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Portfolio > Asset Managers

It's Not "Business As Usual" These Days

By Patrick A. Lang

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All planning tools are not created equal. Some are more appropriate depending upon the interest rate environment and relative asset values. As you are probably aware from personal experience, savers and investors are wringing their hands over the current low interest rates and depressed asset values.

News flash: Low interest rates and depressed asset values create an ideal environment for using selected financial and estate planning strategies.

The two interest rates we’ll focus on are the applicable federal rate and the IRC Section 7520 rate. The AFR is the minimum interest rate that must be charged on loans. The 7520 rate is used to value retained interests or split interest gifts.

The current (February 2010) annual long-term (greater than 9 years) AFR is 4.44% and has been holding relatively steady for the past three months. The current Internal Revenue Code (IRC) Section 7520 rate is 3.4%, just 0.4% above last month’s rate. Let’s look at some of the techniques that work well in the current low interest rate and/or depressed asset value environment.

Outright gifts

The gifting of assets that are depressed in value results in lower gift taxation. In addition, the lifetime gift tax exemption of $1 million and the 2009 annual exclusion of $13,000 can shelter “larger” gifts when asset values are temporarily depressed.

Intra-family loans

Wealthy families often transfer assets between generations to allow the next generation to capitalize on business and investment opportunities. Low interest rate requirements minimize the amount that must flow to the lender, allowing the borrower to retain the capital for longer periods and/or borrow more money as opportunities arise.

Installment sales

An installment sale is used to ease the burden on the purchaser of acquiring a substantial asset, as the sale spreads the repayment obligation over a period of time, rather than requiring the buyer to make a large single payment. Depressed prices and low interest rates make this an attractive technique for intra-family transfers where outright gifting will not be used.

Self-cancelling installment notes

A self-cancelling installment note (SCIN) is an excellent way to structure intra-family transfers, as nothing is included in the estate of the seller (typically the senior generation) since the obligation is cancelled at death. Again, depressed values and low interest rates ease the burden on the purchaser and make the transfer more cost-effective.

Private annuity

A private annuity is similar to a SCIN, but without the cancellation at death. The beauty of the private annuity is its ability to freeze the value of the transferred asset and shift all future growth on the asset to the next generation. Since the value of the asset given up and the value of the annuity received in exchange are equal, there are no gift taxes due on the transaction. Think of this technique as an installment sale for a period of life expectancy.

Loans/sales to defective trusts

These techniques are typically used to get premiums into an irrevocable life insurance trust (ILIT), without paying current capital gains tax on assets sold to the trust. Defective trusts are appropriate when the donor is willing and able to pay income tax on assets held in the trust, resulting in no income tax “drain” on the trust. Lower interest rates create less of an obligation on the part of the trust. Low current asset values require a smaller note back to the seller, which helps keep down the seller’s ultimate estate tax exposure.

Grantor Retained Annuity Trust

A grantor retained annuity trust (GRAT) is a split-interest gift, wherein the donor retains an income interest and the remainder passes to the next generation or a trust for their benefit. Low interest rates result in an increased value of the current income stream, which depresses the value of the remainder interest subject to gift tax.

Charitable Lead Annuity Trust

This tool gives a charity annual payments for a set term with a remainder of the interest given to a non-charitable beneficiary, such as children or grandchildren. The goal is to maximize the value of the annuity interest and minimize the value of the remainder interest to minimize any gift tax exposure. Any appreciation in value above the Section 7520 (“hurdle”) rate passes to the remainder beneficiaries without gift or estate tax exposure. Low interest rates depress the value of the remainder interest gift and increase the charitable deduction for the charity’s annuity interest.

Qualified Personal Residence Trust

While the QPRT is not a perfect match for a low interest rate environment, depressed values and the availability of time-value discounts make this split-interest technique a viable tool under current conditions. All future growth in the value of the home inures to the benefit of the family members who will eventually receive title to the property.

Hopefully some of the above techniques will be appropriate for selected clients. It certainly improves your odds of success to have additional strategies to bring to the table. And with the current low interest rate and the depressed asset value landscape, people should be open to ideas to “make lemonade from lemons” and move forward now with effective estate planning.

Patrick A. Lang, JD, CFP, CLU, ChFC, CFS, is vice president, sales strategies and business development, for National Life Group, Montpelier, Vt. You can e-mail him at [email protected].

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