COVID-19 has deeply impacted the economy in the United States and this will likely continue for a long time.  As a result of the pandemic, interest rates continue to fall and are currently sitting at a historic low.  Today, the interest rate rests at 0.25%, the same as it was during the 2008 Housing Crisis.  Many experts predict interest rates in the United States to remain at these historically low rates while the economy recovers.  In low interest rate environments, certain estate planning strategies have become more feasible.  Estate planning strategies can be used to leverage low interest rates to minimize tax hits and shift wealth.  These strategies are particularly attractive to individuals with relatively large estates (over $10 million individually or $20 million for couples).  These individuals should consider consulting with their estate planning attorneys.

Grantor Retained Annuity Trust (GRAT)

A Grantor Retained Annuity Trust (GRAT) is a type of irrevocable trust which allows a grantor to pass assets to their beneficiaries with little to no gift tax applied.  This strategy requires a grantor to transfer accounts or property into a carefully drafted trust.  The trust is designed to pay the grantor an annuity annually over a specific term of years, which over the term is designed to be close, if not exactly the same, as the value of the gifted assets at the creation of the trust.  At the end of the trust’s term, any property or wealth not paid to the grantor will transfer gift tax-free to the remainder beneficiaries.

The Internal Revenue Service’s published rate of return (the Section 7520 rate, also referred to as the “hurdle rate”) is used as the assumed rate of growth on assets.  However, the goal is for the actual rate of return on the wealth or property in the trust to exceed the Section 7520 rate in place at the time of the trust’s creation.  When this occurs, the remaining wealth or property in the GRAT are transferred to the beneficiaries gift tax-free.  The present low income environment makes it more likely that the trust assets will exceed the hurdle rate and that a grantor’s remainder beneficiaries will receive gift tax-free assets following the completion of the trust’s specified term.

GRATs tend to be used by wealthy individuals who are looking to transfer assets to family members or friends while avoiding the gift tax.  The following factors can impact the effectiveness of a GRAT:

• Health of a grantor and whether the grantor is expected to live beyond the GRAT’s term
• The interest rate (Section 7520 rate) for the month in which the assets are transferred to the GRAT
• The nature of the accounts or property being contributed to the trust and their growth potential
• The remaining lifetime gift tax exclusion amount available to the grantor

Charitable Lead Trust (CLT)

Just like Grantor Retained Annuity Trusts, a Charitable Lead Trust (CLT), also referred to as a Charitable Lead Annuity Trust, can offer significant tax savings.  However, a CLT, unlike GRAT, is particularly focused on gifting to charities.  A CLT is a type of irrevocable living trust that makes payments of of the trust to a beneficiary (a qualifying charity) over a specific term and is tied to the IRS Section 7520 rate.  The term length can either be a set number of years or up until the grantor’s death.  A CLT is a split-interest trust, and thus named two beneficiaries: 1) a charitable lead beneficiary and 2) a non-charitable remainder beneficiary.

Unlike a GRAT, the grantor does not receive the annual annuity payments through the terms of the trust, rather the charity receives them.  Following the expiration of the CLT’s term, all remaining assets in the trust pass to the chosen beneficiaries free of gift and estate tax, or are returned to the grantor.

Because the present interest value is calculated using the Section 7520 rate, the goal is for the money and property in the CLT to grow at a higher rate than the interest rate.  These assets would then be transferred tax-free to remainder beneficiaries.  Additionally, if properly structured, a CLT can provide valuable income tax deductions during the grantor’s lifetime.

It is important to remember that the payments to the charity must be made each year regardless of the performance of the trust assets.  Poor investment performance can result in the need to use trust principal to cover the required charitable payments.  The best time to establish a CLT is in a low interest rate environment, as the asset growth rate is expected to exceed the historically low Section 7520 rate.

Intrafamily Loans

Intrafamily loans are can transfer additional wealth to family members without using your gift tax and estate tax exemption amounts.  A common purpose for these loans is to help family members:

• recover from low credit scores
• eliminate high interest commercial home loans or business loans
• eliminate consumer or educational debts
• purchase shares of a family business
• invest in assets with a high growth rate

Additionally, intrafamily loans keep interest payments within the family rather than enriching commercial lenders.

Intrafamily loans generally use the Applicable Federal Rate (AFR) as the interest rate over the loan’s term.  The AFR is the lowest threshold a loan’s interest rate can be without the IRS classifying it as a gift.  These loans are particularly attractive in a low interest rate environment because of how low the rate can get.  The loan could be invested in assets that are likely to grow faster than the AFR built into the loan.  The difference between the AFR payable to the lender and the realized rate of growth of the invested loan proceeds would accrue to the benefit of the borrower outside of your estate (leaving less to be taxed upon your death).  Intrafamily loans allow you to indirectly transfer growth of assets without it counting against your gift tax exemption amount.

As a reminder, even though these are intrafamily loans, this does not mean that they can be informal.  Such loans must be properly documents with executed promissory notes and, where appropriate, secured with collateral.  This ensures that the IRS cannot reclassify all or part of the loan as a gift.

Give Us a Call

Nielsen Law PLLC provides family focused estate planning to individuals and families in Austin, Round Rock, Cedar Park, and the Central Texas area.  For more information and to learn about our firm, please contact us.