Your Trusted Advisor, Summer 2008

June 24, 2008

Low Interest Rates Present Enhanced Wealth Transfer Opportunities

When the IRS considers the gift tax consequences of transactions between family members, they often look to current market interest rates to ensure that the transactions are reported properly. Recent interest rate cuts by the Federal Reserve have dramatically reduced the rates that the IRS uses for (i) the minimum “safe harbor” rates that will avoid a gift element for an intra-family loan (the “applicable federal rates”) and (ii) the rate used to measure the value of annuities and certain trust interests (the “Section 7520 rate”).

The following table shows what the IRS views as the appropriate rate of interest from 1991 to the present:

Interest rates have an impact on which tools estate planners recommend for their clients. Current low rates of interest make a number of estate planning and wealth transfer techniques even more powerful. While interest rates have edged up slightly for June, rates remain near historic all-time lows.  At the same time, the recent weakening of prices in the market for stocks, bonds, and other investment assets allow those assets to be transferred to family members at favorable gift tax values.

In short, the current low interest rate environment, coupled with the recent economic downturn, provides a unique opportunity to shift wealth while minimizing gift and estate taxes.
The following is a partial list of wealth transfer techniques that are “supercharged” by low interest rates:

New Family Loans and Refinancing Existing Family Loans

A parent with surplus cash might consider loaning that cash to children or other descendants, or to a trust for their benefit, at today’s low interest rates. If the borrower can use those funds to eliminate more expensive debt or to invest for higher returns than the low interest rate on the note, the difference in rates effectively shifts wealth to the children or other descendants, but has no gift tax implications. Parents who have previously loaned money to descendants or trusts may want to consider refinancing the existing loan at the current lower interest rates.

Installment Sales

A parent with an asset that is likely to grow in value could sell that asset to a child or other family member in exchange for a note of equal value, without gift tax implications. If the asset appreciates at a rate higher than the low interest rate note, the extra appreciation would pass to the buyer of the asset without any gift tax consequences. However, a sale may require the seller to recognize capital gains, resulting in the payment of income tax.

Installment Sales to Grantor Trusts

Income tax laws generally treat property contributed to a "grantor trust" as though it were still owned by the grantor. Therefore, if a parent creates a trust that is treated as a "grantor trust" for income tax purposes, a sale of assets to that trust is not recognized for income tax purposes. The parent could sell appreciating property to the trust for an installment note that bears interest at the current low rates.  Since the sale is ignored for income tax purposes, it will not trigger capital gains.¹  The trustee would typically use cash flow from the purchased assets, or other trust income, to make payments to the parents on the note. The installment sale to a grantor trust has the effect of transferring future upside investment returns to the beneficiaries of the trust to the extent those returns exceed the low interest rate on the installment note.

Grantor Retained Annuity Trusts

A grantor retained annuity trust (“GRAT”) pays a predetermined term annuity amount back to the grantor, in exchange for the grantor’s contribution of property. Any amount remaining in the GRAT after satisfaction of the annuity obligation passes without further gift tax to the GRAT’s remainder beneficiaries. The annuity amount can be determined in advance (by formula) so that its present value is nearly identical to the value of the contribution. As are result, there is little or no taxable gift. With current low interest rates, less has to be repaid to the grantor, making it more likely that a significant remainder will pass to the beneficiaries.²

Example: In April, 2008, Mrs. Smith transfers stocks to a GRAT with a current value of $1,000,000. The IRS assumes that the stocks will grow in value at current interest rates (3.4 percent per year). The trust agreement requires that payments be made to Mrs. Smith in the amount of about $228,000 per year for the next five years, at which time any property remaining in the trust will pass to Mrs. Smith's children. Under IRS calculations, the value of the payments to be made to Mrs. Smith is about $999,000 (that is, if the trust invested $999,000 at 3.4 percent for five years and made the $228,000 annual payments from the fund, the payments would exhaust the fund). Since the contributed property is valued at $1,000,000, but the value of the retained payments is $999,000, the IRS treats Mrs. Smith as making a gift of $1,000 to her children in 2008.  If in fact the stocks grow at 10 percent per year, the children will receive not $1,000, but $218,000. This additional value passing to the children is not subject to gift tax.

