the market during the 2008-2009 financial crisis occurred on March 9, 2009, with the Dow Jones Industrial Average (DJIA), the S&P 500, and the NASDAQ indices each closing at its lowest index value. The Section 7520 rate for March 2009 was 2.4 percent, and the long-term, mid-term, and short-term AFRs were 3.52 percent, 1.94 percent, and 0.72 percent, respectively.
If a grantor funded a GRAT on March 9, 2009, the grantor’s investments would need to appreciate above the 2.4 percent Section 7520 rate hurdle by the end of the GRAT term for it to be an effective estate planning tool. Though the GRAT’s specific investments needed to appreciate over the 2.4 percent hurdle, the above chart illustrates how a GRAT funded with $1 million that grew at the same rate as the DJIA would perform over various GRAT terms using the March 2009 Section 7520 rate. The two righthand columns illustrate the GRAT results if the March 2009 Section 7520 rate had been 0.4 percent (the August 2020 Section 7520 rate) instead.
In other words, a 10-year GRAT funded with $1 million of marketable securities that appreciated at the same rate as the DJIA would have repaid the grantor her $1 million, plus a 2.4 percent return, and transferred approximately $2,282,890.87 to the grantor’s children, or a trust for their benefit, with no estate or gift tax consequences. A thorough explanation of GRAT mechanics is discussed below, but the key point is that we are currently in an economic climate that allows for wealth planning transfers that have the potential for tremendous upside with very limited risk.
Overview of Estate Planning Structures
Grantor Retained Annuity Trusts
How It Works. A GRAT is an irrevocable trust to which the creator of the GRAT (the grantor) transfers assets and retains the right to receive fixed annuity payments from the trust for a specified number of years. The creation of a GRAT constitutes a taxable gift by the grantor to the remainder beneficiaries equal to the excess of the initial value of the contributed assets over the present value of the annuity payments to the grantor discounted by the Section 7520 rate. After the GRAT makes the required annuity payments for the pre-determined term of years, any property remaining in the GRAT passes to the designated beneficiaries (or to trusts for their benefit) free of federal estate and gift tax.
Tax and Non-Tax Considerations. A GRAT can be a highly effective wealth transfer option in a low-interest rate environment because of the greater potential for the GRAT’s assets to outperform the Section 7520 rate (also commonly known as the “hurdle rate”) in effect in the month the trust was created. To the extent the assets transferred to the GRAT—e.g., marketable securities or interests in commercial real estate or a closely-held business—reflect current depressed values and would generate an investment return in excess of the current GRAT hurdle rate (0.4 percent in August 2020), the larger the potential tax-free gift to the remainder beneficiaries.
The creation of a GRAT constitutes a taxable gift by the grantor to the remainder beneficiaries equal to the excess of the initial value of the contributed assets over the present value of the annuity payments to the grantor discounted by the Section 7520 rate. The duration of the GRAT and the percentage annuity retained by the grantor can be set so that the present value of the annuity payments retained by the grantor equals the value of the contributed assets to the GRAT, with the result that the remainder interest has a value of zero. The grantor of a “zeroed-out” GRAT makes no taxable gift and uses no gift tax exemption. So, if the GRAT assets do not appreciate beyond the 7520 hurdle rate, the grantor has not used any gift tax exemption, and the transaction is a wash. In some circumstances, it is preferable to design a GRAT so that the present value of the remainder interest of the GRAT at the creation is small (but not equal to zero) in order for the grantor to report the GRAT contribution on a federal gift tax return (Form 709). If properly reported, the statute of limitations will begin running and, thus, limit the time that the IRS has to audit the GRAT transaction.
Another advantage of a GRAT is that during the annuity period it is considered a “grantor trust” as to the grantor. This means that the grantor is considered the owner of the GRAT for income tax purposes and is taxed on all of the income. Payment of the income and capital gains taxes by the grantor is, in effect, a further tax-free gift to the remainder beneficiaries, because the assets can continue to grow during the annuity term without reduction for such income and capital gains tax payments.
