Many advisors believe now is a good time to lock in low interest rates on related-party transactions, which must utilize the Internal Revenue Service's Applicable Federal Rate and Code Section 7520 rate to avoid unintended gift-tax consequences. Deals can even be timed, to a certain extent, to get the lowest rate available.
A window opens on about the 19th of every month. That's when the IRS announces the following month's rates. Las Vegas estate-planning attorneys Oshins & Associates were all set to execute 20 complex transactions for clients in late December when ... January's numbers showed up 25 to 80 bps skinnier!
"That put the brakes on most of the transactions until the new year," says Steve Oshins, the law firm's managing partner. "Our transactions are generally at least $5 million, so a change like that in the interest rate can have a huge impact."
No. 3: Lend To Family
Consider the effect of a parent lending, oh, $1.5 million to a child to invest for nine years. Further assume that the loan closed in January, when the midterm AFR (used for loan terms longer than three years but not more than nine) was 3.58%, its lowest since late '05.
The result: The parent holds a $1.5 million promissory note growing by 3.58% annually, while the child now has $1.5 million invested at a much higher rate potentially-say 10%. The alternative would be that the parent purchases a 10%-yielding investment himself and owes estate tax on the profits at death. The loan, meanwhile, enables the family to shift the spread between the two rates-in this case, 6.42% per annum, before income taxes, on $1.5 million-from the parents to the children, free of transfer taxes.
"The lower the AFR, the greater the opportunity to shift more wealth to the next generations," points out Katie Colombo, an attorney at Oshins & Associates. Clients with existing loans may be able to refinance them at current rates.
This arbitrage is referred to as an "estate freeze." Growth in the parent's estate is frozen at the IRS rate, it is said. The tactic can be spun myriad ways. For instance, a client can create a dynasty trust and lend it money to start a business, Colombo says. "All the growth in the value of the business would be outside the client's estate and pass estate and generation-skipping transfer tax-free."
No. 4: Sell Assets (Even A Home)
To A Defective Trust
Selling property to an intentionally defective irrevocable grantor trust is another estate-freeze technique enhanced by modest AFRs. "This transaction works when the trust assets outperform the AFR," says Tom Hakala, a managing director at Wilmington Trust FSB in New York.
Assuming the client doesn't already have a grantor trust, he creates one and gifts it seed money-perhaps 10% of the value of the property that will be sold to it, although some experts believe a smaller percentage is acceptable, Hakala says. Next, the sale occurs, immediately removing the assets from the client's estate, but not for cash. Instead, the client receives a note from the trust, which must periodically pay the client AFR interest. Often the property is cloaked in a family limited partnership or limited liability company, and the entity's non-controlling units are sold to the trust at a discount for lack of control, liquidity and marketability.
Attorney Gideon Rothschild is using this technique to remove a $5 million residence from a client's $30 million estate (although he isn't wrapping the home in an entity because that can lead to bad consequences). "The client can transfer $500,000 to the trust to use some of his lifetime gift-tax exemption, then sell the house to the trust for $5 million and take back a note at, say, 4% interest," says Rothschild, a partner at Moses & Singer LLP in Manhattan.