Low Interest Rates Provide Taxpayers With Unique Opportunity To Avoid Estate And Gift Taxes
May, 2010
In April, the Federal Reserve renewed its commitment to retain low interest rates for an "extended time." As a result, interest rates continue to be at or near historic lows, however we are also seeing improvement in the capital markets, resulting in growing estate values. There are numerous estate planning techniques that take advantage of the low interest rate environment to get assets such as a family business or appreciating publicly traded stocks outside your taxable estate. Intra-family loans, Grantor Trusts (GRATs and IDGITs) and Charitable Lead Trusts can be used to minimize or eliminate tax on the transfer of the family business or other asset to the next generation.
Unless Congress acts before the end of the year, the federal estate tax is scheduled to be reinstated January 1, 2011. The estate tax exemption will return to its 2001 low $1 million dollars per person, with a tax rate increase to 55% for assets above the exemption. (For those of you residing in a state that also imposes a state inheritance tax, combined effective estate tax rates may be as high as 60% or more.) Estate and gift tax (aka "transfer tax") applies to assets above the exemption and before your probate estate or trust can transfer your assets on your death to your beneficiaries. The assets that are taxed include all assets owned by the deceased taxpayer, however titled, including assets held in a revocable living trust, business interests such as stock or LLC membership, retirement accounts, life insurance policies--owned by and insuring the taxpayer, taxable lifetime gifts, and half of any property owned with a spouse with rights of survivorship or as community property.
Intra-family loans at the Applicable Federal Rate
Intra-family loans are the simplest estate planning technique. A parent can lend funds to a beneficiary at the applicable federal rate (the "AFR"). If the return on borrowed funds exceeds the AFR, the excess is transferred to the beneficiary free of gift tax.
Parents (and grandparents) frequently loan their children money, not realizing that if they make a loan but don't charge any interest, the IRS will re-characterize the disregarded interest component as a taxable gift to the child. Gift tax would be due if the parent has already utilized their annual and lifetime gift tax exclusion. Additionally, to the extent that the interest due on the loan is less than the interest calculated with the AFR, that amount will be imputed interest income to the parent, even though the interest was not collected by the parent. To escape the gift and imputed interest elements, the loaned funds must bear, at a minimum, the AFR in interest. The Internal Revenue Code (IRC) provides two limited exceptions to the imputed interest rules: a 'de minimus' exception for loans that do not exceed $10,000 (and the loan proceeds are not attributable to the purchase of income-producing assets), and for loans of up to $100,000 if the borrower's net investment income in a given year does not exceed $1,000.
AFRs are determined by the IRS each month and include annual, semiannual, quarterly, and monthly rates for short-term loans (terms of three years or less), mid-term loans (terms over three years but not exceeding nine years), and long-term loans (terms longer than nine years). The recently published Annual AFRs for May 2010 are as follows: .79% for term loans of up to 3 years, 2.85% for term loans of 3 years to 9 years, and 4.47% for term loans in excess of 9 years.
Children (grandchildren and any other beneficiaries) can use funds from an intra-family loan to make investments yielding a greater rate of return than the AFR, or they can use the intra-family loan to pay down debts with a higher interest rate. Parents can use the AFR's to structure a loan for a bootstrap sale of the family business. Loans at low rates increase the child's wealth, and transfer assets out of the parent or grandparent's taxable estate, free from gift or estate tax.
Grantor Trusts
Under the tax rules, a grantor trust is a trust whose creator, the grantor, personally takes into account all items of ordinary income and loss as well as capital gain and loss. Certain popular forms of grantor trusts, set up by the creator for the benefit of someone other than the creator, provide valuable and time tested planning techniques for taxpayers who want to pass assets to their beneficiaries. These forms of grantor trust are especially useful when assets are appreciating at a rate faster than the AFR, the grantor will not need the appreciation in the assets in the future, and the grantor wants to avoid or reduce the exposure in their estate to the federal gift and estate tax. Two of these are the Grantor Retained Annuity Trust (GRAT), and the Intentionally Defective Grantor Trust (IDGIT, pronounced 'ijit').
