Take-Away: We are promised rising interest rates for the balance of this year and probably into next year as well. In a period of rising interest rates some estate planning strategies, like GRATs and CLATs,  work better than other conventional estate planning strategies. Similarly, increasing interest rates will dictate the minimum rate of interest that must be charged to avoid an implied gift in intra-family loans.

Background: While estate planning seldom lends itself to rules-of-thumb, a few do apply when it comes to changing interest rates.

  • Life Estate/Remainder Interest: When the estate planning strategy seeks to divide ownership of an asset into a current income (or annuity) interest and a remainder interest, the interest rate will determine the relative present values of each interest, and thus the ultimate effectiveness of the strategy and size of the taxable gift (if any.) When interest rates are high, the value of an income interest or life estate is increased, with a correspondingly lower value assigned to the remainder interest. The flip is also true. When interest rates are low, the value of the income interest or life estate is decreased, while the value of the remainder interest is increased, or higher.
  • Annuity: Interest rates affect a retained annuity interest differently from a retained income interest, however. When the prevailing interest rate is low, the value of an annuity interest is increased, or higher.
  • Unitrust: As a generality, a unitrust interest is not interest rate-sensitive at all.

These rules-of-thumb are applied to a couple of basic planning strategies described below.

Intra-Family Loans: A loan to a family member is  a popular estate planning strategy, simply because little legal expense is involved other than the creation of a promissory Note to document the loan. When interest rates are expected to rise, intra-family loans become more popular. To avoid the loan being characterized as a gift, the loan must bear interest at the relevant applicable federal rate (AFR). [IRC 7872.] In most cases, the AFR will be lower than interest rates charged by commercial lenders. There are three AFRs under the Tax Code: short-term (maturity not over three years), mid-term (maturity between 3 years and not over 9 years) and long-term (maturity over 9 years.) [IRC 1274(d).] AFR’s tend to lag market rates because the AFR is based on the average market rate on outstanding Treasury obligations for a one-month period; thus, to a degree, the required AFR rate is a bit ‘stale’ when compared to prevailing current interest rates, which is where some of the leveraging in this planning comes into effect.

  • Example: Dad loans Son $100,000 cash for 9 years this month. The AFR for mid-term loans in June 2018 is 2.84%. Interest accrues on the Note, with a balloon payment of interest and principal on the 9th anniversary of the Note. Son invests the borrowed funds and he earns on average 4.5% on the invested funds over the 9 years. The difference between what Son pays Dad in interest (2.84%) and what Son earns on his investment (4.5%), or 1.66% annually,  will pass transfer tax free to Son from Dad. The loan at the lower AFR rate locks in future appreciation in the invested loan proceeds to Son in a gift tax-free transfer of wealth.
  • Drawbacks: The downside to family loans is that Dad will someday receive the interest on the Note when the balloon payment is made, and if Dad is at a high marginal income tax bracket at that time, much of the accumulated interest on the Note will be paid in income taxes. One other drawback is that on Dad’s death, if the Note remains outstanding, the value of the Note will be included in Dad’s taxable estate. If Dad had simply gifted the $100,000 to Son, the entire $100,000 plus any future appreciation of that invested amount would escape estate taxation on Dad’s death.
  • Loan Variation: Dad loans cash to an intentionally defective grantor trust (IDGT) which trust names Son as its beneficiary. Unlike the straight-up loan to Son in the form of a promissory Note, Dad loans cash to the grantor trust, in exchange for the Trustee’s Note. As lender, Dad is not required to recognize the interest income on the Note that is paid to him from the grantor trust of which he is treated as the owner, paid either in installments or with a balloon payment when the Note comes due,  in contrast to the straight-up loan to Son, when Dad has to report the interest accrued on the Note when the balloon payment comes due. Because Dad must also pay the income taxes on the IDGT’s income and its other earnings (since it is a grantor trust) the additional income taxes paid by Dad will constitute additional gift tax-free gifts to the IDGT (and indirectly to Son.) Two benefits thus result from Dad loaning cash or assets to the IDGT: (i) the arbitrage of the two interest rates if the IDGT invests the loan proceeds at a greater return than the AFR rate required to be charged by Dad on the loan to the IDGT; and (ii) no income tax is paid by Dad on the investment earnings using the IDGT’s assets, which permits the IDGT’s investment earnings to be re-invested on a gift tax-free basis, further leveraging this planning technique.

