Strategies to consider in the future.
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 some techniques to consider as interest rates climb and review the non-interest rate considerations to keep in mind when making any estate-planning decision.
High(er) Interest Rate Strategies
Notwithstanding the current modest uptick in interest rates, estate planners shouldn’t abandon the strategies that work best when interest rates are low, such as intra-family loans, sales to grantor trusts, grantor retained annuity trusts (GRATs) and charitable lead annuity trusts (CLATs), all of which were discussed in Part I of this article.1 But, as interest rates (and, in turn, the discount rate applicable under Internal Revenue Code Section 7520 (7520 rate)) continue to rise, the following strategies will become increasingly attractive:
• Qualified personal residence trusts (QPRTs);
• Grantor retained income trusts (GRITs); and
• Charitable remainder annuity trusts (CRATs).
QPRTs
A QPRT is an estate-planning technique in which a grantor transfers the grantor’s personal or vacation residence into an irrevocable trust for the grantor’s desired beneficiaries, while retaining exclusive use of the residence for a term of years. Like GRATs, which work best in a low interest rate environment, QPRTs are explicitly sanctioned in IRC Section 2702. This official stamp of approval makes QPRTs a conservative planning strategy that’s appreciated by risk-averse clients.
Here’s how a typical QPRT works:
• The present value of the grantor’s retained use of the residence—which is effectively an income interest in the trust property—is determined using the 7520 rate.
• The difference between the fair market value (FMV) of the residence and the present value of the grantor’s retained interest is a gift to the trust.
• In a high interest rate environment, the present value of the grantor’s retained income interest will be higher, and the amount of any remainder gift will therefore be lower.
Accordingly, if all other factors are equal, a QPRT will be more effective at a higher 7520 rate (when the value of the grantor’s income interest is higher) than at a lower 7520 rate (when the value of the grantor’s income interest is lower). (See “QPRT—Lower Interest Rate Environment,” p. 16 and “QPRT—Higher Interest Rate Environment,” p. 16.)
If the grantor dies during the QPRT term, the QPRT will fail, and the entire value of the residence will be included in the grantor’s estate. Thus, in addition to the right to occupy the residence, the grantor of a QPRT retains a reversion in the event of the grantor’s death during the QPRT term. This reversion factors into the value of the gift at inception. The reversion isn’t nearly as interest rate sensitive as the income interest, but can substantially increase the value of the retained interest in the case of an older grantor. The grantor’s age can therefore impact the attractiveness of a QPRT as much, or more than, the 7520 rate.
Other drawbacks associated with QPRTs include:
• The grantor’s need to find a new residence or begin paying rent to the remainder beneficiaries at the end of the QPRT term (though the rent payments work to further reduce the grantor’s taxable estate).
• In certain states, additional steps must be taken so that the grantor can retain valuable property tax benefits, such as local homestead property tax exemptions.
• QPRTs aren’t efficient tools for generation-skipping transfer (GST) tax planning, because the grantor’s GST tax exemption can’t be allocated until the grantor’s term interest terminates under the estate tax inclusion period (ETIP) rules.
To avoid the mortality risk and other disadvantages of QPRTs, a grantor might instead consider selling the grantor’s residence to a GST tax-exempt grantor trust (that is, a trust that’s treated as owned by the grantor for income tax purposes) in exchange for a promissory note. As in any sale to a grantor trust, the grantor will typically fund the trust with a seed gift to which the grantor’s GST tax exemption is allocated so that the entire trust is GST-tax exempt. Further, using this technique, the grantor needn’t outlive the term of the note for the plan to work (unlike with a QPRT), although some uncertainty remains regarding the treatment of such a note in a grantor’s estate. To continue using the residence, the grantor would need to lease the house back at fair market rent to avoid estate tax inclusion under IRC Section 2036. This cost is offset from a tax perspective because paying rent to a grantor trust moves additional cash out of the grantor’s estate without generating gift or income tax. As noted above and in Part I of this article, however, sales to grantor trusts typically work better in lower interest rate environments (or when the property sold is expected to appreciate substantially).
GRITs
Mechanically, GRITs are similar to QPRTs. The grantor contributes property to the GRIT and retains an income interest for a specified term, with the remainder passing to the grantor’s chosen beneficiaries.
Other similarities between GRITs and QPRTs include:
• The grantor’s retained income interest is valued using the 7520 rate, and the difference between the FMV of the property contributed to the trust and the value of the grantor’s retained interest is a gift to the trust.
• In a high interest rate environment, the present value of the grantor’s retained income interest will be higher, and the amount of any remainder gift will therefore be lower.
• Drawbacks include the fact that the grantor must survive the chosen term of the grantor’s retained interest for the strategy to work, and the ETIP rules will preclude allocation of the grantor’s GST tax exemption prior to expiration of that term.
