With interest rates in a trough, savvy advisors with clients concerned about estate taxes are pouncing on techniques that benefit from a tame Applicable Federal Rate-the interest rate required by the Internal Revenue Service to guarantee arm's-length dealing, particularly in intrafamily transactions-or the Section 7520 rate, which is pertinent to many trusts.
"Now is the time to do it, I'm telling clients who I know want to give money away or who have charitable intentions," says attorney Robert H. Louis, managing director of the Personal Wealth Services Group at Saul Ewing LLP, in Philadelphia. The trick is knowing which vehicles are juiced by a low rate and which are impeded.
For financial advisors, the big news is that a low IRS interest rate can improve how you look to the client. In order for many estate-planning strategies to be successful, says attorney David Handler, a partner in the Chicago office of Kirkland & Ellis, investment performance has to beat the IRS's interest rate. "Well, there's never been a lower hurdle rate, and you can lock it in: If you do a five-year GRAT [grantor retained annuity trust], you're at the [low] rate for the whole term," Handler says. Because the IRS changes its rates monthly, many estate-planning attorneys predraft documents so that they're ready to act when an opportune rate comes along.
The IRS announces each month's rates in a revenue ruling that you can find at www.timevalue.com or www.pmstax.com. For historical IRS interest rates, log on to www.evans-legal.com. The short-, mid-and long-term Applicable Federal Rates are each based on recent yields of marketable Treasury obligations of corresponding maturities. For example, the mid-term AFR derives from U.S. government securities with three to nine years remaining to maturity.
Today's low AFRs enhance intergenerational loans, which let clients freeze asset values and push appreciation to family estate-tax-free. In one case, a 70-year-old client did not want the $10 million recently received from the sale of a business to grow inside his estate. So he loaned it at AFR interest (about 6% at the time) to a generation-skipping trust for his children (he could have loaned it to the kids directly), which invested in the stock market. If the securities return 10%, after one year the trust's corpus grows to $11 million, minus $600,000 interest ($10 million loan principal, times 6% AFR) paid to the father. The interest is taxable income to Dad, but the trust's $400,000 growth in excess of the AFR is outside his estate because it's in the trust (or, if lent to the kids directly, in their accounts), passing estate-tax-free. Not only does a low AFR make this strategy more viable, it also lets clients refinance existing loans, says Handler, noting that the short-term rate has been under 3% recently.
Selling to a defective grantor trust, another strategy designed to remove future appreciation from the estate, is useful for clients worth $5 million-plus who covet control, says attorney Mike Mulligan of Lewis, Rice & Fingersh in St. Louis. A defective grantor trust is an irrevocable trust whose income taxes are paid by the individual (the grantor) establishing the trust. The trust buys property from the grantor in exchange for a promissory note bearing interest at the AFR-the lower the rate, the easier it is for the trust to make the note payment-and if the property grows by a greater percentage, the excess escapes estate tax. To maintain control, Mulligan says, the client can put the property in a family limited partnership, retain a small general-partner interest (inured with the right to manage the partnership-that's the control element) and sell limited-partner units (rather than the property per se) to the defective trust, taking a valuation discount along the way.
Handler's promissory notes are drafted to permit note prepayment by the trust at any time without penalty-so it's no surprise his clients are looking at refinancing old notes now. "We can either have the trust repay the loan, if it has the money, and then have the grantor make a new loan of a comparable amount at today's lower AFR, or we could make a new loan and use the proceeds from it to pay off the old loan," Handler says. When a trust document is silent about prepayment, refinancing could be viewed by the IRS as generating a taxable gift, he warns.
Low Rate For Annuities
The Internal Revenue Code Section 7520 interest rate, a mutation of the mid-term AFR, is used to value annuities for tax purposes, including private annuities. Useful for removing assets and their future appreciation from the estate without triggering gift tax, a private annuity is an arrangement in which the client sells assets, usually to children, who promise to make fixed periodic payments to the seller for life, explains Tricia Hill, an estate-planning attorney with The Clark Law Firm in Eugene, Ore. When the interest rate is low, the buyer's payments are smaller (i.e., more affordable), and less interest (which is subject to income tax) flows back into Dad's estate. These two considerations make many clients' goals easier to accomplish while following the requirement of structuring a private annuity such that the fair market value of the property sold equals the present value of the payment stream, says Hill.
