The current War in Ukraine has added fuel to the fire of inflation, which started in the aftermath of the Covid-19 pandemic and the fiscal stimulus implemented in response. It seems likely that the Federal Reserve will raise interest rates, perhaps as much as 2% over the next year to 18 months.
As interest rates rise, the changing rates affect estate planning. There are strategies that are most effective in high-interest rate environments as well as strategies that are most effective in low-interest-rate environments. There is no “one-size-fits-all” strategy for both high and low-rate environments. Beginning in 2010 and through 2021, interest rates have been at historic lows, reflecting the low rates of inflation. Now, inflation is rising and most likely, interest rates will follow. When interest rates begin to rise, it is time to change strategies; and, while the interest rates remain low, implement the strategies that are most effective in a low-interest-rate environment. When the Fed raises the rates, implement the strategies that work best when interest rates are higher.
Which Interest Rates Affect Estate Planning
Each month, the Internal Revenue Service publishes short-, mid- and long-term rates (the Applicable Federal Rates, or AFRs) and the §7520 rate. The AFRs reflect the minimum interest rate that must be charged for loans between related parties; the §7520 rate (used to calculate annual payments for certain techniques ) is 120% of the mid-term AFR. All of these rates are calculated based on the yields of certain government debt obligations, and the target federal funds rate has a direct impact on these yields. Since the AFR and the §7520 rate are used when implementing a number of estate planning techniques, the effectiveness of these techniques changes when these rates change. Rising interest rates can motivate you to lock in interest rates while they remain low or prepare to capitalize on potentially higher rates in the future.
Usually, the rate that will apply to a specific strategy is the rate in effect on the date the strategy is implemented. So, you should consider the strategies that are most effective in the evolving interest rate environment and how those affect your financial goals.
Strategies For The Current Low-Interest-Rate Environment
Planning in the current low-interest-rate environment often involves lending strategies that leverage the low interest rates in order to transfer wealth with little or no gift tax. At their core, these strategies involve senior family members lending younger family members money at the relevant interest rate; the loan proceeds are invested by the younger family members. The interest rate reflects the hurdle that the investments’ growth must overcome before the strategy will work to transfer value to the younger family members. For example, the §7520 rate for March of 2022 is 2.0%. If you make a loan of $1,000,000 to a child now, the interest rate will be 2%. If, as the interest rates rise, the child actually makes 8% on the funds, the child will get the difference between the interest rate paid, (here $20,000) and the amount received from the invested loan proceeds, (here $80,000), for a net benefit of $60,000, gift tax free. This technique enables wealthier family members to “freeze” the value of the assets that they lend, which would generally be included in their estates for estate tax purposes and pass the asset’s appreciation to less wealthy family members or trusts for their benefit.
An Intra-family-loan is the simplest way to implement a low-interest-rate environment strategy. A cash loan can be structured as an interest-only loan with a balloon payment on maturity; if the assets purchased by the borrower with the loan proceeds appreciate more than the interest rate paid on the loan, the excess passes to the borrower free of gift tax.
Another low-interest strategy is an installment sale to an intentionally defective grantor trust (IDGT): This is similar to an intra-family loan, but the borrower is a trust created by the lender; the borrower trust is a “grantor trust” with respect to the lender for income tax purposes (which means that the lender/grantor is responsible for any income tax, including capital gains tax, incurred by the trust), and the asset sold to the trust or the property into which the cash from the loan is invested is often a non-cash asset, such a closely held company stock. Because the lender and the borrower are the same taxpayer, no gain is realized on the sale of the asset to the trust. And because the lender is required to pay the trust’s income tax liability, the loaned assets are able to grow inside the trust without being depleted by income tax payments. In addition, the asset appreciation over the interest rate accrues to the trust beneficiaries free of gift tax. This structure also uses the relevant AFR.
A third strategy for low-interest rate environments is the grantor retained annuity trust (GRAT). The GRAT acts like an installment sale to an IDGT, except the annual payments to the grantor must be fully amortized over the term of the GRAT, and the §7520 rate (which is higher than the short- and mid-term AFRs) must be used. Appreciation over the §7520 rate accrues to the trust beneficiaries. The economic benefits of this strategy are often not as great as that of the installment sale strategy, since the annuity includes portions of both interest and principal. It is, however, possible to create a series of short-term, rolling GRATs (the donor funds a new GRAT each year with the annuity from the previous GRAT) rather than a single, longer-term GRAT, to increase the wealth transfer benefits and capitalize on market volatility.
Finally, there is the charitable lead annuity trust (CLT). Like a GRAT, asset appreciation over the §7520 rate passes to the trust beneficiaries gift tax free. Unlike a GRAT, the annuity payments during the trust term are made to charity and not the grantor, who is therefore not able to continue to benefit from the assets contributed to the CLT. Depending on how the CLT is structured, the grantor may receive either a charitable gift tax deduction or a charitable income tax deduction in the year the CLT is funded.