Weekly Investment Update
Low Rates Give Estate Planning A Boost
Published Tuesday, January 6, 2009 at: 7:00 AM EST
Several techniques to cut gift- and estate-tax liability depend on interest rates published by the IRS, and those rates, like others, recently neared record lows. Despite fears of inflation rate that many believe will creep up and continued volatility in the stock market, hitching your estate plan to one or more of these vehicles or revisiting plans created when rates were higher could deliver major benefits.
Loan to family. Each month, the IRS publishes short-, mid-, and long-term Applicable Federal Rates (AFRs). When you make a loan, you need to charge interest at least as high as the AFR that applies to the loan term. (If you accept less, the loan may be considered a gift.) Suppose you lend your daughter a sum of cash for nine years at a mid-term AFR of 3%. If your daughter invests the borrowed money in a portfolio returning 7%, that four percentage point difference means she’ll come out ahead, earning more than she must repay. But that gain will be in her estate, not yours, and the loan reduces the size of your estate, cutting potential estate taxes. Of course, if her return is less than the 3% “hurdle rate,” this becomes a losing strategy.
Sale to an intentionally defective grantor trust. This accomplishes many of the same goals as a loan to family members and it benefits from low interest rates in the same way. In addition, because you, rather than the trust, pay income tax on earnings from the trust assets, your estate is further reduced, while the trust assets grow unencumbered by taxes. If you sold property to a defective trust some time ago and received a note, you may be able to refinance at a lower interest rate.
Transfer to a grantor retained annuity trust. GRATs are designed to remove assets from your estate with minimal gift-tax consequences. You transfer income-producing property to an irrevocable trust, which pays you an annuity. What-ever remains in the trust at the end of its term goes to the beneficiaries you’ve chosen.
Because you’ve made a gift of assets to the trust and, ultimately, to your beneficiaries, gift tax may apply. But rather than basing the tax on the actual value of the assets transferred when the trust expires, the IRS calculates what that remainder would be after deducting the value of the annual payments you receive and assuming the assets appreciate at a specified interest rate. Here, too, if the actual return on trust investments exceeds the IRS assumption, the amount that’s transferred to your beneficiaries will exceed the amount that was subject to gift tax. (For a GRAT to work, you must outlive the trust term; otherwise, the assets go back into your estate.)
Normally, a GRAT involves paying some gift tax. But thanks to a 2002 U.S. Tax Court decision, it’s possible to “zero out” the value of your gift so there’s no gift-tax liability. In a zeroed-out GRAT, the value of the annuity payments you’re scheduled to receive equals the IRS-calculated value of the trust assets; it’s assumed that there won’t be anything left for beneficiaries at the end of the trust’s term, and no gift means no tax. But again, if assets appreciate at a rate above the AFR, there will be a gift, though still no tax.
Transfer to a charitable lead annuity trust. This works much like a GRAT, except that assets are transferred to a trust that benefits a charitable organization. During a specified term or for the rest of your life, the charity gets income from the trust. At the end of the term or upon your death, the assets go to beneficiaries you choose. You get an income-tax deduction based on the present value of the projected income the charity will receive, and a low AFR translates into a high present value. A low AFR also means a smaller remainder that will be subject to gift tax. When funding a lead trust, you can use the IRS interest rate for the month the gift was made or for either of the two prior months.
These are complex estate-planning vehicles, but we can work with your attorney to determine if they would be a good fit for you. Keep in mind that legislative proposals greatly influence the dynamics of these techniques, so call us to discuss the latest developments.
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