Every month, the Internal Revenue Service issues its "Applicable Federal Rates" for the following month. These rates are a key component in many estate planning strategies and, as a general rule, lower rates provide for significant opportunities to shift wealth to junior generations. The Applicable Federal Rates for the current month are at a historic low. For example, the current rate for a loan of three years or less is a mere 0.16%!
What do these historically low interest rates mean for you? It means that now is the time to:
- Transfer assets to a grantor retained annuity trust (GRAT).
- Make an "intra-family" loan to your children or grandchildren.
- Make loans to trusts for the benefit of your descendants.
- 4. "Refinance" existing intra-family notes or trust notes that bear a higher rate.
Transfers to GRATs
By way of brief background, a grantor retained annuity trust (or "GRAT") is a statutorily sanctioned type of trust whereby the grantor transfers property in trust but retains the right to receive payments from the trust for a predetermined period of years. Most commonly, the payments are structured such that, after accounting for a federally mandated rate of return on the property transferred into the GRAT (called the "§7520 Rate" and based on the Applicable Federal Rates for the month in question), the present value of the payments will equal the value of the property transferred into the GRAT. When the annuity payments are structured in this manner, the GRAT is often referred to as being "zeroed-out" because the remainder interest has no value for gift tax purposes; thus, no gift tax is payable and no gift tax exemption is used in connection with the funding of the GRAT. To the extent that the investment return on the GRAT property exceeds the §7520 Rate, value will remain in the trust after all annuity payments are made thereby effecting a tax free gift of the excess return.1 The §7520 Rate for October is only 1.4%. Accordingly, to the extent that an investment return in excess of 1.4% is achieved, there will be a tax-free transfer of assets to the ultimate beneficiaries of the GRAT (typically the grantor's spouse and children).
As a result of the historically low interest rates, it's also a good time to loan money to younger family members. As noted above, the minimum interest rate in October for a loan of up to three years is 0.16% and loans between three and nine years carry a minimum interest rate of only 1.19%. To the extent that the loan recipients are able to invest the borrowed funds and generate a return greater than the minimum interest rate, wealth will have been successfully transferred without any gift tax.
By way of example, if a loan of $1 million were made to a child for 3 years at 0.16% and the child invests the proceeds in an investment earning 5% after taxes, the excess after 3 years of $152,581 will have been transferred to the child gift tax-free.
Loans to Trusts
Instead of making loans directly to family members, another option is to make loans to a "grantor trust" for their benefit. A grantor trust is a type of trust in which all income is taxable to the grantor individually. This in effect permits additional "gifts" to the beneficiaries (in an amount equal to the income tax) without the grantor being considered to have made any further taxable gifts.
Similarly, it may also be appropriate to sell assets to a grantor trust in exchange for a promissory note. Again, assuming the assets that are sold to the trust appreciate at a rate that exceeds the Applicable Federal Rate, wealth will be passed on to the next generation without the imposition of a gift tax.
Refinancing Existing Notes
If you currently hold an outstanding promissory note from a family member or grantor trust that has an interest rate higher than current interest rates, it may be advisable to refinance that note now.