- Grantor-Retained Annuity Trust ("GRAT"), create a self-funded annuity that reduces your estate tax. A GRAT is a trust into which the grantor transfers assets in exchange for an annuity interest, payable for a specific term. At the expiration of the annuity term, the remainder interest continues to appreciate in trust free of estate or gift taxes, or can be passed on to the remainder beneficiaries, typically a child, grandchild or other family member. The present value of the annuity payment is based on the IRS's "7520 Rate." The 7520 rate is 120% of mid-term AFR (3.4% in May of 2010), which is also near historic lows.
When the grantor transfers assets to the trust, a taxable gift is made to the remainder beneficiaries calculated on the present value of their remainder interest (e.g. the fair market value of property placed in the trust less the present value of the retained annuity), a value which with careful planning can result in a small, near zero gift, with little to no associated tax due. Then, if the trust assets appreciate at a rate greater than the 7520 Rate, at the end of the annuity period, the excess will pass to the trust's remainder beneficiaries free from tax. The value of the remainder interest (and any future growth) is forever removed from the taxpayer's estate for estate tax purposes. Other than the cost of creation and administration, there is no significant estate tax cost to using a zeroed out GRAT as long as the grantor survives the GRAT period. Although there is some possibility that GRAT's for terms shorter than ten (10) years will be eliminated as part of the Obama tax plan, there will still be benefits to longer term GRAT's for transfers of appreciating interests in a family business or closely held stock.
- Intentionally Defective Grantor Trust ("IDGIT"), sell your assets to a trust you create for the benefit of your loved ones and reduce your estate taxes too. This goes by various acronyms including "IDGIT" and "IDGT", and is also sometimes alternately called an intentionally defective irrevocable trust or "IDIT." The term "defective" is unfortunate, because it connotes something is wrong, however the defect is in fact what makes this a valuable planning tool. The trust transfer is defective for income tax purposes, because the income arising from assets in the trust is taxable to the grantor. The grantor establishes the IDGIT, which then purchases assets from the grantor in exchange for an installment note with interest that must be at least equal to the AFR. Because the transfer is considered defective, there is no tax on the grantor's sale of assets to the IDGIT, and the interest that the grantor receives on the note is also not taxable to the grantor. The entire value of the property in the trust in excess of the amount owed on the note is excluded from the grantor's estate and can be used for the benefit of the remainder beneficiaries. The appreciation in any assets sold to the IDGIT that exceeds the interest payments to the grantor remains in the trust for the benefit of the named beneficiaries free of gift and estate taxes.
Charitable Lead Trusts
Establish a charitable trust to provide for your loved ones and your favorite charity while reducing your estate tax. A Charitable Lead Trust ("CLT") is similar to a GRAT. It also provides for the transfer of assets to an irrevocable trust. However, a CLT makes annual payments to a designated charity for a term of years or for the life of a remainder beneficiary. At the end of that designated time period, the residual assets pass to the non-charitable remainder beneficiary, usually a family member. The taxable gift to the remainder beneficiary is measured by the fair market value of the assets placed in the trust less the present value of the annual payments. As with the GRAT, the value of the annual payments are determined using the "7520 rate." If the assets transferred to a CLT produce a return in excess of the "7520 rate" that excess passes to the remainder beneficiary without being subject to tax.
Current economic conditions present a variety of estate planning opportunities for transferring wealth at minimal cost when compared with the tax savings they represent. The attorneys at Bullivant Houser Bailey can assist you in comparing and contrasting the use of intra-family loans, GRAT's, CLT's and IDGIT's as well as structuring these as part of your estate plan.
Pursuant to the provisions of Internal Revenue Service Circular 230 that apply to written advice provided by Federal tax practitioners, please be advised (a) that if any advice herein relating to a Federal tax issue would, but for this disclaimer, constitutes a "reliance opinion" within the meaning of Circular 230, such advice is not intended or written to be used, and cannot be used by the affected taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer, and (b) any written statement contained herein relating to any Federal tax issue may not be used by any person to support the promotion or marketing of, or to recommend, any Federal tax transaction(s) or matter(s) addressed herein. We would be happy to discuss the effect of this disclaimer, and alternatives to this disclaimer, with you if desired.