Strategies to consider now.
Interest rates are rising, and the trend is expected to continue. Advisors must understand how interest rates impact estate planning and which techniques work best in differing rate environments. Let’s look at how interest rates affect estate planning and which techniques to consider now before rates increase further.
Effect on Estate Planning
Interest rates affect estate planning in two important ways. First, many common planning techniques work by dividing the ownership of an asset into a current income (or annuity) interest and a remainder interest. Interest rates determine the relative present values of these interests and thus the effectiveness of such techniques. Second, interest rates dictate the minimum rate that must be charged to avoid the characterization of a loan as a gift.
Here are a few basic rules of thumb:
• When interest rates are high, the value of an income interest is increased, while the value of a remainder interest is decreased.
• When interest rates are low, the value of an income interest is decreased, while the value of a remainder interest is increased.
• Interest rates affect annuity interests differently from income interests.
• When interest rates are low, the value of an annuity interest is increased.
• Although annuity and income interests are interest rate-sensitive, unitrust interests aren’t.
Given these rules, certain techniques will be more effective in lower interest rate environments and others in higher interest rate environments.
Two Key Rates
Each month, the Internal Revenue Service publishes two key estate-planning rates, valid for the following month, that are tied to prevailing interest rates.
The first is known as the applicable federal rate (AFR). This is the minimum interest rate that must be charged to avoid a gift loan under Internal Revenue Code Section 7872. Pursuant to IRC Section 1274(d), there are three AFRs: a short-term rate (a maturity not over three years); a mid-term rate (a maturity over three years, but not over nine years); and a long-term rate (a maturity over nine years). The mid-term AFR is based on the average market yield (during any 1-month period selected by the Treasury Secretary and ending in the calendar month in which the determination is made) on outstanding Treasury obligations with remaining periods to maturity of more than three years but not more than nine years. AFRs, therefore, tend to lag the market.
The IRC Section 7520 rate (7520 rate) is the discount rate used to determine the present value for transfer tax purposes of the current (or retained) interest in the case of split-interest transfers. The 7520 rate is equal to 120 percent of the mid-term AFR for a given month, rounded to the nearest 0.2 percent.
Because the IRS typically publishes these rates around the third week of each month, a transaction may be timed to take advantage of the rates for either the current month or the following month.
Low(er) Interest Rate Strategies
Although interest rates have begun to rise, they’re still relatively low from a historic perspective. (See “Historic Perspective,” this page.)
Estate freeze strategies that seek to transfer future appreciation (but not the value of the underlying assets) out of an individual’s taxable estate work best when interest rates are low because the goal is to arbitrage the spread between the AFR or 7520 rate and actual investment performance. That spread represents the potential transfer tax-free wealth transfer. Strategies to consider include intra-family loans, grantor retained annuity trusts (GRATs), sales to grantor trusts and charitable lead annuity trusts (CLATs).
Intra-family Loans
Simple yet effective, intra-family loans generally cost less and are most effective in a low interest rate environment. As noted above, to avoid the characterization of a loan as a gift, the loan must bear interest at the relevant AFR. In most instances, however, the relevant AFR will be lower than the rates charged by commercial lenders.
An intra-family loan should be documented and its formalities respected. For example, interest payments should be made on time, and there should be no pre-arranged plan to forgive the interest annually. But, families otherwise have great flexibility in structuring these loans.
A loan could, for example, be structured as a term loan or a demand loan, be self-amortizing (with interest and principal paid over the term of the loan) or require interest-only payments. It’s common to structure an intra-family loan as an interest-only loan with a balloon payment of principal at the end of a 9-year (or greater) term in an effort to maximize the potential transfer tax-free wealth transfer.
Consider a loan of cash from a parent to a child. If the child can invest the borrowed funds to generate a return that exceeds the interest rate on the loan, then the return in excess of that interest rate will pass transfer tax-free from the parent to the child. The mid-term, annual AFR for a 9-year loan made in April 2018 was 2.72 percent. Even conservative projected returns on a well-balanced investment portfolio over such a term stand to exceed that rate.