The duration of the GRAT annuity period retained by the grantor is a very important consideration. If the grantor survives the annuity term, the property remaining in the GRAT will pass to the remainder beneficiaries, outright or in further trust, without the imposition of gift or estate tax (although there may be generation-skipping transfer tax consequences depending on the relation of the remainder beneficiaries to the grantor at the time of the distribution). However, if the grantor dies before the expiration of the annuity term, a portion or all of the GRAT assets will be included in the grantor’s estate for estate tax purposes. The longer the annuity term, the greater the risk that the grantor may die during that period, resulting in estate tax liability.
Generally, there are two philosophies to consider when determining the appropriate annuity term for the GRAT. First, to tighten the exposure during volatile markets as well as to limit the mortality risk of the grantor passing away during the GRAT term, it may be appropriate to use a shorter-term duration for the GRAT, such as two or three years. Alternatively, and particularly in historically low interest rate environments, longer-term GRATs, such as seven-year or ten-year GRATs, may be preferable because clients can lock in the low interest rates. Further, where GRATs perform better than expected during the initial years of the GRAT term, the grantor may choose to lock in the significant asset appreciation by purchasing the appreciated assets from the GRAT in order to hedge against losing those gains in later years. Another estate planning tool is to engage in “rolling” GRATs. Under this method, when the grantor receives an annuity payment from one GRAT, the grantor immediately uses that payment to fund a new GRAT.
Generally, the investment return on the assets contributed to a GRAT in the early years greatly affects the GRAT’s overall performance; therefore, it is important for clients to consult with their advisors regarding (1) whether there are assets that are suitable for use in a GRAT, (2) the right duration for the annuity period of a GRAT, and (3) the best investment strategies for the assets that are held in the GRAT. GRATs require revaluation of the trust property each year, so marketable securities are well-suited to use in a GRAT transaction.
Sales to Intentionally Defective Grantor Trust
How It Works. A sale of assets to an Intentionally Defective Grantor Trust (IDGT) can be another attractive tool when interest rates are low. An IDGT is an irrevocable trust, contributions to which are completed gifts for gift and estate tax purposes, but whose assets are treated as owned by the grantor for income tax purposes. Therefore, the grantor can sell assets that she owns to the trust without recognizing any capital gains because the transferor and the trust are considered the same for income tax purposes.
In a typical sale to an IDGT, the grantor sells an asset to the trust in exchange for a promissory note with interest calculated at the applicable AFR for the term of the note. Because the sale is for full and adequate consideration, the sale to the IDGT does not trigger any gift tax or use the gift tax exemption. This transaction is an “estate freeze” in the sense that the grantor now owns a promissory note equal to the fair market value of the assets sold to the trust. The assets in the trust and any future appreciation on those assets, however, are removed from the grantor’s estate for estate and gift tax purposes. The grantor pays the income tax generated on the trust assets, which is effectively an additional tax-free gift to the trust.
Tax and Non-Tax Considerations. From an income tax perspective, for the sale of assets to the IDGT to be free from capital gains tax and the interest payments on the note not to be considered taxable income to the grantor, the trust must be a “grantor trust” for income tax purposes. The grantor must be willing to pay the taxes on all income generated by the assets in the trust, including capital gains on the sale of trust assets. Because the sale transaction is disregarded for income tax purposes, one downside of the sale is that the IDGT’s income tax basis in the purchased assets will be the grantor’s basis before the sale. If the grantor chooses to “toggle off” grantor trust status during her lifetime, the grantor may recognize gain if the trust’s liabilities exceed the grantor’s basis in the assets. There is some ambiguity as to the income tax consequences at the grantor’s death if the grantor dies with the note outstanding, including recognition of gain and by whom.
Although by definition a sale is not a gift, it may be prudent to report the sale on a gift tax return (Form 709) filed by the grantor for the year in which the sale occurs. If the sale transaction is adequately disclosed on the gift tax return, the statute of limitations will begin to run, so that the IRS has a limited period within which to review the sale and make a determination as to whether the sale price reflected the fair market value of the assets on the date of the sale. Additionally, the assets should be appraised as of the date of the sale to establish the sale price, though the appraisal may be costly if the grantor is transferring closely held business interests or other hard-to-value assets.
