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Estate Planning Alert: Low interest rates plus low valuations create extraordinary planning opportunities

Interest rates are at historic lows.  Market values of many assets are lower than they were a few years ago.  This juxtaposition creates potentially significant wealth transfer opportunities.  A few strategies offer particular advantage.  Let’s first review why the juxtaposition works and then review the planning opportunities.

The interest rates for loans to family members and related party transactions are lower than they have been in several decades because they are set by the IRS each month based on U.S. Treasury rates.  These rates in turn set the valuation rate used to determine the value of property transferred in certain types of gift strategies. As a result, this rate is at an all time low of 1.4% (in November).  In the valuation process, this interest rate is the assumed rate for valuing the remainder interest that is the taxable gift component in some of the strategies discussed below.  This rate is often referred to as the “hurdle-rate” in terms of the rate of return required for the strategy to perform as well as the valuation projection for tax purposes.  While relative investment rates of return are low, the assumed rate is fixed at the time of the transfer, so when rates of return increase to more normal levels and market values increase as a result, the chance for success of these strategies should be greater than under normal circumstances.

This juxtaposition also occurs at a time when the lifetime gift tax exemption is at an all time high of $5,000,000 ($5,120,000 in 2012 after the inflation adjustment). This allows for larger taxable gifts without concern about not having enough exemption left to cover estate taxes or about having to pay gift tax on the larger gifts (which would have been the case prior to 2011). CAUTION: You may hear a rumor that the Congressional Super Committee working on deficit reduction is considering a reduction of the gift tax exemption to $1,000,000 effective as early as November 23rd, the deadline for the Committee’s report. While no assurances can be given, this appears to be speculative based on reported comments from sources familiar with the work of the Super Committee.

Planning ideas and strategies

The simplest approach to capture this “double-barreled” opportunity is to make a low interest loan to a family member.  In November, the rate for a demand loan or for a term as long as three years is .19%.  For a loan longer than three years but no longer than nine years, the rate is 1.20%.  For a term longer than nine years, the rate is 2.67%.  If you want to assist a child or other family member by making a loan, these are the minimum rates that will apply.  The borrower is not burdened by high interest charges and could use the loaned money for his or her desired purposes.  If the lender dies, the loan is an asset but will not disappear.  If the borrower is a beneficiary of the lender’s estate plan, the loan balance can be distributed to the borrower or be offset against the inheritance.

The Installment Sale to a Grantor Trust (ISGT) or sometimes referred to as an Intentionally Defective Grantor Trust (IDGT) allows a senior generation member to sell an asset to a trust for the benefit of family members.  With the low current market valuations, it is more likely than normal that the assets sold will increase in value from their depressed current values.  The trust pays most of the purchase price with a promissory note at the current low interest rates described above.  While interest will be paid, the grantor of the trust will pay any taxes on income received and on capital gains realized—the payment of the income tax is another transfer to the beneficiaries of the trust, but the payment is not treated as a gift to the trust beneficiaries.

Another strategy is the Grantor Retained Annuity Trust (GRAT).  Under this strategy, the senior generation contributes property to a trust in return for an annuity payment during the term of the trust.  The term and the annuity rate determine the amount of the gift to the trust’s remainder beneficiaries.  There are two limitations: (1) if creator of the trust dies during the term, some or all of the trust assets will be part of the creator’s taxable estate and (2) the property transferred could be used up by the annuity payments leaving no value for the remainder beneficiaries.  Here is an example:

  • The grantor transfers $1 million to a trust that pays the grantor an annuity of $510,500 per year for two years.  The remainder value at the end of the term is projected at $16,081 (the amount of the taxable gift).  If the rate of return is only 3%, the tax free gift of the exess over the projected gift value is $8,500.  But if the value at the end of the two years is $1.25 million, the gift tax advantage is almost $235,000.

If the investment return is greater than the valuation (hurdle) rate, the gift of the remainder will be worth more than the predicted result under the IRS valuation rate.  If the investment rate of return is less or if the trust runs out of property in making the annuity payments, the creator will have wasted some of his/her lifetime gift exemption.  Picking assets that will likely increase in value will help this strategy work better.  The term of the trust is a critical concern.  Shorter terms of at least two years are common; longer terms, such as 10 years create greater risk of the creator of the trust dying during the term causing partial inclusion of the trust property in the estate of the creator of the trust.  Pending tax proposals may require a minimum 10-year term for a GRAT or eliminate valuation discounts on the property placed in the GRAT.  This would adversely affect GRATs and the elimination of valuation discounts would also adversely affect ISGTs.

In the family business context, the low market valuations and the large gift tax exemption make it a good time to recapitalize the corporation with preferred and common (or voting and non-voting shares as to S-Corporations) and in the process make significant gifts to family members of common (or non-voting) shares as part of the overall succession plan.  Alternatively, the shares could be sold to family members via a low-interest promissory note back to the senior generation instead of using an outright gift.  Current low tax and interest rates also provide an ideal opportunity for the business to borrow money to either pay a dividend or to redeem shares owned by the senior generation.

A related strategy with a charitable advantage is referred to as a Charitable Lead Annuity Trust (CLAT).  In this type of planning, the trust pays an annuity to selected charities over a term of years. At the end of the term, if the investment rate of return exceeds the valuation rate, the remainder that is available to the family beneficiaries will be greater than the amount projected using the IRS valuation rate. A Charitable Lead Annuity Trust is often used as a vehicle to fund ongoing annual gifts or to establish and fund an endowment gift through the annuity payments.

The time may be short to take advantage of these opportunities due to pending tax reform discussions.  The best time to act may be now!

For more information, please contact:

Roger L. Shumaker
216.348.5801
rshumaker@mcdonaldhopkins.com

Jeffrey P. Consolo
216.348.5805
jconsolo@mcdonaldhopkins.com

Estate Planning

Our estate planning and probate services for individuals and families are focused on helping clients meet their estate planning objectives through income, estate and gift tax minimization. Our services include preparation of wills, living trusts, financial powers of attorney, charitable trusts, and related documents. We take a comprehensive approach to the planning process to ensure that the goals of the family are carried out and that the estate is appropriately managed.

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© 2011 McDonald Hopkins LLC All Rights Reserved. This Alert is designed to provide current information for our clients, friends and their advisors regarding important legal developments. The foregoing discussion is general information rather than specific legal advice. Because it is necessary to apply legal principles to specific facts, always consult your legal advisor before using this discussion as a basis for a specific action.