3 Estate Planning Strategies for a Low-Rate Environment

The ongoing rise in capital markets has likely created significant wealth for many of your high-net-worth clients. Although the estate tax exemption currently stands at a generous $5.43 million per individual, the wealthiest clients continue to seek estate and gift tax mitigation strategies. For clients whose net worth exceeds the exemption threshold, now may be an excellent time to implement estate planning strategies designed to take advantage of today’s historically low interest rates. 

Section 7520 of the Internal Revenue Code provides for a key interest rate that is used to value certain interests involved in various estate planning strategies, including annuities, life interests, interests for a term of years, and remainder and reversionary interests. Published monthly by the IRS, the Section 7520 rate is based on the midterm applicable federal rate, or AFR. As of May 2015, the Section 7520 rate stands at a low 1.8%, making certain gift and estate tax planning strategies very attractive.

Let’s take a brief look at several strategies that may be appropriate for some of your wealthiest clients. 

Strategy One: Intrafamily Loans

An intrafamily loan is one of the simplest ways to take advantage of low rates. Simple doesn’t mean ineffective, however. With an intrafamily loan, wealthy parents and grandparents can provide their children and family members with access to capital at a very low interest rate compared with loans available through traditional retail banks.

Why would clients charge their family members any interest at all? The answer is gift taxes.

In addition to the Section 7520 rate, the IRS publishes short-term, midterm, and long-term AFRs that represent the minimum interest to be charged on loan instruments in order to avoid triggering gift taxes. The rates as of May 2015 are as follows (compounded annually):

-- Short-term rate (for loans with terms of three years or less): 0.48%
-- Midterm rate (for loans with terms of between three and nine years): 1.53%
-- Long-term rate (for loans with terms over nine years): 2.30%

As long as these minimum interest rates are applied based on the proper loan term, clients can avoid triggering a taxable gift while helping family members buy a home, start a business, or make other investments. If those ventures produce a rate of return that exceeds the rates mentioned above, those proceeds are not considered part of the client’s taxable estate.

Strategy Two: Grantor Retained Annuity Trusts (GRATs)

A GRAT allows a client (the grantor) to transfer assets to a trust while retaining an annual annuity payment from the trust for a certain number of years. Assuming the grantor survives the term of the GRAT, the assets remaining in the trust pass to the GRAT beneficiaries—the grantor’s children, for example.

When funding a GRAT, the grantor makes a taxable gift of the trust’s remainder interest, but that gift is discounted to reflect the annual retained income interest. If the assets owned by the GRAT appreciate at a rate above the Section 7520 rate, the appreciated assets essentially pass to the trust beneficiaries outside of the grantor’s taxable estate and free of additional gift taxes. 

GRATs have a few moving parts that we’ll explore in a future post, but there is one constant: the lower the Section 7520 rate, the more likely it is that the GRAT will be a successful strategy for a client. 

Strategy Three: Charitable Lead Annuity Trusts (CLATs)

For clients seeking a wealth transfer strategy to meet their estate and charitable planning needs, a CLAT is worth considering. Similar to the GRAT, the CLAT is complex, but again, the Section 7520 rate plays a key role in the strategy’s effectiveness, as it is used to calculate the remainder interest that will pass to the client’s family members. With a historically low 7520 rate, any appreciation above that rate represents wealth that will pass to family members free of additional gift and estate taxes. 

Unique Wealth Transfer Opportunities

The current interest rate environment presents valuable opportunities to implement wealth transfer strategies designed to maximize the amount your wealthy clients can give to family members while minimizing the gift and estate tax impact. 

In future posts, I will explore each of these strategies in greater depth and provide examples of how advisors have successfully used them with clients.

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