If the grantor is creating a new IDGT to purchase assets, it is recommended that the grantor make a “seed” gift to the IDGT before the sale, so that the trust has sufficient assets to serve as security for the promissory note. This “seed” gift will use the grantor’s gift tax exemption, if available, or will incur gift tax if the grantor does not have any available exemption at the time of the “seed” gift. The IRS may take the position that a trust purchasing assets for a note without security is not a sale for full and adequate consideration and recharacterize the sale as a gift.
The grantor should also consider her cash flow needs before engaging in this type of transaction. This transaction is a completed transfer for estate and gift tax purposes, so although the grantor receives the payments due on the note, she no longer has access to the assets sold to the IDGT. In some circumstances, a grantor may include her spouse as a potential beneficiary of the IDGT to retain the ability to indirectly have access to the assets in the IDGT, but the access would terminate on divorce or the death of the spouse.
Sale of Non-GST Exempt Assets to GST Exempt Trusts
The generation-skipping transfer (GST) tax is a tax separate from and in addition to the estate and gift tax. It is imposed on transfers to or for the benefit of an individual who is two or more generations younger than the transferor (a skip person) or a trust for the benefit of skip persons. This tax is currently imposed at a flat rate of 40 percent of the value of the transferred property that is subject to the GST tax. Each individual in 2020 has an exemption from the GST tax of $11.58 million.
A trust to which GST exemption has been effectively allocated and which is not subject to the GST tax is referred to as a “GST Exempt Trust”; any other trust is referred to as a “Non-GST Exempt Trust.” The current low interest rates may provide a planning opportunity to shift appreciating assets from a Non-GST Exempt Trust to a GST Exempt Trust. The GST Exempt Trust can purchase appreciating assets from the GST Non-Exempt trust using a promissory note with interest at the applicable AFR. This transaction, which uses the depressed value of trust assets and the low AFR rates, effectively freezes the value of the GST Non-Exempt Trust and allows the appreciating assets to now be exempt from the GST tax for future generations. Depending on the identity of the trust beneficiaries, as payments are made on the promissory note to the GST Non-Exempt Trust, those payments can be used to make distributions to the grantor’s children or other beneficiaries not subject to the GST tax. Depending on the terms of the Non-GST Exempt Trust, there may be adverse income tax consequences to such a sale that should be considered.
A simple but effective technique in a low interest rate environment is an intra-family loan. This is particularly ideal for older generations who want to assist younger generations through either a direct loan of cash or a loan to a trust for such family member’s benefit.
Making New Loans: Intra-family lending allows an individual to assist family members without making a current gift. These loans can benefit family members who may have difficulty obtaining traditional bank loans or finding such favorable rates. They can allow the family lender to serve as the bank and enable a child or grandchild to purchase a home, acquire a property, or fund a new or existing business.
To avoid having any part or all of an intra-family loan considered a gift for tax purposes, the loan must be adequately documented and secured and must bear an interest rate greater than or equal to the applicable monthly AFR specified for the term of the loan. The family member providing the loan will report income on the interest received from the borrower, but as long as the loan recipient can invest the borrowed funds and generate an investment return greater than the minimum AFR interest rate, the loan will be successful as a wealth transfer technique. The terms of the loan agreement can be structured in many ways, including as an interest-only loan with a balloon payment of principal on maturity.
Alternatively, the loan can be made to an irrevocable trust for the benefit of family members, rather than directly to individual family members. Structured this way, to the extent the loan proceeds produce a rate of return in excess of the interest rate on the loan, such excess is a tax-free transfer to the trust. By way of example, assume in August 2020 a parent loaned $2 million to a trust for 15 years, using the long-term AFR rate of 1.12 percent. If the loan proceeds are invested to produce a 6 percent annual return, at maturity, after repayment of the loan principal, the trust will have more than $2,050,000 remaining, all gift tax free. Also, if the trust can be structured as a so-called “grantor trust” for income tax purposes, the interest payments on the loan will not be taxable to the grantor, and the grantor can pay the tax on all income and gains generated by the trust assets, allowing the trust to grow without reduction for income tax liability.
