Although it may seem counterintuitive, the current economic conditions brought on by the COVID-19 global pandemic, including down markets and reduced interest rates, provide estate planning opportunities many individuals may want to consider as part of their overall estate plan.
Last September we discussed the advantages of certain estate planning strategies in low-interest rate environments. Fast forward to today, the Applicable Federal Rates ("AFR") have fallen again for June (between .18% to 1.31% depending on the loan term), so such strategies may be even more advantageous in the current environment.
Besides the current low-interest rate environment, the Tax Cuts and Jobs Act ("TCJA") of 2017 temporarily doubled the lifetime exclusion amount from $5,000,000 to $10,000,000 indexed for inflation through 2025 ($11,580,000 for 2020). If taxpayers do not use this $5,000,000+ increase in exemption by 2025, under current law, they will lose the opportunity to do so. If you may not have a taxable estate with the current exemption amount but possibly do if the limit was $5,000,000 per person, we recommend reviewing your balance sheet to determine whether any assets can be transferred out of your estate by using this temporary increased exemption. With the markets being down, it may be possible to transfer marketable securities or business interests out of one's estate at lower values this year and use a lower amount of estate exemption to do so.
Below are various estate planning techniques that may be worthwhile to review during the current economic environment.
Sales to Intentionally Defective Grantor Trusts (IDGT)
An IDGT is a trust that is disregarded as separate from the grantor for income tax purposes, which allows the grantor to pay income taxes on the income earned on the assets while those assets grow outside of the estate, further reducing their gross estate. When the grantor dies, the assets and any growth earned while in trust transfer to the beneficiaries free of estate or gift tax.
For example, a grantor could sell a business interest to an IDGT in exchange for an installment note at the current AFR. The IDGT must be funded with at least ten percent (10%) of the sales price, which is treated as a taxable gift. If the value of the business interest outpaces the installment note payments made to the grantor, the beneficiaries of the IDGT receive that growth free of estate or gift tax. When interest rates are low, an increased amount of appreciation on assets held in the IDGT is left to heirs because less interest is paid back to the grantor under the terms of the installment note.
IDGTs are an especially effective wealth transfer tool when assets are expected to appreciate and can transfer assets such as business interests or marketable securities. When transferring business interests, this strategy can be paired with valuation discounts such as those for lack of control or marketability. By using valuation discounts, a grantor can transfer ownership in a business at a lower value and therefore reduce the sale price to the IDGT. Under current economic conditions, business valuations may be depressed, allowing for asset transfers at lower values.
Grantor Retained Annuity Trusts (GRAT)
GRATs are used to transfer highly appreciating assets, such as certain marketable securities, to beneficiaries. The grantor creates an irrevocable trust and retains the right to receive an annuity based on the original cost of the property plus a rate of return over the trust’s term. When the term expires, the trust terminates, and the beneficiaries receive the remaining assets at their appreciated value. The goal for a GRAT is to leave as much value as possible to the beneficiaries upon termination after satisfaction of the annuity payments.
The §7520 Rate is used to value the annuity payments due back to the grantor during the GRAT term. In a low interest rate environment, annuity payments are lower, making it easier for a GRAT to outpace the "hurdle" rate and transfer additional value of the grantor's estate.
Zeroed-Out GRATs are especially beneficial for those individuals who have used their lifetime estate tax exemption. These GRATs use a high payout to reduce the present value of the taxable gift to zero, therefore avoiding gift tax consequences.
A loan provided to a family member in exchange for a note with a fixed term can be an effective way to transfer wealth tax efficiently. The lender must charge interest at the AFR to avoid the loan being treated as a gift. If the borrower invests the loaned money and earns more than the AFR, the excess transfers to the borrower without gift tax consequences. A grantor trust can also be used to prevent interest payments from being taxable to the lender.
In addition, loan principal can be forgiven each year and treated as a gift. If the forgiveness is below the annual exclusion amount in the year of forgiveness and no other gifts are made to the borrower, there are no gift tax consequences.
For existing intra-family loans, with drop-in interest rates, it may be an opportune to refinance these notes to lock in the current lower AFR.
Whether you're just starting to review your estate plan for gifting opportunities or you're looking to use the extra lifetime exemption provided for by the TCJA, the Tax Warriors are here to help review your personal balance sheet to discuss how you can take advantage of the estate planning opportunities the current economic environment presents.