Tax and Estate Planning in Today’s Low Interest Rate Environment
by Ted Simpson
Interest rates have dropped significantly in recent months and, given the state of the economy, may continue to remain low. This can have a significant impact on many tax and estate planning strategies. Lower interest rates affect the income, estate and gift tax values of many types of transfers. In many cases, the drop in rates produces more favorable results for clients engaging in certain types of transactions. In other cases, however, the lower rates result in higher tax costs. This article examines how low interest rates affect key tax and estate planning transactions and strategies.
The value of annuities (other than commercial annuities), life estates, term interests, remainders and reversions for estate, gift and income tax purposes is determined using tables issued by the IRS under Code § 7520. The value in a given month under the tables may be higher or lower than the value in an earlier or later month because the interest factor under the tables changes monthly. For charitable transfers, the interest rate for the month of the transfer or for either of the two preceding months may be used. The § 7520 rate for November 2011 was 1.4%. The 1.4% interest rate is an all-time low. The rate for December 2011 is 1.6%. In comparison, the all-time high was 11.6%.
Historically, private annuities have offered a number of income, gift and estate tax advantages. They also can save estate administration expenses and offer other non-tax advantages as well. In the typical private annuity transaction, a parent transfers property to his or her child in return for that child’s unsecured
promise to pay the parent a fixed, periodic income for life. If the fair market value of the property transferred equals the present value of the annuity under the § 7520 valuation tables, there is no gift tax due.
Entering into a private annuity when interest rates are lower results in a lower annual payment amount that the younger family member will have to make to the older family member to prevent a gift from arising on the transfer. Even though the lower interest rates result in a lower annual payment to the senior family member, that person often will prefer a lower rate so as to be able to transfer property at the lowest possible cost to the younger family member. As an example, in October 2011, if a client who is
70 years old transfers property worth $1 million to his or her daughter in exchange for a private annuity, the daughter must make an annual payment of $79,879.22 to prevent a gift from arising on the transfer. This figure is determined by dividing $1 million by 12.5189, which is the annuity factor from Table S for a 70-year old and an interest rate of 1.4%. By way of comparison, when the §7520 rate was at its all-time high of 11.6%, the annual payment to prevent a gift would be $163,534.94 ($1 million divided by 6.1149).
Grantor Retained Annuity Trust (GRAT)
An individual can save transfer tax by setting up a GRAT. The individual retains an annuity interest for a specified term at the expiration of which the trust property goes to a child or other individual named at the outset. Gift tax is payable but only on the present value of the remainder interest, which is the value of the property transferred to the trust less the value of the retained annuity interest. A lower interest rate increases the value of the annuity retained by the grantor and thus reduces the value of the
gift of the remainder in a GRAT.
The post-transfer appreciation in the value of the trust assets will escape transfer tax. However, this
is so only if the grantor survives the trust term. If the grantor dies during the trust term, at least a portion of the trust property will be included in his gross estate. However, an individual who sets up a GRAT and dies before the end of the term would be no worse off than if he had not entered into the transaction, except that he will have incurred the costs of setting up and administering the trust.
As an example, in October 2011 a client transfers $1 million to a trust, which is to pay him an annual annuity of $80,000 for 10 years. At the end of the 10 years, the trust property is to go to the client’s daughter. The value of the client’s retained annuity is $741,696. This figure is determined by multiplying $80,000 by 9.2712, which is the annuity factor for a 10-year term and an interest rate of 1.4%. The value of the gift of the remainder to the client’s daughter is $258,304. By way of comparison, if the interest factor were 11.6%, the value of the retained annuity would be $459,520 ($80,000 times 5.7440) and the value of the gift would be $540,480.
Qualified Personal Residence Trust (QPRT)
A QPRT is like a GRAT, except that the grantor retains an interest in the residence instead of an
annuity interest, allowing the grantor to remain in the house during the term of the QPRT. A lower interest rate results in a lower value for the retained interest and a higher value for the gift of the remainder interest.
As an example, a client establishes a QPRT, retaining a 10-year term interest. At the end of the 10-year period, the residence is to go to her son. The value of the residence at the time of the initial transfer to the trust is $400,000. The remainder factor is .870203, making the value of the gift $348,081. By way of comparison, if the interest factor were 11.6%, the value of the gift would be $133,480 ($400,000 times .333701). Thus, a higher § 7520 rate produces a better result for this strategy. Accordingly, a person may want to wait until interest rates rise before engaging in this type of transaction.
Grantor Retained Unitrust (GRUT)
The interest factor does not affect the value of a gift of a remainder interest in a GRUT because the retained unitrust interest is the right to receive a fixed percentage of the trust’s assets, and changes in rates benefit the unitrust holder and the remainder person equally.
Charitable Remainder Annuity Trust (CRAT)
With a CRAT, the donor retains an annuity interest for himself or someone else such as a family member and names a charity to receive the remainder at the end of the annuity term. The donor gets a current income tax deduction for the present value of the charity’s remainder interest. Now may not be a good time to establish a CRAT because a lower interest rate produces smaller income, gift and estate tax charitable deductions, and a higher gift tax value for a gifted annuity interest.
Charitable Remainder Unitrust (CRUT)
A CRUT is similar to a CRAT, except that the donor retains a fixed percentage of the trust’s assets on an annual basis. A change in the § 7520 rate does not affect income tax deductions for CRUTs or gift tax costs in connection with them.
Charitable Lead Annuity Trust (CLAT)
With a CLAT, the charity receives an income interest for a term of years, with the remainder being paid to a private beneficiary. A lower interest rate results in a larger gift or estate tax deduction for the interest going to the charity and a smaller value for any gift of the remainder interest going to a private beneficiary. Thus, it may be a good time to establish a CLAT if the grantor is going to give the remainder interest to a family member.
With the § 7520 rate at an all-time low, it may be the right time to consider one or more of the above estate planning or charitable planning options. Please call Ted Simpson to discuss how the low interest rates may affect your tax and estate planning goals.
For more information about estate planning, asset protection, and taxation, contact Randy Duncan at 503-242-0000.
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