While the perils of Covid-19 have continued to take a human as well as an economic toll in United States, a perfect storm of estate planning possibilities is brewing at the same time. In the words of Warren Buffet, you need to run in and seize opportunities, when everyone else is panicking and running out.
The opportunities here are not that of the stock and real estate markets, even though the chaos in both markets and the rest of the economy seems to be helping our clients. For individuals and families looking to reduce estate taxes, the current pandemic has created the “perfect storm” a rare occurrence of historically low interest rates combined with dramatically reduced market values of businesses, real estate and securities.
In addition, it is now quite apparent the next few administrations will have to increase taxes at all levels, in order to compensate for all Covid-19 financial incentives provided to the masses in 2020 and beyond. We are of the opinion that it is very likely for the estate tax exemption to be reduced significantly in the years to come. As always, the middle class will be the target of increased taxes to recoup the generous giveaways of the Federal and State governments.
This unique—and probably temporary—economic environment allows the transfer of assets from a person’s taxable estate while using up a comparatively small amount of their estate and gift tax exemptions. Strategies for transferring these assets could include the creation of new or additional trusts such as the Grantor Retained Annuity Trusts (GRAT’s) or Intentionally Defective Grantor Trusts (IDGT’s) both of which will be explained in more detail below. In addition, there are intra-family loan opportunities which would allow an individual to financially assist family members at historically low rates without making a current gift.
As a reminder, under current law the estate and gift tax exemption is $11.58 million per person ($23.16 million for married couples) but will be reduced to approximately $5 million per person as of 2026, or even sooner. Given the current political and financial climate, it is unlikely the tax exemption would be raised or kept at the current limits, or estate taxes lowered in the foreseeable future.
OVERVIEW OF CURRENT OPPORTUNITIES:
- Intra Family Loans:
Intra-family loans are an uncomplicated way to take advantage of low interest rates while avoiding making a gift of money. This type of loan allows older or wealthier individuals to act as a bank and provide funds to a child or grandchild to (for example) purchase a home or start a business.
Loans previously taken out by a family member via a traditional lender at high interest rates could also be refinanced by the lending relative. Alternatively, the loans could be made to an irrevocable trust for the benefit of family members, rather than directly to an individual. The terms of the loans can be structured in many different ways, such as an interest-only loan with a balloon payment of the principal when the loan comes due.
But in order to keep the loan from being considered a gift for tax purposes, the loan must have an interest rate greater or equal to the monthly AFR (applicable federal rate) specified for the term of the loan. The AFR is the minimum interest rate that the Internal Revenue Service allows for private loans. Each month the IRS publishes a set of interest rates that the agency considers the minimum market rate for loans. Any interest rate that is less than the AFR would have tax implications.
Currently the May 2020 AFR is at an all-time low: 0.25% for short term loans (three years or less) 0.58% for mid-term (more than three and less than nine) and 1.15% for long term (nine years or more.) These are unprecedented low rates.
- Grantor Retained Annuity Trusts (GRATs):
With interest rates at an historic low, moving currently undervalued assets into a GRAT is an effective strategy to transfer wealth and minimize estate tax.
In a GRAT arrangement, a grantor transfers assets into a trust but retains the right to receive an annuity from the trust over a specified number of years. After the end of the specified term, the remaining assets then pass to the named beneficiaries free of estate tax. The interest rates that must be used to calculate a GRAT annuity payment are found in IRS Section 7520. Once the rate and payment levels are set, they usually cannot be changed.
The May 2020 Section 7520 interest rate is extremely low: 0.8%. (For some perspective, in January 2019 the interest rate was 3.4%.) If the assets in this type of trust make at least 0.8% rate of return, any additional appreciation that the assets have accumulated at the end of the GRAT term would go to the beneficiaries.
- Intentionally Defective Grantor Trusts (IDGT):
Low interest rates may also incentivize individuals to transfer assets (either by sale or loan) to an Intentionally Defective Grantor Trust (IDGT). In this situation, a grantor transfers assets to a trust that is designed to be “intentionally defective” which means the assets grow outside of the grantor’s estate for gift and estate tax purposes, while the income generated by the assets is taxed to the grantor—not to the trust, or the beneficiaries. So the grantor uses his or her funds and assets—apart from the trust—to pay income taxes, which is the same as a tax-free gift to the trust.
These are trying times for many, both personally as well as financially. However, all chaos and down markets bring with them opportunities for those who are able to see through the clouds and look beyond the immediate doom and disaster. This downturn is not any different. A vaccine will be found, a cure will come about and years from now the economy will go back to normal and likely even thrive. How you take advantage of opportunities today will affect your assets and estate for generations to come. We are here to help and to discuss and implement ideas and structures for long term planning.
