By Richard Kissel II and Aaron P. Snellenbarger
We are almost halfway through 2020 and have seen the stock market fall, rally and fall again. We have been trapped in our houses unable to help our unstable economy, attempting to find new hobbies to pass the time and, of course, practicing social distancing. The silver lining to this pandemic is that it has provided an opportunity for us to better ourselves, and with falling interest rates, transfer our clients’ wealth to the next generation. Currently, for May 2020, the Federal 7520 Interest Rate (the “7520 rate”) is 0.8% (anticipated to be 0.6% in June). The Applicable Federal Rate (“AFR”) for obligations of more than three and up to nine years is 0.58% (interest compounded annually), and the AFR for obligations of less than three years is 0.25% (interest compounded annually).
The 7520 rate and the AFR are important rates when transferring wealth to future generations through transfers that efficiently use a client’s available applicable federal exemption (“exemption”), which is currently $11,580,000. This article discusses three estate planning transactions that use the 7520 rate or the AFR: (1) grantor retained annuity trusts (“GRATs”); (2) intra-family promissory notes (“notes”); and (3) defective grantor trusts (“DGTs”).
A GRAT is a relatively conservative estate planning transaction that moves wealth free of estate tax to a future generation of a client’s family. The GRAT uses a minimal amount of a client’s exemption (often less than $100) with the only risk of loss being transaction costs to draft and establish the trust. When using a GRAT, the client who creates the trust (the “grantor”) transfers (hopefully) appreciating property to a GRAT while retaining the right to an annuity for a fixed term, generally between two years and 15 years.
A successful GRAT is funded with an asset(s) that appreciates at a rate greater than the 7520 rate in effect when the GRAT is formed (currently 0.8%). Any amount greater than the 7520 rate is transferred to the future generations of a client’s family free of federal gift and estate tax. If the GRAT property does not appreciate at a rate greater than the 7520 rate, the asset(s) of the GRAT are transferred back to the client.
A note is the simplest way to transfer a client’s assets to a family member. In an intra-family loan, an older generation loans money to a younger generation at the AFR, who then uses the loan proceeds to purchase investment property.
In order to avoid a loan being reclassified as a gift, the loan should be made for “adequate and full consideration” or “in the ordinary course of business.” This means the note should have an interest rate of at least the AFR. The borrowing family member should have the ability to repay the note and make annual payments of at least the outstanding interest. The payments should be reported for federal income tax purposes, and an accountant should diligently document payments or missed payments.
To be successful, the investment property purchased must outperform the AFR, which is currently 0.25% for a note of less than three years.
A DGT transaction uses the combination of a grantor trust, appreciating property and a promissory note to transfer wealth. Because of its use of leverage, a DGT transaction has the potential to transfer the greatest amount of wealth tax-free to future generations.
Step one in a DGT transaction is the formation of a grantor trust for the client. The trust is drafted as a grantor trust so that capital gain is not recognized on the sale of assets to the trust and permits the grantor to pay income tax on the trust’s income without making a gift. The trust will often contain provisions that allow its assets to be exempt from federal generation-skipping transfer (“GST”) tax and protected from the beneficiaries’ creditors.
Step two, the trust receives a seed gift from the client using exemption and GST exemption. The gift is often equal to 10% of the overall transaction’s value or a personal guarantee from the client of an equivalent value. This transfer or guarantee gives the trust the substance necessary to enter the promissory note in step three.
Step three, the client’s property is sold (often at a discount) to the trust in exchange for a promissory note back to the client, charging interest at the AFR.
A DGT transaction succeeds when the property transferred appreciates at a rate greater than the AFR. Additionally, the client’s estate is reduced by the amount of any discount applied to the property sold in the DGT transaction.
While the current times are unprecedented, so is the opportunity to transfer a portion of a client’s wealth to the next generation free of federal gift and estate tax using the estate planning transactions discussed in this article.•
• Richard Kissel — [email protected] — and Aaron Snellenbarger — [email protected] — are attorneys in Taft’s Private Client group. Opinions expressed are those of the authors.