Background: I was recently asked to summarize the high points in my December’s Briefing with regard to the impact of increasing interest rates on estate planning strategies. In other words, the person who asked for the summary did not want to read the 22 page handout that I prepared, which is a reasonable request considering how busy people are at the end of a calendar year (and how tedious reading that outline not doubt will be.) Accordingly,  what follows are some broad generalizations that reflect how an increasing interest rate environment can impact basic estate planning that is discussed with individuals who are planning their estates.

Impact of the IRC 7520 Rate: As prevailing interest rates rise, so does the IRC 7520 rate. The 7520 rate is used to value retained interests in many common estate planning strategies. Consequently, an increasing IRC 7520 rate will impact estate planning strategies, either positively or negatively, which are summarized below.

Applicable Exemption Amount: Using a ‘big picture’ perspective, the higher the interest rates leads to higher inflation, which in turn leads to a higher individual’s applicable exemption amount. A higher applicable exemption amount provides  more ‘wiggle room’ to wealthier individuals when planning their estates.

Charitable Lead Trusts: As the IRC 7520 interest rate increases, a donor who funds a charitable lead annuity trust (CLAT) will have a smaller charitable income tax deduction associated with the charitable lead portion of that CLAT. Like a GRAT, a CLAT can be ‘zeroed out’ with regard to its remainder interest. But as the IRC 7520 rate increases, it will be that much more difficult for a CLAT to shift wealth to the CLAT’s remainder beneficiaries gift tax-free, since the CLAT assets will have to increase more than the IRC 7520 rate used to value the charity’s lead interest in the CLAT.

Charitable Gift Annuities: As the IRC 7520 rate increases, so will the donor’s currently available charitable income tax deduction. However, as the IRC 7520 rate increases, the proportion of the tax-free income of the annuity payments received over the donor-annuitant’s lifetime falls, which means more of the donor’s annuity payment will be taxable.

Charitable Remainder Trust: As the IRC 7520 rate increases, the larger the value of the charity’s remainder interest will be, which leads to a larger charitable income tax deduction available to the donor-settlor. As a generalization, a charitable remainder unitrust (CRUT) is not impacted much with rising interest rates. A charitable remainder annuity trust (CRAT) is more beneficially impacted by a rising IRC 7520 rate; with the higher IRC 7520 rate, there is a larger value assigned to the CRAT’s charitable remainder interest, which makes it more likely that the CRAT will satisfy the Tax Code’s mandatory CRAT ‘tests’, i.e. satisfy the  10% ‘test’ that at least 10% the present value of CRAT’s assets is dedicated to the charitable remainder interest on the CRAT’s formation, and satisfy the 5% probability ‘test’ that the CRAT is sustainable for the charity to ultimately receive its remainder interest in the CRAT. This means that younger current beneficiaries might be named as the lifetime annuity beneficiaries.

Grantor Remainder Annuity Trust: As the IRC 7520 rate increases, a GRAT can still work to shift wealth if the GRAT is ‘zeroed out.’ The GRAT will work to shift wealth at the end of the annuity payment term, but only if the investments held in the GRAT appreciate more rapidly than the IRC 7520 rate that is used when the GRAT was initially funded and the settlor’s retained annuity amount is determined. In other words, a GRAT is sort of a risk-free strategy, in that there is no adverse tax or economic consequences to the settlor if the GRAT’s  investment return is not greater than the IRC 7520 rate that is used, other than the loss of transaction costs when the GRAT was created and funded. Therefore, a GRAT is often best for those individuals who are risk averse, or who think the market will ‘spring back’ in the next couple of years.

Qualified Personal Residence Trust: As the IRC 7520 rate increases, the higher will be the imputed value of the settlor’s retained right of occupancy of the principal residence, and thus the smaller the value of the QPRT’s remainder interest which is a taxable gift. Consequently, less of the settlor’s applicable exclusion amount must be used to shelter the gift of the QPRT’s remainder interest to children. A QPRT is a great way to leverage the taxable gift of the remainder interest and remove an appreciating residence from the settlor’s taxable estate.

Grantor Retained Income Trust: As the IRC 7520 rate increases, the value of the settlor’s retained income interest increases, thus lowering the taxable value of the GRIT’s remainder interest. A GRIT works well if non-income producing assets are the corpus of the GRIT, like vacant land or valuable collectibles. Like the QPRT, a GRIT is an effective tool to leverage a gift of appreciating assets out of the settlor’s taxable estate at relatively a low gift tax-cost.

Retained Life Estate: As the IRC 7520 rate increases, so will be the deemed value of the donor’s retained life estate interest. Thus, the gift of the remainder interest in an asset will result in a smaller taxable gift. If the gift of the remainder interest is to a non-family member, this will result in a smaller taxable gift of the remainder interest. Conversely, if the gift of the remainder interest in a principal residence or farm is to a charity, the result of an increasing IRC 7520 rate will mean a smaller income tax charitable deduction that is available to the donor.

Conclusion: All of these generalizations need to be viewed within the context of an individual donor’s objectives. Some donors are motivated to generate a present federal income tax charitable deduction in order to reduce their current income tax burden. Other donors are more motivated to remove appreciating assets from their taxable estate with the smallest gift tax consequence as possible. The above summaries are only intended as a ‘snapshot’ of how to initially view a conventional estate planning strategy in an increasing interest rate environment.