It seems clear now, in 2009, that estate taxes are here to stay. Couple that with the constant barrage of negative economic reports, and your clients could probably use some good news.
Here is something that may help: This may be an excellent time for them to do common wealth transfer techniques. Why? They have the benefits of a double discount when implementing these techniques through:
(1) Reduced market value.
(2) Historically low interest rates.
Depressed asset values alone help clients when making gifts to their family: the lower the value, the lower the potential gift tax.
Low interest rates can also help drive down the value of gifts they make. The gift tax value resulting from common estate and gift tax techniques are based on a variety of factors, including current Treasury note interest rates. Often, the lower the rate is, the lower will be the gift’s value. In effect, there is a double discount–low asset values and low interest rates.
How interest rates come into play
With many common gift tax transfer techniques, the tax code and the Internal Revenue Service require calculations that are, in part, based on applicable federal rates. AFRs, in turn, are based on different durations of U.S. Treasury notes and are reset by the Treasury every month. Depending on the technique and design, clients might use a short-term, mid-term or long-term AFR.
The various AFRs have gradually decreased in recent years. In January 1989, the mid-term AFR was 10%. Since 2002, the rate has hovered between 4% and 5%. Today, in early 2009, they are at near historic lows.
What does this mean for your clients? The lower the AFR, often the smaller the gift value for tax purposes. Effectively, they can benefit from the combination of low interest rates and depressed property values.
How does this work?
Let’s look at an example of low AFRs used with a wealth transfer strategy such as a grantor retained annuity trust. A GRAT is a trust to which the grantor transfers property with a retained right to receive payments for a period of years, otherwise referred to as an annuity. GRATs generally result in a taxable gift of a future interest made by the grantor. Because the gift won’t be completed until the future transfer, typically to the children, the value of the gift is usually far lower than even the current market value.
The value of the gift is determined by subtracting the value of the annuity from the fair market value of the property transferred to the trust. Like a commercial annuity, the amount required to create the specified stream of annuity payments increases as the earnings on the annuity decreases, and vice-versa. So, as the AFR decreases, the present value of the annuity increases and therefore reduces the amount of the taxable gift. The benefits come from:
? Lower asset growth rates on the assets are assumed by the IRS due to the lower AFR, resulting in even lower calculated remainder interests after the annuity payments are satisfied.
? The value of the gift made to the trust is already reduced because of the economic downturn.