The GRAT acts very much like an installment sale to a grantor trust, but the GRAT has several advantages relative to the installment sale technique:

• If the IRS disputes the value of the property contributed to the GRAT, the trust requires the annuity payment to be adjusted to offset any increase in the gift tax value of the property, so no additional gift is made. This self-adjusting feature gives GRATs an advantage when the contributed property has an uncertain valuation.
• Unlike an installment sale to a grantor trust, the GRAT does not require initial funding other than the property transferred in exchange for the annuity.
• If the GRAT property declines or fails to grow enough to satisfy the annuity in full, no one is required to make up the difference. The GRAT’s grantor therefore retains all of the downside investment risk during the annuity term.

The GRAT also has disadvantages relative to the installment sale to a grantor trust:

• The interest rate used by the IRS to determine the value of the annuity payments can be as much as 20 percent higher than that allowed for an installment note.
• The GRAT must make payments to the grantor every year; it cannot be deferred as long as installment note payments (which might provide for no payments, or payments of interest only, for the term of the note).
• The remainder paid out of the GRAT will generally not be exempt from the generation-skipping transfer tax unless GST tax exemption is allocated to the full value of the remainder at the end of the annuity term. In contrast, the grantor trust used for an installment sale could be made fully exempt at the beginning by applying GST exemption to the gift contribution when the trust is formed. All of the extra growth retained by the grantor trust after repayment of the low-interest installment note would also be GST tax exempt.

Private Annuity and Self-Cancelling Installment Note

A parent or other donor can transfer cash or property to an individual, trust, or entity in exchange for an annuity payment.³  As with a GRAT, if the transferred property grows faster than the IRS interest rate, the excess growth is transferred without further gift tax. Alternatively, a transfer can be made for an installment note that is cancelled if the seller/lender dies before it is fully repaid. With either the private annuity or the self-cancelling installment note, the transferee receives a windfall if the transferor dies early, but is obligated to pay the obligation in full if the transferor lives longer than expected. Both techniques are more valuable when interest rates are low.

Charitable Lead Annuity Trusts

A charitable lead annuity trust (“CLAT”) pays a predetermined term annuity amount to charity, with any property remaining after satisfaction of the annuity passing to non-charitable remainder beneficiaries without further gift tax. The annuity payment is typically designed to offset the value of the contributed property, so that there is little or no taxable gift on creation of the trust. The CLAT can be thought of as like a GRAT, but with the annuity paid to charity. As with the GRAT, the CLAT’s remainder beneficiaries are more likely to benefit most when interest rates are low.

Charitable Gift of Remainder in Private Residence

A donor can make an irrevocable gift to charity of a remainder interest, following the donor’s life, in the donor’s private residence. This may qualify for an income tax charitable deduction, and will remove the residence from the donor’s taxable estate. All other factors being equal, the charitable deduction will be greater when interest rates are as low as they are today.

Low Interest Rates May Not Last Long

Inflation remains a real threat to the economy, due in part to the weakening dollar and increases in commodity prices. The threat of inflation means that the current low interest rates may not last for long. Therefore, parents and other donors who would like to take advantage of the opportunities presented by these low interest rates should act promptly. Please contact us to discuss which of these techniques are best suited to accomplish your estate planning goals. 

Welcome Mary Mason

Bracewell & Giuliani's wealth management group welcomes Mary Mason to the team.

Ms. Mason earned her law degree in 1999 from South Texas College of Law and her undergraduate degree in 1993 from Texas A&M University.

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¹ The grantor’s pre-sale income tax basis in the property would carry over to the grantor trust.  The grantor must generally contribute some property to the trust prior to the sale to ensure that the sale for a note is respected by the IRS as a true sale.

² For more on GRATs, see the spring 2007 issue of Your Trusted Advisor.

³ If the property appreciated before it was transferred, capital gain will generally be recognized immediately unless the transfer is to a grantor trust.