With the current uncertainty in the economy, many people are finding it difficult to focus on estate planning. The silver lining to the current economic slump, however, may be that temporarily reduced asset values, coupled with low interest rates, are helping to make a number of smart estate planning opportunities possible. In addition, when you consider some of the tax law changes being considered by Congress, there may be a limited opportunity to maximize the use of certain estate planning techniques for the benefit of your family. This alert discusses proposed estate and gift tax changes and the planning techniques that are particularly beneficial in today’s environment of low interest rates and depressed asset values.

Current Environment and Anticipated Gift and Estate Tax Amendments

While most people are aware of the current economic crisis, they may not know that an interest rate key to certain gifting techniques is currently near a historic low. Each month since the mid-1980s, the Treasury Department has published a rate used by the Internal Revenue Service (IRS) to value annuities, life estates, term interests and remainder interests. This rate, known as the § 7520 rate, is 2.4 percent for March 2009. Prior to January 2009, the lowest this rate had ever been was 3.2 percent and it has been as high as 11.6 percent.

Many estate planning commentators expect significant gift and estate tax law amendments to be enacted in 2009. Some anticipated changes would restrict the use of certain estate planning techniques to reduce gift and estate taxes:

  • Elimination of zeroed-out gift grantor retained annuity trusts by imposition of a requirement of a taxable gift of 10 percent of the value of the property given to the trust;
  • Elimination of qualified personal residence trusts; and
  • Elimination of valuation discounts (such as minority interest and lack of marketability) for family limited partnerships unless a substantial portion of the entity’s receipts are from the public.

A bill has been introduced in the House of Representatives that would (1) deny valuation discounts for an interest in an entity controlled by members of the same family after a transfer is made, but only to the extent that the entity owns passive assets, and (2) eliminate or limit valuation discounts for lack of control if members of the same family control the organization after a transfer has been made.

Estate Planning Strategies to Consider

Below Market Loans to Family Members

New Loans. A simple estate planning technique that can be used to provide liquidity to members of your family without making taxable gifts is to make a loan at a minimum IRS interest rate, known as the applicable federal rate. For March 2009, you can lend an unlimited amount to your children or other family members at a rate of 0.72 percent. The recipient of the loan can use the funds for any purpose (e.g., starting a business, paying down debt that has a higher interest rate or making other investments). If the funds are invested wisely, you will have effectively transferred wealth free of gift tax. For loans of more than three years up to nine years, the March 2009 rate is 1.94 percent. For loans with terms longer than nine years, the March 2009 rate is 3.52 percent. These rates are less than what is being offered by banks and no credit check or collateral is necessary.

Existing Loans. The present economic climate also presents opportunities for family lenders and borrowers who have existing loans at interest rates that are higher than the current applicable federal rate. One option is for the borrower to pay off the existing higher-rate loan and enter into a new loan at the current lower rate. Another possible option (e.g., where the borrower does not have the means to pay off the existing loan) may be for the borrower to issue a “new” note at the current lower rate and substitute it for the “old” note at the higher original rate.

Grantor Retained Annuity Trust

A more complex but potentially more effective planning option involves a grantor retained annuity trust (GRAT). A GRAT is a type of trust that provides for an annual payment back to the grantor – the person who created the trust – for a specified number of years (at least two or three years). The annual payments are based on the value of the assets contributed to the GRAT at the time of funding. The payments are often structured so the grantor receives the original value plus a modest rate of return equal to the § 7520 rate. At the end of the trust term, the remaining trust assets, if any, pass to the beneficiaries specified in the trust instrument, either outright or in further trust. If the assets in the GRAT appreciate at a rate exceeding the applicable § 7520 rate, the grantor will have succeeded in transferring additional assets to the remainder beneficiaries without any additional gift tax consequences. Funding a GRAT becomes much more attractive when funded with assets that are expected to increase in value and when interest rates are low – conditions that both exist today. If, however, the grantor dies during the trust term, the trust assets are pulled back into the grantor’s estate.

Installment Sales to Grantor Trusts

Another technique that can be used to take advantage of the current economic climate involves the sale of assets to a specially designed grantor trust. A grantor trust is one in which the grantor is treated as the owner of all trust property for income tax purposes. As a result, the grantor is taxed on all income (ordinary and capital gain) earned by the trust. In addition, a sale between a grantor and a grantor trust has no income tax effect; no gain is realized and the income tax basis of the property does not change. Generally, in a sale to a grantor trust, the grantor sells assets to the trust at a discounted value in exchange for payments – in the form of cash or stock – on an installment basis for the term of the note at the applicable federal rate (which for this type of transaction is lower than the § 7520 rate). At the end of the note term, the assets (and all of the appreciation) are owned outright by the trust without incurring any transfer tax liability. If the trust assets appreciate at a faster rate than the applicable federal rate, the transfer tax benefits can be significant. Like a GRAT, this technique can be particularly advantageous when interest rates and asset values are low. As with most sophisticated estate planning techniques, an installment sale to a grantor trust involves some risk. However, in the right circumstances, such as currently exist, the potential benefits of this technique can be significant.

Each family’s goals and circumstances are unique, and it is important to gain a full understanding of the available options before deciding which technique(s) would be most appropriate to pass wealth to members of your family.