A family may be able to achieve even greater benefits using a loan to an intentionally defective grantor trust (a grantor trust), which is a trust that the grantor owns for income tax purposes. A drawback of typical intra-family loans is that the lender must recognize interest income. A lender isn’t required to recognize interest income paid to him from a grantor trust of which he’s the owner, however. And, because the grantor-lender must pay any income tax due on the grantor trust’s earnings, these tax payments will constitute additional transfer tax-free gifts to the trust.
For this strategy to work, many practitioners believe that the grantor-lender should make a small “seed” gift of approximately 10 percent of the loan value to the trust before it borrows money to demonstrate the trust’s ability to repay the loan. Making a seed gift has the added benefit of allowing the grantor-lender to allocate his generation-skipping transfer (GST) tax exemption to the gift so that all of the trust’s assets will be GST tax-exempt for future generations.
Trust-to-trust lending creates another planning opportunity. Consider, for example, a client with two grantor trusts, one that’s GST tax-exempt and one that isn’t. If highly appreciating assets are held in the non-exempt trust, the trustees could consider loaning the assets (at the appropriate AFR) to the exempt trust to lock in the transfer tax-free future appreciation for additional generations.
While intra-family loans are more effective in a lower interest rate environment, a family’s flexibility to structure a loan to lock in low rates for an extended period or refinance, if and when interest rates decline, makes this technique useful even as interest rates begin to rise.
GRATs
A GRAT is an estate-planning technique in which a grantor transfers property into a grantor trust and takes back a fixed-term annuity interest. The goal of a GRAT is to pass any appreciation in excess of the required annuity payments to the remainder beneficiaries. GRATs are explicitly sanctioned in IRC Section 2702, making them among the safest strategies available.
Here’s how a typical GRAT works:
• The present value of the grantor’s retained annuity is calculated using the 7520 rate, which is sometimes referred to as the “hurdle rate,” because the GRAT’s investments must appreciate at a rate higher than the applicable 7520 rate for the GRAT to succeed.
• The difference between the value of the transferred property and the present value of the annuity is a gift. The amount and term of the grantor’s annuity are often set so that the gift is zero or nearly zero.
• If the GRAT’s investments outperform the
applicable 7520 rate and the grantor survives the term of the annuity, the remaining assets will pass to the remainder beneficiaries transfer tax-free.
The performance of a GRAT typically improves at a lower 7520 rate when the value of the annuity interest is higher and declines at a higher 7520 rate when the value of the annuity interest is lower. (See “GRAT in Lower Interest Rate Environment,” p. 20 and “GRAT in Higher Interest Rate Environment,” p. 21.)
GRATs can still be an effective planning tool even as interest rates start to rise, however, particularly if the value of the assets contributed to the GRAT is depressed (due to a downturn in the economy, valuation discounts or otherwise) or is expected to appreciate significantly. Although short-term GRATs are generally preferred over longer term GRATs due to the lower risk that asset depreciation will offset appreciation during the GRAT term, a longer term GRAT that allows a grantor to lock in a lower 7520 rate may be more attractive in a rising interest rate environment. A grantor can enhance the performance of a longer term GRAT by locking in early appreciation in the GRAT assets through the exercise of a power granted in the trust instrument to substitute stable value assets for the appreciated assets.
Despite the benefits of GRATs, there are some tradeoffs. GRATs are inefficient GST tax vehicles because the estate tax inclusion period rules preclude allocation of a grantor’s GST tax exemption prior to expiration of the annuity term. Moreover, there’s a mortality risk associated with the use of a GRAT because the grantor must survive the annuity term to avoid inclusion of the GRAT assets in the grantor’s estate and accomplish a tax-free transfer.
Sale to Grantor Trust
A sale to a grantor trust enables a grantor to further leverage the interest rate benefits of intra-family loans through the use of valuation discounts.
Here’s how a typical sale to a grantor trust works:
• The grantor creates a grantor trust for the benefit of the grantor’s family.
• The grantor makes a seed gift to the trust of 10 percent of the total assets ultimately sold.
• The grantor sells assets (up to nine times the seed gift) to the trust in exchange for a 9-year promissory note bearing interest at the mid-term AFR. If the grantor sells a fractional or non-controlling interest in an asset, a valuation discount may be available to further leverage the sale.
