By: Matthew Curtis, JD
“Make hay while the sun shines” is an adage that is very familiar to farmers and to many others as well. It comes from an old English proverb that advises one to act when the opportunity presents itself, if not, the opportunity may slip away. We are all aware that interest rates have been at (or near) historic lows for some time. Many economists are suggesting that rates may be rising soon. If so, the time to take advantage of a historic opportunity for planning may be fleeting.
The level of interest rates can play a significant role in the success or failure of several time-tested transfer techniques for families with wealth. A grantor retained annuity trust (GRAT) is a strategy by which the owner (grantor) of an asset transfers all or part of the asset to a trust but continues to receive fixed payments from the GRAT for a period of time. When the payments and time period have ended, the trust returns the original amount back to the grantor. The benefit comes from the potential that the asset(s) have increased in value. If so, that “appreciation” is retained by the GRAT for the benefit of the remainder beneficiaries, such as children or grandchildren, free of estate and gift tax.
The current low interest rate environment makes GRATs more attractive because of the way the tax code values the transaction. Each month, the IRS sets a new rate at which generally fluctuates with prevailing bond yields. Generally speaking, the rate by which the GRAT is valued is locked in as of the date of the transfer. It is called the “7520 rate.” The greater the spread between the rate at which the trust assets are growing and the applicable 7520 rate, the greater the amount of assets that are transferred tax-free. Low rates are good.
Another effective strategy for reducing potential estate taxes is to sell rapidly appreciating assets to a grantor trust in exchange for a note. The minimum interest rate on the note is again set by the IRS. Like the 7520 rate, each month the IRS sets new rates for short-term, mid-term, and long-term transactions between family members. If the asset that is sold appreciates at a rate greater than the interest rate on the note, then the appreciation is transferred tax-free. Again, low rates are good!
One unique attribute in both of these techniques is that, for income-tax purposes, when someone creates a trust but retains certain rights such as the ability to substitute property and maintain aspects of control in the trust, transactions between the trust and the grantor are not taxable events. That means the sale of appreciated property to the trust does not trigger a capital gains tax. It also means the grantor who funded the trust is responsible for the taxes on the income and realized gains created inside the trust. The payment of these taxes for the benefit of heirs is like an additional gift that can be made above and beyond the annual gift threshold.
The rates set by the IRS are effectively hurdles that rise and fall with prevailing interest rates. When interest rates inevitably begin to rise, the gap between the hurdle rate and the appreciation rate will narrow. So…as the proverb goes, make hay while the sun shines.