Significant declines in key economic indicators during the COVID-19 pandemic have encouraged the Federal Reserve to maintain its aggressive monetary policy, keeping benchmark interest rates near zero. Despite the financial fallout and future uncertainty created by the coronavirus, high-net-worth individuals should consider these periods of low-interest rates to be a prime time to implement certain estate-planning and wealth-transfer opportunities that minimize or even eliminate gift and estate tax consequences. This is especially true when considering that the very generous estate and gift tax exemptions under current tax law are set to expire and be reduced by half in five years, which may occur even sooner depending on the results of the November 2020 elections.
Today’s historically low-interest rates translate to equally low Applicable Federal Rates (AFRs), which are the minimum rates of interest the IRS allows to be charged on loans between related parties without triggering gift taxes. As of May 2020, the AFR is as low as 0.25 percent for loans of up to three years and 1.15 percent for loans extending longer than 9 years.
With an intrafamily loan, a senior family member removes assets from his or her taxable estate by lending money or other assets to a junior family member or a trust, entering into a traditional lender-borrower relationship with a promissory note and stated repayment terms. As long as the interest rate on the loan is equal to or higher than the current AFR, the loan will not be considered a gift and the transfer will not be subject to gift tax.
The junior family member/borrower receives the loan proceeds as cash, which he or she may invest in the public equity markets, at currently depressed values, for future income and appreciation. He or she will pay interest on the loan at the low rate back to the senior family member/lender, thereby keeping wealth within the family, and he or she will receive the benefit of any income generated by the investment or appreciation above the loan’s interest rate.
Similarly, with today’s historically low AFRs, junior family members/borrowers may want to consider refinancing existing intrafamily loans to secure preferable rates and repayment terms. In doing so, families must take into account the consideration that must be provided to the lender to ensure the loan is not treated as a taxable gift.
Another wealth-transfer strategy that works well in low-interest rate environments, especially when asset values are low, is a grantor retained annuity trust (GRAT).
The unique feature of a GRAT is that the senior family member/grantor funding the trust for heirs retains a right to receive over the life of the GRAT the value of hid or her initial contribution via qualified annuity interest payments with a rate of return set by the IRS (commonly referred to as the hurdle rate or Section 7520 rate). When the terms of the annuity and GRAT expire, assets remaining in the trust (above the annuity payments and any appreciation of principal), will pass to the grantor’s intended beneficiaries tax-free.
With securities, real estate and businesses currently at depressed values, grantors may sell or gift these assets to a GRAT at the current discounted value, removing them and their future appreciation from their taxable estates and allowing for greater leverage on estate freezes. Further discounts for lack of marketability and lack of control may also be applied for transfers of minority interests in companies and limited partnership interest. These discounts on assets allow for greater leverage on estate freezes. In addition, gift tax exposure may also be eliminated when grantors “zero-out” the GRAT or approximate the value of the annuity to the value of the transferred property at the time of funding. In other words, the annuity payments equal the value of the contributed assets plus the hurdle rate, which, as of May 2020, is as low as 0.80 percent.
All appreciation of GRAT asset above the current depressed values and the hurdle rate will pass to heirs free of gift taxes. However, it is important to note that if a grantor passes away before the distribution of all annuity payments, the trust may be considered part of the grantor’s estate and subject to estate tax.
Senior family members wishing to take advantage of intrafamily loans and or GRATs during this period of low-interest rates and depreciated assets value may also want to consider the benefits of using intentionally defective grantor trusts (IDGTs). Grantors may fund IDFTs for the benefit of their heirs by removing assets and their future value from their taxable estates, thereby freezing the value of their estates and reducing estate tax exposure. However, grantors do retain certain powers that require them, and not trust beneficiaries, to pay tax on all trust income even though they are not entitled to take any trust distributions. With grantors using non-trust assets to pay income tax liabilities for the trust, they are further reducing their taxable estates.
Now is a good time to meet with your financial advisors to assess your current estate plan and implement strategies that can allow you to leverage current market conditions to achieve your specific goals.
About the Author: Eric P. Zeitlin is managing director of Provenance Wealth Advisors, an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors and Accountants, and a registered representative with Raymond James Financial Services. For more information, call (954) 712-8888 or email email@example.com.
Provenance Wealth Advisors (PWA), 515 E. Las Olas Blvd., Ft. Lauderdale, FL 33301 (954) 712-8888.
Eric P. Zeitlin is a registered representative of and offers securities through Raymond James Financial Services, Inc., Members FINRA/SIPC.
Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors and Accountants. PWA is not a registered broker/deal and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc., and Provenance Wealth Advisors.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of the advisors of PWA and not necessarily those of Raymond James. You should discuss any tax or legal matters with the appropriate professional. Prior to making an investment decision, please consult with your financial advisor about your individual situation. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Investments mentioned may not be suitable for all investors, RJFS does not provide tax advice.