• Because the trust is a grantor trust, no gain or loss is recognized on the sale, and no interest income is generated on the promissory note.
• If the assets transferred by gift and sale to the trust appreciate in excess of the interest rate on the promissory note, the excess is a tax-free transfer to the trust.
• The grantor’s GST tax exemption can be allocated to the seed gift so that all trust assets are GST tax-exempt.
(See “Gift/Sale to Grantor Trust,” p. 21.)
Like an intra-family loan or a GRAT, a sale to a grantor trust works best in a lower interest rate environment because the hurdle rate associated with this transaction is based on prevailing interest rates (in this case, the AFR). Although interest rates are rising, this technique may still be effective if the promissory note is structured for a longer term to lock in current rates.
Compared to a GRAT, a sale to a grantor trust may be more effective because:
• The 7520 rate used to value the grantor’s retained annuity interest in a GRAT is 120 percent of the mid-term AFR charged on the promissory note.
• It provides greater flexibility because payments of interest and principal can be structured as desired, whereas the GRAT annuity payments must be made within fixed timeframes.
• It’s more GST tax-efficient because the grantor’s GST tax exemption may be allocated to the fixed seed gift immediately, whereas in a GRAT, exemption can’t be allocated until the end of the annuity period. At that point, allocation is inefficient because exemption sufficient to cover the unpredictable and potentially substantial asset appreciation during the GRAT term is required.
• It can be enhanced through the use of valuation discounts, whereas a valuation discount provides no benefit in the case of assets contributed to a GRAT because the grantor’s annuity payments have a fixed proportion to the value of the contributed assets.
On the other hand, GRATs are statutorily sanctioned and may be structured to avoid generating a taxable gift.
In a rising interest rate environment, however, the most significant advantage probably lies in the ability to use a sale to a grantor trust to lock in still relatively low interest rates for a longer period of time with less mortality risk, combined with the flexibility to refinance, if and when interest rates decrease.
CLATs
A CLAT is similar to a GRAT except that the fixed annuity is payable to charity rather than the grantor for a period of years.
Here’s how a typical CLAT works:
• A grantor transfers assets to the CLAT either during life or at death.
• The present value of the charitable annuity is calculated using the 7520 rate.
• The difference between the value of the transferred property and the present value of the annuity is a gift. The amount of the charitable annuity is often set so that the gift is zero or nearly zero.
• If the CLAT’s investments outperform the applicable 7520 rate, the remaining assets will pass to the remainder beneficiaries at the end of the annuity period transfer-tax free.
The performance of a CLAT, like a GRAT, typically improves at a lower 7520 rate and declines at a higher 7520 rate. (See “CLAT in Lower Interest Rate Environment,” this page and “CLAT in Higher Interest Rate Environment,” this page.)
Unlike a GRAT, a CLAT won’t fail if the grantor dies during the annuity term, but the upfront charitable deduction of a grantor CLAT is subject to recapture if the grantor dies during the charitable term. Indeed, a CLAT may be created on the grantor’s death, although CLATs are arguably a better lifetime strategy because predicting the 7520 rate at the time of the grantor’s death can be difficult. It may therefore make sense to consider longer term CLATs now to lock in the relatively low 7520 rate.
Like the other techniques discussed, there are disadvantages and tradeoffs involved in planning with CLATs. Like a GRAT, a CLAT isn’t a good candidate for GST tax planning. Moreover, the CLAT assets are unavailable to the grantor or the remainder beneficiaries during the annuity term, and no commutation is permitted. Finally, some assets are unsuitable for CLATs under the private foundation rules applicable to charitable split-interest trusts.
Looking Forward
As interest rates continue to rise, the strategies discussed in this article will generally become less attractive while other strategies will become more attractive. In Part II, we’ll explore effective techniques for planners to consider employing in a higher interest rate environment.
—This article is adapted from a presentation given by the authors at the 2017 ABA Real Property, Trusts and Estates Committee Spring Symposia in Denver.
In this article, White & Case means the international legal practice comprising White & Case LLP, a New York State registered limited liability partnership, White & Case LLP, a limited liability partnership incorporated under English law and all other affiliated partnerships, companies and entities.