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.
For our example, we will assume a GRAT funded with property assumed to have a fair market value of $1 million. We will also assume the grantor, age 60, will receive payments of $75,000 at the end of each year for 10 years. Had the grantor funded the GRAT in January 2007, the AFR used to value the gift would have been 5.6%. If the GRAT were funded in January 2009, the AFR would have been 2.4%. See chart 1 and note the difference in the value of the taxable gifts based on the change in interest rates.
Private financing for estate planning
Clients might benefit from low interest rates when using private financing, also known as private split-dollar loans. With these arrangements, the client or spouse typically pays the premiums on a life insurance policy held by an irrevocable life insurance trust (ILIT). The premium payments are treated as loans from the premium payer to the trust.
Here, too, the IRS-mandated rates, the AFRs, are used to determine the minimum interest rate the premium payer charges for the loan. With low interest rates, less money or other property needs to be transferred to the trust to enable it to make the required interest payments.
These arrangements usually treat each premium payment as a separate loan, usually annual loans. However, your clients may want to lock in low rates today. There are two options.
The first is for them to make a large loan this year to help jump-start a life insurance policy and provide the trust with enough value to be able to pay premiums and interest on an ongoing basis. Or, they may be able to make a smaller loan to the trust and make ongoing annual exclusion gifts.
The second way is to combine depressed property values with low interest rates. If a client has property that generates income, even with depressed market values, why not suggest they make a loan of the property now while the rates are so low? With depressed property values and depressed interest rates, the loan interest the trust needs to pay is likewise reduced. The benefit is that more of the money generated by the property can remain in the trust and benefit the client’s family.
For example, property worth $1 million two years ago and generating 5% income (or $50,000) still generates that same $50,000 even if it might now only be worth $750,000. A reduced loan of $750,000 can be made and still have that property generate $50,000 each year in the trust for the premium payments. (Note: In some cases, lower values may mean property is generating lower income streams, requiring consideration of whether the property can generate the needed income streams to make payments.)
Impact of depressed rates
If a loan with a term longer than 9 years is used, rates can be locked in for a long period of time. For January 2009, the long-term, IRS-mandated AFR was 3.57%. To consider this in light of rates established by the IRS over the prior 20 years, see chart 2.
This is especially attractive for clients who have limited or no remaining annual gift exclusions and properties that can generate significantly more income than 3.57%. Using this approach can provide substantial leverage.
For example, a property worth $1 million generating $80,000 of rental income could service interest payments of $35,700 as well as premium payments of $44,300. On a 60-year-old male in good health, $44,300 paid for 15 years could buy a universal life insurance policy with a face amount of $1.75 million, with no gifts involved.
What if this property was still generating the same level of income, but the fair market value had dropped to $620,000, like our previous GRAT example? The loan interest on the note would only be $22,134, leaving $57,866 for life insurance premiums. For a 60-year old male, that amount of premium paid for 15 years could buy $2.3 million of UL insurance.
Your clients have potentially an opportunity that may not present itself again. If they have been considering implementing a wealth transfer strategy, there may never be a better time than now to do so from a gift-tax leverage perspective.
Bruce A. Guillemette, MSM, CLU, ChFC, FLMI is assistant vice president of advanced markets in the Life Division of AXA Distributors, LLC., New York. Mark Teitelbaum, JD, LLM, CLU, ChFC, is vice president of advanced markets of AXA Distributors’ Life Division. Bruce and Mark can be reached at [email protected] and [email protected], respectively.