For good or for bad, interest rates are currently near all-time lows, including the “applicable federal rate” (“AFR”) which is used to set minimum interest rates for certain gift and estate tax planning techniques. While bankers and financial institution executives routinely consider the implications of such low rates for their institutions, they also should carefully consider the opportunities these low rates create for their estate planning and for that of their customers. Community bank owners and executives, in particular should not overlook these techniques that may help persevere years of wealth creation.
The October 2011 AFR is 0.16% for short-term obligations (up to 3 years), 1.19% for mid-term obligations (more than 3 years, up to 9 years), and 2.95% for long-term obligations (longer than 9 years). Such low interest rates could make this a good time to consider several estate and gift tax planning strategies that are generally more beneficial during periods of low interest rates. Here are some common techniques for bankers to consider:
Using an intra-family loan, one person loans money to another with an interest rate that can be as low as the current AFR (set based on the duration of the loan) without triggering gift or estate tax. These loans typically go from an older, wealthier generation to a younger, less wealthy generation. The borrower can use these loans to make investments expected to generate a return higher than the interest rate charged or to pay down higher-rate debt. Any returns the borrower obtains on the loan proceeds in excess of his or her loan payments will be retained by the borrower free of gift or estate tax.
Another tax-efficient way to transfer wealth is a Grantor Retained Annuity Trust (“GRAT”). A GRAT allows for the transfer of the anticipated future appreciation of assets to another person without triggering large tax liabilities. With a GRAT, the grantor transfers assets into a trust for a term of years. (Very short-term GRATs have been used in the past, although the IRS is scrutinizing those now that interest rates have fallen sharply.) During the term of the trust, the grantor receives an annuity payment based on the fair market value of the assets placed into the trust. At the end of the trust term, any remaining principal is distributed to the trust beneficiaries, which are generally a younger generation. The taxable gift is equal to the fair market value of the property placed into the trust, less the present value of the annuity payments received by the grantor. The values of the retained annuity payments and remainder interest are based on 120% of the mid-term AFR.
Lower interest rates increase the present value of the retained annuity payments, thereby reducing the value of the taxable gift of the remainder interest. In some circumstances it is possible to structure the GRAT so that the present value of the retained annuity interest equals the value of the property transferred into the GRAT, resulting in no deemed gift to the beneficiaries for tax purposes.
Intentionally Defective Grantor Trusts
A sale to an intentionally defective grantor trust (“IDGT”) may also be attractive when interest rates are low. The transferor sells property to a IDGT in return for an installment note with an interest rate that can be as low as the current AFR. At the end of the trust term, any income and appreciation on the trust assets, minus the note payments, passes to the trust beneficiaries. When the AFR is low, there is a greater chance that the trust assets will generate more income, or increase in value to a greater extent, than is necessary to service the note.
There are other more complicated techniques that also benefit from low-interest rates, so consultation with knowledgeable professional advisors is appropriate.