Key takeaways:
What this may mean for you:
As a result of the coronavirus pandemic, we are experiencing unprecedented times related to the economy and low interest rates. Changes in interest rates can have an impact on certain wealth transfer strategies due to correlations between the interest rates prescribed by the IRS for these strategies and the overall interest rate environment. If you expect to have exposure to Federal estate taxes and are looking to transfer wealth to family members, a low-interest rate environment can offer significant planning opportunities. This update outlines three estate planning strategies to help take advantage of low interest rates and increased estate exemptions.
Each month the IRS publishes an applicable federal rate (AFR) that can be used for personal intra-family loans, as well as certain related discount rates that may be used for present value computations that apply to a variety of estate planning strategies. Both the AFRs and the discount rates can impact the related calculations and the effectiveness of the strategies. Three wealth transfer techniques, grantor retained annuity trusts (GRATs), charitable lead trusts (CLTs), and loan-based solutions, can be more effective when rates are low.
In a low interest rate environment, investors have a low hurdle rate to overcome in order to transfer surplus wealth to their beneficiaries. For example, under a GRAT, the IRS prescribes a specified interest rate, under Section 7520, to calculate the current value of a future gift. If markets are favorable and you achieve a total return greater than the hurdle rate over the term of the trust, the value transferred to the beneficiaries could be greater than the amount initially transferred and reported as a gift. Additionally, the low AFRs may allow you to act as a lender and charge a lower interest rate to your beneficiaries to transfer wealth at a more efficient rate. A rise in Federal interest rates will increase the linked IRS hurdle and intra-family lending rates, making GRATs, CLTs, and inter-family loans less advantageous.
1. GRAT
A GRAT is a wealth transfer technique commonly used to transfer assets to a designated beneficiary. This strategy is typically considered successful when the assets appreciate at a rate that exceeds the discount rate over the term of the GRAT. To structure the transaction, a grantor transfers assets to a trust in exchange for the right to receive payments, on at least an annual basis, for a certain term. At the end of the term, any remaining assets in the GRAT pass to the beneficiaries (or are held in trust for their benefit). If the grantor survives the term, the trust principal is excluded from the grantor's estate for federal estate tax purposes and the only transfer tax "cost" of the initial funding is considered a gift for tax purposes. In times of low rates, the GRAT can be an attractive technique since there is a lower “hurdle” to clear for the GRAT to be successful. However, if a GRAT is funded with equities, market volatility can also be a key variable that impacts the ability to transfer wealth under this strategy. If the contributed assets decline in value, stay flat, or don’t grow much, there is nothing left to transfer. Another point to keep in mind is that if the grantor passes during the annuity period, the full value of trust assets is included in the grantor’s estate and will be subject to estate tax.
2. CLT
A CLT is an irrevocable trust that pays a charitable beneficiary an annuity or unitrust amount for a prescribed period of time. Similar to a GRAT, a CLT is linked to the interest rate the IRS set in the month it was funded. Depending on how it was structured, a CLT may provide an income, gift, or estate tax deduction. In a CLT transaction, a donor transfers property during life (inter vivos) or upon death (testamentary) to the trust, creating an income interest in the property that is tied to the Section 7520 rate the IRS set in favor of a charitable organization for a period of years or for the life or lives of an individual ( or individuals). Low interest rates are favorable for CLTs because they (a) set a lower “hurdle” that trust investments need to clear and (b) reduce the gift and estate tax cost of making substantial long-term gifts to family members. Keep in mind that the charitable payment must be made each year, regardless of whether the trust has generated sufficient income to fully fund the payment. Since a CLT is irrevocable, trust terms cannot be altered after assets have been transferred into the CLT.
3. Loan-based solutions
Low interest rate environments may be advantageous for personal, intra-family loan-based solutions where you, as the lender, can provide your beneficiaries with loans at the prescribed AFR, which may often be below commercial rates.
With interest rates hovering at historical lows for the past few years, this could be a good time for families with estate tax exposure to evaluate estate planning strategies that benefit from linked AFR and Section 7520 rates, which are also at historic lows. We suggest speaking with a Wells Fargo relationship manager, as well as your tax and legal advisors, about what is most appropriate for your individual and family situation.
Authors : Melissa J. Linn, Senior Wealth Planning Strategist, Wells Fargo Private Bank; James Mosrie, Senior Wealth Planner, Well Fargo Private Bank
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