May 11, 2020
By
Joseph B. Colvin
Member, Stoll Keenon Ogden PLLC
(859) 231-3642
joseph.colvin@skofirm.com
The IRS has issued Revenue Ruling 2020-11. The Ruling contains the interest rates used for the month of May under various tax code provisions, including the applicable federal rates and the Section 7520 rate. The Section 7520 rate is the lowest ever!
The rates are important because several planning techniques excel with low interest rates such as: grantor retained annuity trusts (“GRAT”), sale to grantor trust planning, intra-family loans, and charitable lead annuity trusts (“CLAT”). In addition, because of the coronavirus, stock market values are depressed. The combination of depressed values and low interest rates provide a great opportunity for tax planning, but the window for the planning is limited.
Rates
The applicable federal rate (“AFR”) is broken down into three time periods: (1) short-term, meaning less than three years, (2) mid-term, meaning between three and nine years, and (3) long-term, meaning longer than nine years. The rates also vary slightly depending on how frequently interest is compounded. For purposes of this article, we will just consider annually compounding interest. The Section 7520 rate is a single rate. The rates are as follows:
• Short-term: 0.25 percent
• Mid-term: 0.58 percent
• Long-term: 1.15 percent
• Section 7520 rate: 0.8 percent
As mentioned above, this is the lowest Section 7520 rate ever. For comparison, the rate was 2.8 percent last May and 3.2 percent in May 2018.
GRAT
In essence, a GRAT is a short-term bet that growth on certain assets will exceed the Section 7520 rate. A typical GRAT structure is as follows: you create a trust and transfer assets to the trust; in exchange for the assets, you retain a right to an annuity payment for two years; the value of the annuity payment is determined using the Section 7520 rate and is structured to be equal to the amount of assets you transfer to the trust. Because the value of the annuity payments is equal to the amount of assets transferred, you do not use any of your lifetime gift tax exemption. During the 2-year term, the trustee invests the assets and makes the annuity payments. At the end of the term, the trust terminates and the balance is transferred to your descendants. If the growth on the assets exceeds the Section 7520 rate, that balance will transfer to your descendants tax-free.
For example, let’s assume you transfer $1,000,000 to a GRAT. Based on the Section 7520 rate, the annuity payment would be approximately $506,000 per year. If the assets grow at 10 percent, then after only two years, approximately $147,000 would have accumulated in the trust and passed to your descendants tax-free.
A GRAT is a great planning technique for a couple of reasons. For one, as noted above the value of the annuity payments can be structured to equal the initial transfer to the trust and thus not require using any lifetime exemption. In addition, if the growth does not exceed the Section 7520 rate and the GRAT there is no excess to pass to your descendants, all the assets come back to you and the only downside was the cost to set up the GRAT.
Sale to Grantor Trust Planning
A “grantor trust” is a trust that is disregarded for income tax purposes. However, it can be structured to be regarded for estate and gift tax purposes. The result is that you can sell assets to the trust and for income tax purposes, the sale is ignored (thus no gain or loss is recognized on the sale), but the assets are no longer in your estate for estate tax purposes.
For this planning, the trust is typically structured in one of three ways. First, the trust can be for the benefit of your descendants (known as an “IDGT”). Second, the trust can be for the benefit of your spouse and your descendants (known as a “SLAT”). Third, the trust can be for your benefit plus the benefit of your spouse and descendants (known as a “BDIT”). Each trust has its own features and risks to consider.
With the planning, you sell assets to the trust in exchange for a promissory note. The interest rate on the note is the AFR. Thus, if the note is for nine years, then the interest rate is 0.58 percent, or if the note is for 20 years, then the interest rate is 1.15 percent. Similar to a GRAT, to the extent the growth on the assets exceed the interest rate on note, that excess is removed from your taxable estate without using any lifetime exemption.
Intra-Family Loans
Another planning technique that is not a gift but that uses the low interest rates to the advantage of your family is to make intra-family loans. Two common examples are to loan money to children to allow them to purchase a house or start a business (or for an investment opportunity).
For example, while mortgage rates are extremely low, with an intra-family loan you could instead loan the funds to your children at an even lower rate. As long as the interest is at the AFR, the loan will not be considered a gift.
CLAT
A CLAT is a great tool if you are also wanting to donate to charity. It is similar to the GRAT except one or more charities receive the annuity payment. The trustee would invest the assets and as long as the growth exceeds the Section 7520 rate, the excess would then pass to your family.
Thus, if you already donate annually to charities, you could restructure your giving through a CLAT and take advantage of the low IRS interest rate to also pass assets to your family tax-free.
Summary
In the prior market collapse, the market had an approximate 40 percent annualized return in two years after the bottom in March 2009. If this market has even half a similar rebound, then the depressed values combined with the lowest IRS interest rates ever make this a very opportune time to engage in planning.
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