Grantor Retained Annuity Trust (GRAT): This strategy, explicitly sanctioned in IRC 2702, attempts to pass appreciation, in excess of the required annuity payments to the grantor, onto the GRAT’s remainder beneficiaries, gift tax-free. The GRAT works somewhat differently than the Intra-Family loan described above. The present value of the grantor’s retained annuity interest is calculated using the IRC 7520 rate, which is often called the hurdle rate. The IRC 7520 rate is equal to 120% of the mid-term AFR rate published for the month the grantor transfers assets to the GRAT, rounded to the nearest 0.2%. Thus, while the mid-term AFR rate for June is 2.84%, the IRC 7520 rate for June is 3.4%. Accordingly, the GRAT’s investments must appreciate at a rate higher than the IRC 7520 rate used to calculate the annuity interest for the GRAT to succeed as a planning technique, which is why sometimes GRATs do not work to shift wealth to a younger generation. The difference between the value of the transferred property to the GRAT and the value of the retained annuity is a taxable gift, i.e. the value of the remainder interest in the GRAT is a taxable gift by the grantor. In order to avoid incurring a taxable gift on the transfer of assets to the GRAT, the GRAT can be zeroed out, by setting the annuity rate high enough, so there is no value assigned to the remainder interest in the GRAT, and thus no gift tax has to be paid- the value of the remainder interest is valued at $0.00. If (i) the GRAT’s investments outperform the IRC 7520  hurdle rate, and (ii) the grantor survives the GRAT term of the annuity payments, the remaining assets held in the GRAT when the annuity term ends will pass to the remainder beneficiaries gift tax-free. Thus, the performance of the GRAT typically improves at a lower IRC 7520 rate when the value of the annuity interest is higher, and the performance declines at a higher IRC 7520 rate when the value of the annuity interest retained is lower. Generally a short-term GRAT is preferred over a longer term GRAT due to the lower risk that the asset depreciation will offset asset appreciation during the GRAT’s annuity term. That said, a longer term GRAT that allows the grantor to lock-in a lower IRC 7520 rate when the GRAT is created may be more attractive in a rapidly rising interest rate environment.

  • Benefits: Because a GRAT is a grantor trust for income tax reporting purposes, if the grantor has retained the right to substitute assets of equivalent value with the GRAT (thus making it a grantor trust) if the transferred assets quickly appreciate in value, the grantor can substitute those appreciating assets to himself, in effect locking-in that early appreciation inside the GRAT, while exposing those appreciated assets to a basis step-up if the grantor dies holding appreciated assets.
  • Drawbacks: As a  generalization, GRATS are inefficient tax strategies. For starters, the grantor cannot assign any generation skipping transfer tax exemption (GSTT) to the GRAT until the grantor’s annuity period is over. Thus, if the GRAT performs as anticipated, there will be a larger value assigned to the remainder interest in the GRAT, and it is only then that more of the grantor’s GST exemption will have to be applied to protect those assets from future GST taxation, i.e. more of the grantor’s GST exemption will be used, and there will be no leveraging of the exemption to shelter any appreciation- a dollar of exemption must be used to shelter a dollar of appreciation of the GRAT’s assets. There is also the risk that the grantor does not survive the annuity period- a mortality risk. The grantor must survive the GRAT’s annuity term to avoid inclusion of all of the GRAT’s assets in the grantor’s taxable estate, in order to achieve the tax-free transfer of the asset appreciation. Along these same lines, if the GRAT investments underperform in the early years of the retained annuity, it is highly unlikely that over-performance of the investments in later years will cause the GRAT to shift wealth gift tax-free. More likely all of the GRAT assets will be consumed to pay the grantor his/her annuity, and nothing will be left inside the GRAT to pass on to its remainder beneficiary at the end of the annuity term.
  • Example: Dad transfers $1.0 million to a 5-year zeroed-out GRAT. The IRC 7520 rate is 3.2%. The GRAT’s investment assets grow on average at the rate of 6.0% a year. The present value of Dad’s retained annuity stream is $1.0 million, so there is no taxable gift to Son, who is the remainder beneficiary of the GRAT. After 5 years, Dad’s annuity payments end, and there is about $100,000 left in the GRAT that passes to Son gift tax-free. However, if using the same facts the IRC 7520 rate was 5% (not 3.2%)  when Dad transferred assets to the GRAT and retained an annuity from the GRAT, at the end of the GRAT’s annuity term, the amount of the remainder interest that passes to Son gift tax-free  is only about $36,000. Again, if the hurdle rate is higher when the GRAT is created (5% not 3.2%) it will be more difficult to beat overcome the hurdle rate with the GRAT’s investments.

