Today’s economic environment presents unique estate planning opportunities for high-net-worth clients to consider with their trusted tax and legal advisors. Assuming your clients are comfortable that they have more than sufficient assets to support their lifestyle, today’s lower valuation of “excess assets” (including marketable securities and real estate) may make them excellent candidates for lifetime gifts.
Lower valuations potentially mean less gift tax exposure on both the federal and the state level. As always, family dynamics and other tax considerations should be evaluated before making these transfers. The graph on this page shows the IRC Section 7520 rate, a “key” estate planning interest rate, during the month of September from 1989 to the present.
Note that while the trend is down on a historical basis, the 7520 rate has been moving up this year: from a low of 2.0% in February to 3.4% today. While the 7520 rate is used when contemplating an estate plan, it is also representative of other rates used, including the short-term, mid-term and long-term applicable federal rates (AFR). While it’s not too late to leverage planning strategies that benefit from low interest rates, time may be of the essence.
The following is a list of the key considerations associated with various strategies that may also involve the purchase of life insurance.
Grantor-Retained Annuity Trusts
A GRAT is an estate-freezing strategy that enables clients to transfer the future appreciation on stock or other property to heirs at no or minimal gift tax cost. GRATs are particularly attractive when asset values are depressed and interest rates are low.
Clients transfer property they expect to appreciate to an irrevocable trust for a fixed term of years. During the GRAT term, they receive a stream of annuity payments, payable with cash or property. When the GRAT term expires, any property remaining in the trust after payment of their annuity passes to their children or another named beneficiary.
Transfer-tax benefits of a GRAT are realized when the transferred property produces a return in excess of the IRS assumed rate of return (IRS Section 7520 rate). If a client dies during the trust term, some portion of the trust property may be included in his or her estate and the beneficiaries receive nothing from the trust. In that circumstance, the client would end up in about the same position as if he or she had not created the GRAT.
Fortunately, this risk can be insured. The grantor can use the GRAT income to purchase life insurance to cover the inclusion of the asset that could potentially revert back into the estate or to increase the inheritance of the beneficiaries.
Installment sale to an Intentionally Defective Grantor Trust
An installment sale to an intentionally defective grantor trust (IDGT) is an alternative estate-freezing strategy that is often compared to a GRAT. This trust is so named because transfers to it can be removed from the client’s estate but are still considered owned by them for income tax purposes. After creating the “defective” trust with an initial gift (typically 10% of the sale price), assets that they expect to appreciate are sold to the trust in exchange for an installment note equal to the property’s fair market value.
During the term of the note, the grantor receives interest payments from the trust and a balloon payment of principal at the end of the note term. As the trust is a grantor trust, no gain or loss is reportable on the sale; and the interest payments are not reportable as income. All future appreciation of the trust assets in excess of the note’s AFR passes to children or another named beneficiary free of estate or gift tax.
In addition, if the IDGT is drafted to allow for the purchase of life insurance on the grantor’s life, the trustee can use the income generated by the transferred asset (after the interest payment on the note) to purchase life insurance. Low AFRs and, therefore, note payments mean that more income is available to purchase life insurance. Also, buying the policy inside of the IDGT assists the trustee in paying the grantor’s estate tax burden without having to worry about gift taxes.