Refinancing Family Loans
The intrafamily loan is another popular estate planning strategy that could become even more popular as the IRS' applicable federal rate drops to record-low levels. When the loan is set up correctly, a client is allowed to lend his or her children money at lower rates than those available commercially without the IRS looking on it as a gift. Can your client refinance a family loan in the same way he can refinance a mortgage?
First, it may not be necessary. Depending on the type of loan, the rate may automatically reset annually. With a term loan, the rate is fixed for the life of the loan. Meanwhile, a demand loan's interest rate changes annually, usually based on a benchmark stated in the loan document.
With the term loan, it may be possible to reset the interest rate and to even prepay the loan with the additional appreciation that the lower loan rate creates. But refinancing the loan in this case is not the same as refinancing a mortgage, because the parents now pay gift taxes. One way to work around this is for the children to obtain a short-term commercial loan to pay back the parents. Then the parents and children can renegotiate a new loan with a lower rate and use the family loan proceeds to pay back the bank. Alternatively, the children could renegotiate the loan either by paying a larger "down payment" or choosing a shorter term. Both solutions can put the parents in the same economic position they were in under the terms of the original loan (and help them avoid gift tax).
Restructuring Installment Sales
In the current market climate, clients with estates should also re-evaluate the strategy of making an installment sale to an intentionally defective grantor trust (IDGT). This is a popular way to fund a life insurance trust while avoiding the creation of a gift. Although there are several formats, the grantor usually sells income-producing property to the trust in return for a promissory note.
As a "grantor trust," the IDGT is an alter ego of the grantor and doesn't incur income taxes. Under these arrangements, the trustee has the means to pay the life insurance premiums without relying on the grantor to make annual gifts to the trust. The note can be paid back through cash flow or expected asset appreciation.
Previously, GRATs were used in conjunction with installment sales to IDGTs. At the end of the GRAT term, whatever was left in the trust was transferred to the remainder beneficiary-that is, the IDGT. The trustee of the IDGT could then pay off the installment note and exit the arrangement without having to touch the cash values of the life insurance.
In today's market, however, the "exit strategy" may be at risk. This transaction can only work if the growth rate of the trust assets is greater than the costs of the loan-or if the GRAT can be relied on to pump money into the trust.
Here again is an opportunity to renegotiate the promissory note. The installment note could be restructured as an interest-only note, giving the trustee time for the trust's principal to recover. Note that the renegotiation must be based on an "arm's length" standard to be accepted by the IRS.
If the trust document allows, the grantor may be able to exchange assets held in the IDGT for ones that might either outperform the loan's interest rate or possibly generate more reliable cash flow.
Fulfilling Promises
The charitable remainder trust (CRT) is another estate planning vehicle at risk in today's market. CRTs allow the grantor to transfer assets out of his or her estate, retain an income interest and provide for a future transfer to charity. They come in two forms: the charitable remainder annuity trust (CRAT) and the charitable remainder unit trust (CRUT).
The CRAT pays a fixed annuity to the grantor or the grantor's family while the CRUT pays a percentage of the trust's value annually. Unfortunately, too many CRTs were designed with overly optimistic assumptions of future growth and income. Today's reality is that either the CRAT's annuity payment is eating into the principal or the CRUT's payments are woefully short of the grantor's expectations. In a bear market, there is a real possibility that both the income beneficiary and the CRAT's charity can end up with nothing. Payout rates are irrevocable and cannot be adjusted for market conditions. Besides adjusting the portfolio's asset allocation, what else can a trustee do?