Charitable Lead Annuity Trust (CLAT): A charitable lead annuity trust is similar to a GRAT, except that the fixed annuity is paid to charities, rather than the grantor, for a period of years. With a CLAT the grantor transfers assets to the CLAT, either during the grantor’s lifetime or on death (a testamentary CLAT.) The present value of the charitable annuity is calculated using the IRC 7520 rate. The difference between the value of the transferred property and the present value of the annuity is a gift from the grantor to the CLAT remainder beneficiaries. The amount of the charitable annuity is usually set so that the value of the gift to the remainder beneficiaries is zero ($0.00.)  If the CLAT’s investments outperform the IRC 7520 rate, the remaining assets held in the CLAT will pass to the remainder beneficiaries at the end of the annuity period gift tax-free. Thus, the performance of a CLAT, like a GRAT, typically improves at a lower IRC 7520 rate (when rates are rising), and it declines at a higher IRC 7520 rate (when rates may be falling.)

  • Benefits: When federal estate taxes were more of a concern, or the grantor was concerned about the maturity of his/her children or grandchildren to manage a large  inheritance, a testamentary CLAT was a  helpful device to avoid paying federal estate taxes, as the annuity paid to charities qualified for the federal estate tax charitable deduction, meaning the value of the remainder interest in the CLAT conferred on children and grandchildren was zeroed out,  and the children/grandchildren would not have access to the assets held in the CLAT until several years after the decedent’s death when the annuity period ended, presumably when they were more mature and thus able to manage their ‘deferred’ inheritance.
  • Drawbacks: Unlike a GRAT, a lifetime CLAT will not fail if the grantor dies during the charitable annuity period. But the charitable income tax deduction that the grantor took when assets were transferred to the CLAT will be subject to recapture. In an increasing interest rate environment a longer CLAT term might be better to lock-in the relatively low IRC 7520 rate when the CLAT was funded. But like a GRAT, a CLAT is not a good technique for GST tax planning, as the grantor’s GST exemption cannot be used until the charitable annuity period comes to a close, so there is no leveraging of the grantor’s GSTT exemption amount.
  • Example: Dad creates a lifetime CLAT. Dad transfers $5.0 million in assets to the CLAT. The IRC 7520 rate is 3.2%. The CLAT is scheduled to continue for 10 years. The CLAT’s assets grow at the average rate of 6% a year. The value of the charity’s annuity interest is $5.92 million, i.e. the remainder interest is virtually zeroed out ($80,000.). At the end of the CLAT annuity period, there will be about $1.15 million in assets available to Son, the CLAT’s remainder beneficiary. Same facts, but the IRC 7520 rate is 5% (not 3.2%) when Dad transfers the $5.0 million in assets to the CLAT.  The amount transferred by Dad to the charity via the CLAT’s annuity payments over 10 years will be $6.47 million, and the amount left in the CLAT at the end of the 10 years for Son will be about $419,000.

Conclusion: As interests rates continue to rise, the use of intra-family loans, GRATs and CLATs will become less popular. At present, clients may want to take advantage of these basic estate planning strategies in anticipation that interest rates will continue to rise. When we experience higher interest rates, yet a new set of estate planning strategies will take their place.