Refinancing Existing Debt. If there are current outstanding loans that have an interest rate higher than the current AFR rates, such as a mortgage or an existing loan to a child or grandchild, it may be beneficial to refinance those existing loans now to lock-in the current lower AFR rates.
Charitable Lead Trusts
How It Works. A CLT has a similar structure to that of the GRAT except that the income payments are made to one or more designated charitable organizations rather than to the grantor. With a CLT, the grantor transfers assets to an irrevocable trust, and the trust makes payments to one or more qualifying charitable organizations—either public charities or private foundations—for a fixed number of years or for the life or lives of the designated individuals, or a combination of the two (the “charitable term”). There are two forms of income payment terms for a CLT:
- A CLT with an annuity payment, referred to as a “charitable lead annuity trust” (CLAT), in which the charitable recipient receives an annuity that is either a fixed percentage of the initial fair market value of the property gifted into the CLT based on the Section 7520 rate in the month the CLT is created or a fixed sum; or
- A CLT with a unitrust payment, referred to as a “charitable lead unitrust” (CLUT), in which the charitable recipient receives a fixed percentage of the net fair market value of the CLT’s assets, revalued each year.
At the end of the charitable term, the assets remaining in the CLT must be distributed to one or more non-charitable beneficiaries, typically, the grantor’s lineal descendants (or to trusts for their benefit).
Tax and Non-Tax Considerations. A CLT is a beneficial structure for a grantor with philanthropic goals and a mission of benefiting charity during a significant time of need, such as the on-going COVID-19 pandemic.
Similar to a GRAT, the creation of a CLT constitutes a taxable gift by the grantor to the remainder beneficiaries that is equal to the initial value of the contributed assets, reduced by the present value of the annuity or unitrust payments to be made to charity, discounted at the Section 7520 rate. As discussed above, a CLT can be structured to zero out at the end of the charitable term, resulting in little or no gift tax. At the termination of the charitable term of the CLT, any appreciation of the property held in the CLT over the Section 7520 rate is passed on to the remainder beneficiaries of the CLT free of federal gift and estate taxes. Property contributed to a CLT is assumed to grow at a rate equal to the IRS hurdle rate in effect at the time of the transfer. Therefore, a CLT, like the GRAT, works best in low interest rate environments, because any investment performance above the hurdle rate passes free of estate and gift tax to the designated family members (or trusts for their benefit) at the end of the charitable term of the CLT.
Using a CLT to make annuity or unitrust distributions to charities allows the charitable recipients to receive benefits over an extended duration of time, as opposed to a lump sum contribution outside of the CLT structure.
Further, a CLT may be structured to qualify as a “grantor trust.” This means that the grantor is considered the owner of the CLT for income tax purposes and is taxed on all of the income earned by the CLT during the charitable term. As such, the assets of the CLT may continue to grow free of income and capital gains tax. The grantor would also receive a charitable income tax deduction (subject to applicable deduction limitations) based on the present value of the CLT’s required annuity or unitrust distributions to charity in the year the CLT is created and funded. Alternatively, the CLT may be structured as a non-grantor trust, meaning the CLT (not the grantor) is considered the owner of the trust’s assets. Structured this way, the grantor will not be entitled to a charitable income tax deduction on the creation of the CLT, and the CLT will have to pay its own income and capital gains taxes. The CLT, however, may claim an unlimited charitable income tax deduction for its annual distributions to charity.
An important note is that CLT’s are subject to annual filing requirements, including filing a Federal Form 5227.
The current low interest rate environment, combined with depressed asset values, provides a rare opportunity to make some lemonade out of lemons. Though the notion that the devil is in the details is as true in sophisticated tax planning as in anything else, a review of your client’s assets may highlight opportunities to capitalize on one or more of the above techniques before the financial markets rebound and interest rates increase.