“If you want to know what the future holds, be a part of its development.” ~ Peter Drucker
Consider Mary and John. They have two adult children and four young grandchildren. They are in their mid-50s and in good health. They have done well for themselves. Through grit and good fortune, they have built a successful company, acquired income generating multi-family real estate, raw land, and a diversified securities portfolio. Their current net worth exceeds $17MM. They expect their assets to appreciate at a combined rate of 8% for the foreseeable future. They expect their gross estate to exceed the estate and gift tax exemption, especially if the current exemption sunsets in 2025 back to the per person $5MM adjusted for inflation threshold. They are looking for a cost and tax-efficient means of transferring wealth to their heirs.
For this post, I will touch on two transfer techniques that are particularly interesting given low rates and depressed asset prices: intra-family loans and Grantor Retained Annuity Trusts.
Interest rates are at all-time lows, including the Internal Revenue Service’s applicable federal rate (“AFR”) and 7520 rate, which are the rates relied on for many wealth transfer planning techniques. Over the last twelve months, the 7520 rate has fallen from an already low 2% to an all-time low of .6% for the month of January, 2021.
This ultra-low 7520 rate provides a historic opportunity for low cost and tax-efficient transfer planning.
Per Rev. Rul. 2021-1, as of January 2021, the annual rate for a short term (3yrs or less) loans is .14%. The mid-term (3 to 9 years) rate is .52%. The long term (over 9yrs) rate is 1.35%. An intra-family loan could be used to seed an investment fund, purchase a home, refinance debt, or perhaps acquire a business. For investment and wealth transfer purposes, the low interest rate combined with depressed asset prices could provide a significant opportunity for a family member to build a portfolio with minimal cost. To keep the strategy low cost and tax-efficient, the source of funds for loan payments would need to be considered. An intra-family loan could be a simple and effective means of transferring future appreciation of principal at very low cost to the borrower and gift tax-free for the lender.
If, on the other hand, a family is looking for asset transfer while minimizing gift and estate taxes, a Grantor Retained Annuity Trust (“GRAT”) may be a good option. GRATs can be an effective and cost-efficient wealth transfer vehicle when the transferor has assets expected to appreciate at a rate higher than 7520 rate; with a January 2021 7520 rate of .6%, the hurdle has never been lower and the commensurate upside higher.
Here is a short example and explanation of how GRATs work.
On January 1, 2021, Mary and John transfer $2MM of marketable securities to a four-year GRAT. The beneficiary of the GRAT is a trust for the benefit of their children. A GRAT is an irrevocable trust and must pay an annuity back to the grantor until the GRAT terminates. The annuity is calculated Any income generated by the assets in the GRAT is taxed to the grantor. Mary and John will receive a $505,261 annuity each year. The annuity is calculated from IRS actuarial tables. The annuity can be paid in the form of cash or assets. When paid, the annuity can be transferred into another successive or “rolling” GRAT as a means of continuing to capture and transfer growth. The annuity is not subject to gift or income tax because it is deemed a return of principal. So, any appreciation above the 7520 rate is transferred gift tax-free to the GRAT beneficiary. Any income generated by GRAT assets, from say dividends, would be taxed to the grantors at their marginal tax rate.
Essentially, the assets are returned to the grantors and they enjoy the income from the assets, but appreciation is captured by the GRAT and transferred out to the GRAT beneficiary.
Returning to our example above, if the trust assets appreciate by ~8% over the four-year period, the GRAT beneficiary would receive ~$505,000 gift and estate tax-free over those four years, and ~$2.02MM of assets will be returned to Mary and John. They could then take those same assets, establish another GRAT and repeat the process.
For this strategy to work, the grantors need to survive the term of the GRAT. There are some procedural hurdles to navigate with GRATs. A gift tax return will need to be filed at inception, and community property rules will need to be navigated. In addition, there is a time frame within which the annuity needs to be paid each year. And if the assets are hard to value, like an ongoing enterprise or business, an annual appraisal may be needed.
From a multi-generational planning perspective, the grantors and the beneficiaries should engage in long term financial planning when designing a transfer strategy such as this. The grantors need to understand the asset base required to fund their lifetime goals before making a transfer, and the beneficiaries need to have a clear understanding of their current financial situation and future goals and the potential impact GRAT assets may have on their plan.
In Part II of this series, I’ll discuss family trusts and family limited partnerships.
For questions or comments reach out to me by email.
Keith A. Pillers, JD, CFP®, CIMA®, CPWA®
Director of Wealth Management
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