Estate and Gift Tax Planning Opportunities in a Low Interest Rate EnvironmentOctober 17, 2019
As many of our clients and their professional advisors are well aware, we are in a period of historically low interest rates. Although such an environment poses some challenges, it also creates a number of opportunities for efficient estate and gift tax planning. The following are estate and gift tax planning strategies that are particularly advantageous when interest rates are low, and should be considered by taxpayers who are seeking to maximize the use of the unified federal estate and gift tax exemption.
Grantor Retained Annuity Trusts (GRATs)
GRATs can be a fantastic wealth transfer tool in low interest rate environments. With a GRAT, the grantor transfers assets to an irrevocable trust and receives an annuity payment each year during the GRAT term. Any assets remaining after all of the annuity payments have been made passes to the residuary beneficiaries free of gift tax.
Often, GRATs are “zeroed out,” meaning that the full value of the initial transfer (plus interest) is paid back to the grantor via the annuity payments. With zeroed-out GRATs, the grantor does not use any of his or her gift tax exemption.
GRATs work particularly well in low interest rate environments because the annuity amounts are a function of the applicable federal interest rate in effect at the time the GRAT is funded. Low interest rates mean a low “hurdle rate” – appreciation above the hurdle rate passes to the residuary beneficiaries free of gift tax. Therefore, the lower the applicable federal interest rates, the greater the potential for tax-free transfers of wealth. In the event that a GRAT “fails” because the assets do not appreciate during the GRAT term, the GRAT property is simply returned to the grantor through the annuity payments.
Note that while GRATs can be very effective tools for transferring wealth to the next generation, they are not ideal for transfers to grandchildren or more remote descendants. This limitation has to do with rules related to the allocation of the generation skipping transfer (“GST”) tax exemption. Under the GST tax rules, you would be required to allocate GST tax exemption to value of the GRAT assets at the end of the GRAT term. Thus, the appreciation during the GRAT term does not escape the GST tax regime.
However, clients who are charitably inclined and would like to name grandchildren or more remote descendants as the ultimate beneficiaries of a GRAT could consider coupling their GRATs with a Health and Education Exclusion Trust (“HEET”). Simply put, a HEET is a trust that is designed to extend over multiple generations, the assets of which can be used to pay medical and educational expenses of the settlor’s grandchildren, great grandchildren, etc. The primary estate tax planning benefit of using a HEET is that gifts to a HEET do not require use of GST tax exemption even though the beneficiaries of the trust are more than one generation removed from the person making the transfer. Therefore, GRATs that feed into a HEET would not require allocation of GST exemption at the end of the GRAT term.
The basic structure of a HEET is as follows:
- The settlor’s grandchildren and more remote descendants would be the primary beneficiaries of the trust.
- The trustee would be authorized to make “qualified transfers” on behalf of descendants. “Qualified transfers” would include tuition payments for full or part-time students (but would not include things like room and board, books, etc.). In addition, “qualified transfers” include medical expenses, which would include most types of medical expenses.
- There is also a required charitable component to a HEET: there must be at least one charitable beneficiary of the trust, which is required in order to achieve the GST tax outcomes. The charitable beneficiary must have a “significant interest” in the trust, which term is not defined by the tax code or regulations. Thus, there is not clear guidance as to what constitutes a “significant interest,” but, many practitioners believe that the charitable beneficiary must receive, at a minimum, an annual unitrust payment from the trust of 5-10% of the trust’s assets.
The October 2019 interest rate applicable to GRATs is 1.8%. As long as interest rates remain at these levels, GRATs will remain a potentially powerful gift and estate tax planning device (whether coupled with HEETs or not).
Sale of Property to a Grantor Trust
Another gift and estate tax planning technique that leverages low interest rates is the sale of property that is expected to appreciate to an intentionally defective grantor trust. In such a transaction, the grantor first makes a “seed” gift to the trust, which is typically 10% of the value of property to be sold to the trust. The grantor then sells assets to the trust in exchange for a promissory note.
Because interest rates are low, the promissory note will carry a low interest rate. The terms of the promissory note might call for a balloon payment upon the maturity date, or payment of principal installments throughout the term of the loan. (For maximum leverage, the loan would be interest only with a balloon payment at the end of the term.) In either case, as long as the trust property appreciates at a rate that exceeds the applicable interest rate, then the excess appreciation during the term of the loan represents a tax-free transfer for gift and estate tax purposes.
On the income tax side, because the trust is a grantor trust (and is taxable for income tax purposes to the grantor), the initial sale to the trust will not trigger recognition of federal capital gain. (Some states treat grantor trusts differently, so it is important to understand the tax rules that apply within your state.)
When selecting property for this sort of transaction, it is important to identify assets that will produce sufficient cash flow to service the loan. In addition, the property sold to the trust, if not publicly traded securities, should be professionally appraised to minimize the likelihood of an IRS challenge to the transaction.
The October 2019 interest rates that apply to this type of transaction range from 1.67-2.86%, depending on the term of the loan and the interest compounding intervals specified in the promissory note.
Intra-family lending also works well in low interest rate environments, and can be an effective way to assist family members without using gift tax exemption or incurring a gift tax. The minimum interest rates applicable to intra-family loans are typically lower than rates available through commercial lenders, and to the extent that the borrower is able to earn a rate of return on the borrowed funds that exceeds the interest rate, the borrower keeps the excess without gift or estate tax consequences. The October 2019 interest rates that apply to intra-family loans range from 1.67-2.86%, depending on the term of the loan and the interest compounding intervals specified in the promissory note.
Charitable Lead Annuity Trusts (CLATs)
CLATs are conceptually similar to GRATs, but with at CLAT, the annual annuity amount is paid to a charitable organization (rather than the grantor) during the term of the CLAT. At the end of the term, any assets remaining pass to non-charitable remainder beneficiaries. Thus, similar to a GRAT, a CLAT works best in low interest rate environments where appreciation over the term of the CLAT exceeds the hurdle rate. If structured as a zeroed-out CLAT, the appreciation in excess of charitable annuity payments would pass free of gift or estate tax to the remainding beneficiaries.
On the income tax side, a CLAT can be structured as a grantor trust or as a non-grantor trust. In either case, the donor does not receive a charitable deduction upon establishing the CLAT. If the trust is established as a grantor trust, all income tax items would flow through to the grantor during the life of the CLAT. The grantor would be taxed on any income and would also receive an annual income tax deduction when annuity payments are made to the charitable beneficiary.
Alternatively, if the trust is structured as a non-grantor trust, the income tax items do not flow through to the grantor during the term of the trust, and the grantor receives no income tax deduction for the charitable annuity payments. Instead, the annuity payments made by the trust offset income earned by the trust each year.
The October 2019 interest rate applicable to CLATs is 1.8%. During low interest rate periods, CLATs represent a good opportunity to fund to charitable projects and transfer wealth to the next generation while minimizing estate and gift tax.
From a gift and estate tax planning perspective, the success or failure of the techniques described above relies on the spread between applicable interest rates and the market performance of transferred assets. In addition, with techniques such as a sale to a grantor trust, it is also important to consider cash flow requirements. Therefore, in addition to selecting a vehicle that meets your wealth transfer (and possibly philanthropic) objectives, it is also important to carefully select the assets to be used.
For more information, or to discuss if one or more of these strategies may be appropriate for you, please contact any of the attorneys of the Hinckley Allen Trusts & Estates Practice Group.PDF