Low Interest Rates? Move Wealth Downstream

With interest rates significantly below historic averages, individuals have been encouraged to borrow at low cost to refinance their homes and other loans. However, these low interest rates are not only applicable to consumer and commercial lending. The IRSs published applicable Federal rates (AFR) are also at their lowest level in decades, which presents a number of planning opportunities for moving wealth to younger generations with little or no gift tax implications.

The short-term AFR, which is the rate used to measure the tax implications of loans with a term not exceeding three years, was 1.23% for July 2003 (compared to 2.84% in July 2002, 4.07% in July 2001 and 6.6% in July 2000). These low rates make this a good time to structure family loans and sale/gift transactions.

Intrafamily Loans

Lending money to a child or grandchild, for example, to assist with (1) a home purchase, (2) funding home improvements, (3) starting a business or (4) providing cashflow for other purposes has never been more attractive. Intrafamily loans may be made without gift tax implications as long as the lender charges interest at a rate no less than the AFR. With appropriate planning, an intrafamily loan can provide a significant benefit to a second-generation family member with relatively modest tax implications to the first-generation family member. Not only can such loans be made at rates lower than those commercially available, but the payment terms can be designed to fit a borrowers specific needs. Balloon notes that call for the payment of interest only currently are an attractive way to provide liquidity without the immediate burden of substantial loan payments.

Example 1: X is in the 35% top Federal income tax bracket and lends $250,000 via a 30-year promissory note to his son and daughter-in-law, H and W, so that they can purchase a new home. The note is secured by a mortgage. The interest rate is 4.17% (the July 2003 long-term AFR) and is payable on December 31 each year (interest only); the principal is due at the end of the 30-year term. X decides on a year-by-year basis whether to forgive or collect the interest, depending on his own needs.

If X forgives the interest at the end of the loans first full year, he will be forgiving $10,425, which is less than the $22,000 combined total in annual exclusion gifts he can make to H and W in 2003. The tax rules still require him to report the forgiven interest for income tax purposes, but the forgiveness results in a Federal tax cost to him of $3,649 ($10,425 x 35%). Because the law treats H and W as actually having paid the interest to X, they are entitled to a $10,425 deduction, which saves them $3,649 in Federal income taxes, if they are in the 35% bracket. Thus, overall, the transfer is a washX has shifted a tax benefit on a dollar-for-dollar basis to H and W.

Other Planning Strategies

Several more sophisticated planning ideas that work very well during low interest rates are an installment sale to an intentionally defective grantor trust, a grantor retained annuity trust (GRAT) and a charitable lead annuity trust (CLAT).

An installment sale to an intentionally defective grantor trust uses the AFR based on the term of the installment note. A GRAT and a CLAT both use the Sec. 7520 rate, which is based on 120% of the AFR for mid-term loans. (The Sec. 7520 rate for July 2003 was 3.0%.) These techniques work well when the parent-donor has an asset that he or she thinks will appreciate dramatically over a term of years. The IRS assumes that the assets in a GRAT or CLAT will grow at the Sec. 7520 rate. Thus, if the investment performance of the trust assets exceeds the assumed IRS rate used to measure the transfer tax costs, the trust beneficiaries could significantly benefit from the economic spread. Additionally, the remainder benefit from these strategies, which is left in trust to the clients heirs, can be significantly enhanced by using closely held stock or other assets (such as a family limited partnership interest) to which valuation discounts apply.

Example 2: J established an intentionally defective irrevocable trust benefiting her son S. She gifts assets to the trust to create a lending cushion with sufficient equity to support the valuation of the promissory note (at least 10% of the installment note amount is typically recommended). J then sells $1 million of Z stock to the trust for a 20-year balloon promissory note that requires interest to be paid at the July 2003 rate of 4.17% on an annual basis each December 31. There are no gift tax implications, because interest will be charged at the AFR. Due to the grantor status of the trust, the stock sale is disregarded for income tax purposes, as are the annual interest payments.

J has to report the trusts income on her personal income tax return, because she is deemed to be the assets owner for income tax purposes. The payment of the income tax liability is beneficial for the trust; however, J is indirectly contributing to the trusts growth without independent gift tax consequences. Assuming a 10% appreciation rate on the Z stock and annual interest payments of $41,700, at the end of the 20-year term, the stock will be worth roughly $4,339,132. Of that amount, $1 million must be used to satisfy the principal balance on the promissory note J holds. The trust retains the balance of $3,339,132, to ultimately distribute to S without any additional estate or gift tax consequences.

Forming a GRAT with the same $1 million asset and a 20-year term, and creating a minimal remainder-interest gift of approximately $1,000 on formation, would require annual payments of $67,150 back to the donor as his or her retained annuity. At the end of the term, the remainder interest left in trust for the parent-donors heirs would be $2,881,484.

Forming a CLAT with the same $1 million asset and a 20-year term, and creating a minimal remainder-interest gift of approximately $1,000 on formation, would require payments of $67,150 to the donors selected charity annually. At the end of the term, the remainder interest left in trust for the parent-donors heirs would be $2,881,484.

Conclusion

Many people are predicting that interest rates will start to rise if the economic recovery rebounds strongly. Thus, it is imperative to consider these planning techniques now for clients, so that they can maximize the estate and gift tax benefits of the current low-interest-rate environment.

From Jeff Call, CPA, CFP, PFS, Bennett Thrasher PC, Atlanta, GA