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The IRS issues every month a “7520 rate” (named after the code section to which it relates) which is used as an assumed rate of return to measure the values of gifts in certain advanced estate planning techniques. The 7520 rate for March is at a historically low 1.4%. Generally, many estate planning techniques succeed when assets transferred outperform the 7520 rate, and, therefore, when the rates are low, there is more opportunity to beat the 7520 rate. Here are some estate planning strategies that work well when interest rates are low and others that do not.
I. The Good
A grantor retained annuity trust (“GRAT”) pays an annuity to the grantor for a specified term of years (the “retained interest”) with the balance at the end of the term passing to designated beneficiaries (the “remainder interest”). The present value of the remainder interest is a gift, while the retained interest is not. The GRAT produces a tax benefit only if the assets produce a total return in excess of the 7520 rate. This is why the GRAT is attractive when the 7520 rate is very low. And the GRAT has little downside when the retained annuity is calculated to “zero out” the gift, which is when the grantor retains an annuity equal to the value of the entire trust and is not considered to have made a gift. In that case, if the GRAT assets do not outperform the 7520 rate, the grantor takes back all the transferred property and ends up in the same position as if the GRAT were not done in the first place (except for transaction costs). GRATs are usually short-term (2 years), to capture market volatility. Oftentimes, multiple GRATs will be created and each will hold a single investment, such as stock in one company. In a time of low interest rates, however, a longer term GRAT with more diversified assets may be attractive since the 7520 rate will be locked in, but the grantor must survive the term for the GRAT to work affectively.
For clients with philanthropic goals, the charitable lead annuity trust (“CLAT”) produces a similar benefit to GRATs when interest rates are low. Here, the charitable beneficiary receives the annuity and any growth in the trust in excess of the 7520 rate passes to the non-charitable remainder beneficiaries at termination of the CLAT free of gift or estate tax. The value of the gift to the remainder beneficiaries is discounted by the value of the charitable annuity which is deductible for gift tax purposes.
CHARITABLE GIFT OF REMAINDER INTEREST IN HOME OR FARM
The gift to charity of a remainder in a personal residence or farm works great for the charitably-inclined donor. With this strategy, the donor usually deeds a personal residence or farm to a charity and retains a life estate. If a residence is transferred, it does not need to be the donor’s primary residence. And this technique does not require a trust (contrast the QPRT). Because the retained use of the property is equivalent to an income stream, the lower the interest rate, the less the retained interest is deemed to be worth (and correspondingly, the more the charitable gift is worth). With retained life estates, the value of the property is included in the donor’s gross estate, but a 100% estate tax charitable deduction avoids any estate tax.
SALES AND PRIVATE ANNUITIES
Note payments on a sale to a intentionally defective grantor trust (“IDGT”) or low interest loans to family members will be lower when interest rates are low, and so too are the payments on a private annuity when interest rates fall. A popular strategy for very large estates is the sale to an IDGT. Here, the grantor creates an irrevocable trust for his beneficiaries and structures it to be a “grantor trust” for income tax purposes (making it a disregarded entity for income tax purposes). The grantor then sells assets to the IDGT that are expected to produce a high total return in exchange for an installment note paying the lowest rate of interest possible (interest rate is determined by the applicable federal rate which varies according to the term of the note). If the rate of return on the transferred assets exceeds the interest rate paid by the IDGT on the note, there is a tax-free transfer of assets from the grantor to the beneficiaries.
II. The Not-So-Good
In the case of a Qualified Personal Residence Trust (“QPRT”), the grantor transfers a residence into a trust and retains the right to use the residence for a term stated and upon expiration of the term, the remainder passes to named beneficiaries. The gift is the present value of the remainder interest while the value of the retained term interest is not a gift. The retained term interest is valued using the 7520 rate. Retaining less means you gift more. QPRTs work best when interest rates are high and are less attractive when interest rates are low. In addition, for the QPRT to be successful for tax purposes, the grantor must survive the term, otherwise the residence is included in the grantor’s estate for estate tax purposes.
CRATS AND CHARITABLE GIFT ANNUITIES
With both charitable remainder annuity trusts (“CRATs”) and charitable gift annuities, the donor receives an annuity for a term and upon expiration, the remainder passes to a charitable beneficiary. The charitable deduction is determined by subtracting from the value of the property or cash contributed, the value of the retained annuity interest. The higher the value of the retained annuity interest, the lower the charitable deduction. When interest rates are low, the value of the retained annuity is high and the charitable gift (and charitable deduction) is low.
With values and the 7520 rate low, and the gift tax exemption high at $5,120,000 (until January 1, 2013), now is the time to be considering gift planning…but don’t wait too long!