While interest rates remain low, investors have opportunities to gift family wealth at a lower estate and gift tax cost. Popular techniques will “freeze” the value of family wealth for estate and gift tax purposes while passing future appreciation to family members thereafter. These techniques provide greater rewards when interest rates are low because gifted wealth has a better chance to appreciate faster than the lower interest rates used to measure success.
As long as estate and gift tax exemptions remain historically high, these techniques also offer families a rare opportunity to transfer vast wealth. Even for families who already have used some or all of their exemptions on prior gifts, some of these techniques can be used to transfer appreciation without making an additional gift. The following available techniques take advantage of low interest rates when shifting family wealth and appreciation across generations.
Family loans provide an easy means to transfer wealth when interest rates are low. When parents loan cash to a child, for example, parents must charge a minimum applicable federal rate (AFR) of interest depending on the loan term. This autumn, rates have fallen near and well below 1% for family loans.
A child can then reinvest the cash and retain all appreciation in excess of the lower AFR interest and later loan repayment. If markets remain strong, this provides a great chance for parents to move appreciation to their children gift tax-free in return for nominal interest payments.
Sale to Intentionally Defective Grantor Trust
There remains an anomaly in the tax code that allows parents to gift assets to family through a trust while remaining the owner for income tax purposes. This type of trust is known as an intentionally defective grantor trust (IDGT). One parent can establish an IDGT for the benefit of a spouse and family while providing assurance the spouse would have additional support following the gift if the other parent were to predecease.
This technique works well when a parent sells a private family business or private investments to the IDGT in return for a family loan. The family loan can be structured as discussed above, and the IDGT beneficiaries can keep all appreciation in excess of the lower AFR interest and later loan repayment.
The parent who creates the IDGT would not pay capital gains when selling assets to it—nor pay income tax on the family loan interest—because he or she remains the owner for income tax purposes, but only for income tax purposes. So, the parent will continue to pay any income tax on IDGT property. These payments allow the parent to reduce his or her estate while preserving IDGT assets for future growth. Several decades ago, the IRS ruled that these payments are not considered gifts to the trust, which further supports the benefits of the IDGT planning technique.
Grantor Retained Annuity Trust
A grantor retained annuity trust (GRAT) allows parents to gift property appreciation to family quickly at little to no gift tax cost. For this purpose, a parent would create an irrevocable gift trust to receive, for example, a concentrated stock gift. The parent would retain an annuity interest for a short time frame, and the remaining stock and appreciation would pass along to the family beneficiaries thereafter.
The parent’s annuity payment is typically designed to return all initial value to him or herself within a short time frame. This allows the parent to fund a GRAT without making a gift (since the annuity value would essentially equal the GRAT value).
The IRS bases the annuity on a relatively low interest rate (120% of AFR), so GRATs are most beneficial when the gifted property appreciates at a higher rate of return than the market delivers because of the arbitrage between lower IRS interest rates and higher market appreciation rates. The net value between these rates can remain in the GRAT for the family beneficiaries after the parent receives any required annuity payments.
Does that sound familiar? The most famous example of successful GRATs involved the family of Sam Walton, who founded Walmart. The Walton family used several short-term GRATs to transfer Walmart stock and appreciation to their children, who are now billionaires. These GRATs worked because Walmart generated significant dividends and appreciation that paid the parent’s annuity and left billions of appreciation to family.
Charitable Lead Annuity Trust
A charitable lead annuity trust (CLAT) allows a parent to pay an annuity to charity first and then leave wealth to their family afterward. A CLAT works well for philanthropic families who desire to (1) freeze estate values, (2) make a charitable gift, (3) receive a corresponding charitable deduction, and (4) leave appreciation thereafter to family.
The IRS bases the charitable annuity payment on a relatively low interest rate (120% of AFR), so CLATs are most beneficial when the gifted property appreciates at a higher rate of return than the market delivers. The value of the charitable annuity payments and charitable deduction are calculated up front, and the appreciation left to family later increases based on market performance.
For the past several years, Congress has proposed various legislation to reduce or eliminate the use or benefits of these planning techniques. Election outcomes may affect how soon Congress revisits prior proposed legislation. As interest rates rise, these techniques provide less effective results overall. Now is a good time to consider the benefits of shifting wealth to preserve the family legacy.
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