GRITs were an extremely popular estate-planning tool prior to enactment of IRC Section 2702 in 1990 but now have more limited use. The zero value rule of Section 2702 was intended to prevent the perceived abuse whereby a parent would value the parent’s retained income interest for gift tax purposes based on an assumed income stream to the parent, but then invest the trust differently to provide less actual income to the parent, such as investing in non-dividend paying growth stocks. Section 2702 thus prevents a grantor from establishing a GRIT (other than a statutorily approved GRAT or QPRT) for a “member of the family,” which is defined by Section 2704(c)(2) to mean an “individual’s spouse, any ancestor or lineal descendant of such individual or such individual’s spouse, any brother or sister of the individual and any spouse of any ancestor or lineal descendant of such individual or such individual’s spouse, or any spouse of any brother or sister of the individual.” However, GRITs may still be created for the benefit of unrelated persons and certain relatives such as nieces, nephews and more distant relatives, who are outside the definition of family members under Section 2704(c)(2).
CRATs
A CRAT is an estate-planning technique in which the grantor transfers property to the trust and the grantor (or another person designated by the grantor, such as a spouse or child) retains an annuity interest in the transferred property for life or a specified term, with any remaining assets passing to charity when the annuity period ends. Although a CRAT is effectively the inverse of a CLAT from a mechanical perspective, it’s treated somewhat differently for tax purposes.
Here’s how a typical CRAT works for tax purposes:
• The grantor contributes property to the CRAT in return for an annuity stream that’s valued using the 7520 rate.
• The grantor receives a current income tax deduction equal to the value of the gift to charity, which is the difference between the value of the assets contributed to the CRAT and the value of the retained annuity interest. The gift to charity must be equal to at least 10 percent of the value of the property contributed to the CRAT.
• As the 7520 rate increases, the present value of the retained annuity interest will decrease and the amount of any remainder gift will therefore increase (along with the grantor’s potential income tax deduction). (See “CRAT—Lower Interest Rate Environment,” this page, and “CRAT—Higher Interest Rate Environment,” p. 19.)
• If the annuity stream is payable to someone other than the grantor’s spouse, then gift tax considerations will also apply.
A CRAT can be a particularly useful tool for avoiding or deferring capital gains tax on the disposition of highly appreciated assets because the CRAT itself is income tax-exempt. (The annuity payments are taxable to the recipient, however, and are deemed to carry out ordinary income, capital gains, tax-free income and return of principal according to a tiered system.) A CRAT can thus give the grantor or other individuals access to increased cash flow in the form of defined annuity payments until the annuity period ends and the remaining assets pass to charity.
As noted above, the principal reason that CRATs are attractive in a high interest rate environment is the potential for an increased income tax deduction. If rates are too low, however, CRATs may not even be an available technique for some grantors because certain levels of annuity payments could cause the actuarial value of the remainder interest to fall below the 10 percent minimum requirement. Further, in the case of a CRAT that features a lifetime annuity, low interest rates could also make it impossible to select a young annuity beneficiary, as the anticipated annuity payments would cause the CRAT to fail either the minimum 10 percent remainder requirement or the separate 5 percent probability of exhaustion test (or both).
Other Factors
Of course, interest rates alone shouldn’t dictate a client’s estate-planning decisions. There are many other tax and non-tax considerations that may impact whether a certain estate-planning technique makes sense in a particular client’s situation.
Let’s consider some of these factors:
• Asset values and federal and state estate tax exemption levels. In the absence of planning, will assets (taking into account portability to the extent appropriate) meaningfully exceed available federal and state estate tax exemptions so that the costs of planning are justified?
• Life expectancy. If the grantor isn’t likely to survive the chosen term of the retained interest, strategies such as GRATs, QPRTs and GRITs may be ineffective.
• Actual financial returns. Certain strategies may produce (albeit reduced) benefits even in a non-optimal interest rate environment. For example, in the case of a GRAT or sale to a grantor trust that would typically work best in a lower interest rate environment, if the potential investment return exceeds even high prevailing interest rates, these strategies may nevertheless be effective. Similarly, there’s little point to implementing a GRAT or sale to a grantor trust even in a low interest rate environment if the contributed assets aren’t expected to meaningfully outperform the hurdle rate.
• Client dispositive goals. Clients have widely differing interests and goals. For example, not all clients are charitably inclined, so no matter where interest rates go, CLATs or CRATs may never be appropriate for such clients. On the other hand, certain planning techniques, such as charitable remainder unitrusts, which aren’t interest rate sensitive, may be best suited to address specific client goals.
• Family circumstances. Some grantors will have a greater need (whether real or perceived) to retain full control of and access to their assets than others. Other grantors may have differing views on the timing and amount of gifts to descendants and the possible impact of such gifts on their descendants’ motivation.
Effective estate planning requires that advisors be cognizant of the environment in which they’re planning. Notwithstanding the key role that they play in many estate-planning strategies, interest rates are only one of the factors to consider. In an otherwise unlimited landscape of planning techniques, however, focusing on interest rates, at least at the outset, can help advisors narrow the options and reduce confusion for their clients.
Endnote
1. Kerry O’Rourke Perri, Dana M. Foley and Alistair “Sandy” Christopher, “Estate Planning In a Rising Interest Rate Environment: Part I,” Trusts & Estates (June 2018).
—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 publication, 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.