Wealth Transfer Opportunities in a Low Interest Rate Environment

by Barry Levin

We are currently living in a historically low interest rate environment. While this may not bode well if one is trying to maximize the earnings from such investments, for the high net worth investor these low interest rates offer some interesting and valuable opportunities for wealth transfer between generations.

In our last newsletter, I examined the new estate and gift tax laws that are in effect for 2011 and 2012. These new laws offer substantial opportunities for those who are interested in making substantial gifts and perhaps leveraging those gifts. But, even if one is not prepared or positioned to take such actions, current low interest rates still offer opportunities for wealth transfer.

There are four well-recognized planning techniques that offer substantial benefits when interest rates are low. All these techniques involve looking to the Applicable Federal Rate ("AFR"). The AFR is established monthly by the US Treasury, whether for determining the lowest "safe harbor" rate at which a loan may be made or determining the present value of interests that parties may have in a "split-interest" trust. While this article does not allow us to discuss all the complexities of these techniques, let's take a look at their basics and how they might be used. The four are:

* Intra-Family Loans

* Installment Sales

* Grantor Retained Annuity Trusts
(GRATs)

* Charitable Lead Annuity Trusts
(CLATs)

Intra-Family Loans. In its simplest form, a parent can lend her child[ren] funds at an interest rate that is below what the child would be able to obtain on a loan from a commercial lender. The interest rate that the parent must charge without making a gift is based on the monthly AFR.

For October, 2011, for instance, the annual short-term (up to 3 years), mid-term (>3 up to 9 years) and long-term(>9 years) interest rates are .16%, 1.19% and 2.95%, respectively. Such a loan could be used to buy a house, set up a business or make an investment that is expected to yield a greater return than the interest rate. The loan could be for interest only with a balloon payment at the end of its term, or amortizing.

For the lender, especially for mid and long-term loans, this rate may be as much as she is earning on a bank CD and still allows the lender to own the asset in the form of a note from the borrower.

Any such loan should be documented in writing, as in any arm's length transaction. There are many 'bells and whistles' that can be added to the basic form, such as lending to a multi-generational trust or lending to a 'grantor' trust where the lender pays the taxes on the trust earnings, but the low interest rate is, nevertheless, the driver that makes the technique beneficial.

Installment Sales. Under this approach a seller can sell an asset to the buyer for an installment note at the appropriate AFR (see above). This is particularly useful where a parent would want to transfer stock in a family business or real estate whose value is currently depressed and where the asset to be sold produces sufficient income to allow the younger generation buyer to pay off the loan.

As mentioned in our prior article, such a sale can be 'seeded' with a gift so that there is a down-payment to be made to the seller. The sale can be structured as interest-only if needed, can be direct to the buyer or to a multi-generational trust, and/or could be to a 'grantor' trust where the seller pays the income taxes on the trust income and delays or minimizes the payment of capital gains taxes on the sale.

Where the sale is of stock or another partial interest in an asset, the sale can be made at a discounted value,so that both immediate appreciation and future, post-sale appreciation is built into the sale.

GRATs. A GRAT is a trust in which the 'grantor' (the person who creates the trust) transfers assets, such as publicly-traded stock or stock in a family business, to a specified term in return for a fixed annual payment in either cash or trust assets. At the end of the trust term, which the grantor must survive for the technique to be effective, the remaining assets pass to (or continue in trust for)the beneficiary[ies], often the grantor's child[ren].

The present value of the interest which will pass to the remainder beneficiary[ies] is valued at the time of the GRAT's creation based on the value of the assets put in (with a minority interest in family-business stock, a discount will be built into the valuation, so there is a likely immediate benefit from this discount) and is a taxable gift. But this gift can be avoided based on the annuity and term established in the GRAT instrument.

The minimum annuityrate (or assumed rate of return) is established monthly by the Treasury (for October, 2011 it is 1.40%), so any appreciation in the value of the GRAT assets beyond the Treasury's assumed rate of return inures to the beneficiary[ies] free of gift tax.

For example, if, in October, 2011, a grantor puts $1,000,000 of company stock, valued, by a third party applying a 35% discount, at $650,000, in a 5-year GRAT which is 'zeroed out' so that there is no taxable gift involved, and the asset appreciates at 4% per year,then, at the end of 5 years the remainder will be worth approximately $483,000 with no taxable gift having been made.

CLATs. If one has a charitable intent, the current low interest rates offer a benefit. A CLAT works like a GRAT, except that a charity receives the annuity payment for the term of the trust. The remainder passes to the ultimate beneficiary[ies], most often the grantor's child[ren]. The objective is to pass any appreciation above the Treasury assumed rate of return (1.40% for October 2011) to the remaindermen,sometimes without making a taxable gift to them.

Lower interest rates increase the value of the interest passing to the charity and decrease the value of what is passing to the remaindermen. For example, if, in October 2011, the grantor puts $1,000,000 of assets in a 10-year CLAT that pays an annuity of 10.787% to her favorite charity, the gift she makes to the remainderman is valued at $0, but if the assets appreciate at 4% per year, the remaindermen receive approximately $185,000 free of gift taxation.

If the annuity were reduced to 8%, the taxable gift would be approximately $258,000 (easily covered by the increased gift tax exemption) and the remaindermen receive approximately $520,000 at the end of the CLAT term.

In summary, in the right circumstances, low interest rates = opportunities. If you would like to discuss these techniques, or your business developments or wealth management needs, please feel free to contact The Beringer Group.