Low Interest Rates Create Attractive Trust & Estates Opportunities

As advisors, the COVID-19 Pandemic continues to strain our daily lives and the lives of our clients – but it also creates a very ripe environment for unique trust and estate planning opportunities. The Applicable Federal Rate (AFR) and Section 7520 interest rate are at historical lows for the month of September at 0.14% (short-term AFR), 0.35% (mid-term AFR), and 1.00% (long-term AFR). In February of this year, the mid-term AFR was at 1.75%. While this may not mean much on its face, these rates determine the tax consequences of certain wealth transfer strategies, which are much more efficient in low rate environments.

One of the simplest strategies is an intra-family loan. If the borrower, normally a trust, can earn a greater rate of return on the borrowed funds than the applicable AFR that the borrower must pay on the borrowed funds, then the difference is a wealth transfer that is not subject to federal gift tax. Obviously, the lower the AFR, the easier it is to earn a return greater than it.

In line with the intra-family loan is a sale to a grantor trust, which is a particularly apt strategy to transfer assets that are likely to appreciate significantly, such as a business interest. As the name implies, a grantor sells an asset to a grantor trust in exchange for a promissory note, with an interest rate at the applicable AFR based on the term of the loan. If done properly, no taxable gain is recognized on the sale for federal income tax purposes and no gift tax is incurred since it is a sale; meanwhile, the trust obtains an appreciating asset that should exceed the value of the promissory note. Normally discounts are also involved when selling nonmarketable or non-controlling interests further reducing the sale price and thereby shifting more appreciation to the trust.

A GRAT is a trust to which an individual transfers assets while retaining the right to periodic payments (an annuity) for a term. The transfer to the trust is a taxable gift to the trust beneficiaries, but only to the extent that the value of the assets transferred exceeds the present value of the retained annuity. The present value of the retained annuity will be higher in a low interest rate environment (all other factors remaining constant) and that reduces the taxable gift. If the GRAT’s assets grow at a rate better than the Section 7520 rate (which is 0.4% for the month of September) the tax-efficient transfer of wealth to the GRAT’s remainder beneficiaries is greatly enhanced. With low interest rates, that goal is much easier to meet.

For our clients who have a philanthropic bent, charitable lead trust (CLT) operates in a similar fashion as a GRAT, except the initial payments are made to a charity of the grantor’s choosing, with the remainder of the trust property being returned to either the grantor or to another beneficiary. Accordingly, a CLT is a great wealth transfer strategy for those individuals with charitable intentions and who do not currently need the income generated by the assets being transferred.

Again, these wealth transfer strategies are uniquely advantageous for the month of September, given the low AFR and Section 7520 rates, and may not be available again for some time, if ever. Now is a great time to chat with our clients about how low interest rates make certain wealth transfers more appealing.

– Randy Moyer, Barley Snyder