Annuities are common in the world of trusts. As a financial vehicle, a trust has two distinct components: the income stream that it generates, which often is an annuity, and what's left at termination, called the remainder.
Both the income and the remainder involve dollars in the future-but to value the transaction today for tax purposes, you need present values. Under IRS rules, when the income stream is an annuity, you calculate its present value, subtract it from the fair market value of the assets initially placed in the trust, and the difference is the present value of the remainder interest, says Gregg A. Parish, an academic associate at the College for Financial Planning. Arithmetically:
Amount placed in trust today - present-value annuity = present-value remainder interest
The lower the Section 7520 rate used to discount the annuity, the greater its present value (verify this by examining the factors in any present value table, which grow as the interest rate declines), concomitantly reducing the worth of the remainder interest-a fabulous outcome for the client looking to gift that remainder interest to kin. As the remainder's value drops, so does the amount of the gift/gift tax.
Consider the GRAT. The grantor gets an income stream, receiving a fixed-dollar payment (i.e., an annuity) from the trust for its term, and gives away the remainder. Louis has a 72-year-old client who wants to gift $325,000 to family in light of the January 1, 2002, increase in the estate- and gift-tax lifetime exemption to $1 million. How much can the client move out of her estate and into a GRAT so that the present value of the remainder interest-her gift-is $325,000? More than when the 7520 rate was at higher levels, says Louis. "When the 7520 rate is low, you can give away more money at the same tax cost," he says. (But if the grantor dies before the GRAT terminates, the trust assets are included in the estate, Parish says.)
Similar math abets the qualified personal residence trust (QPRT), which Robert E. Barnhill III, a CPA/attorney in Lubbock, Texas, likens to "a GRAT with a house as the remainder interest." Appropriate for the client seeking to remove a pricey home from the taxable estate, a QPRT enables the grantor to live in the residence for the trust term (which is tantamount to an annuity), after which title to the home passes, as the remainder, to beneficiaries. A QPRT's primary disadvantage is that the grantor must part with the home at the end of the term and can't continue to live there without a fair market arrangement with the new owner (usually the children). If the grantor dies before the QPRT term ends, the property is included inher estate, Parish says.
For the philanthropic client, charitable lead annuity trusts (CLATs) are extremely attractive in today's low interest-rate environment, says Bill Laskin, vice president of PG Calc Inc., a planned-giving software company in Cambridge, Mass. A charity receives an annuity from the trust-because an annuity's present value is boosted by a low 7520 rate, the client receives a larger charitable deduction than she would for making a comparable gift when the rate is high-and the remainder is typically a gift to family (made smaller by a low 7520 rate, reducing gift tax).
"The ideal client for a charitable lead trust is someone who doesn't need current income and whose kids don't need current income but who ultimately wants to provide some benefit for the kids," says attorney Nancy Crow, a shareholder in the Denver law firm Pendleton Friedberg Wilson & Hennessey PC. Laskin points out that a special rule allows the donor to use the 7520 rate for the month the gift was made or for either of the two prior months-choose the lowest for your client's CLAT. The two-month look-back also applies to charitable gifts established at death, Laskin says. For example, a client who passed away in February and whose will created a charitable lead trust can use the historical low reached by the 7520 rate in December.
It's worth noting that the annuity genre of a charitable-remainder trust suffers when the 7520 rate is low. The charitable deduction for donating the remainder interest shrinks, Laskin says, and a low rate also dampens the trust's payout to the grantor (reducing the grantor's income) in order to meet the requirement that the trust have less than a 5% chance of corpus exhaustion. The best bet these days for the deduction-hungry client intent on a charitable-remainder trust is the unitrust version, which is influenced by the current federal interest rate much less than an annuity trust.
Another charitable transaction adversely impacted by a low federal interest rate is the gift annuity, in which an individual donates assets and the charity agrees to make payments to the donor for life. The donor is entitled to a charitable deduction, which is made smaller by a low interest rate.