Tax Law and Business Organization Strategy

How Today's Low Interest Rates Affect Tax and Estate Planning

Interest rates have dropped significantly in recent months and may remain low given the state of the economy. Sagging rates can have a significant impact on many tax and estate planning strategies. Lower interest rates affect the income, estate, and gift tax values of many types of transfers. In many cases, the drop in rates produces more favorable results for persons engaging in certain types of transactions. In other cases, however, the lower rates result in higher tax costs. This post examines how low interest rates affect key tax and estate planning transactions and strategies.

IRS valuation tables. 

The value of annuities (other than commercial annuities), life estates, term interests, remainders, and reversions for estate, gift, and income tax purposes is determined using tables issued by IRS under Code Sec. 7520. The value in a given month under the tables may be higher or lower than the value in an earlier or later month because the interest factor under the tables changes monthly. For charitable transfers, the interest rate for the month of the transfer or for either of the two preceding months may be used. (Code Sec. 7520(a))

The Code Sec. 7520 interest rate for October 2011 is 1.4%. (Rev Rul 2011-22, 2011-41 IRB) The 1.4% interest rate is an all-time low. The all-time high was 11.6%.

How low rates affect various noncharitable planning strategies.

The discussion that follows explains various noncharitable financial and estate planning strategies and shows how they stack up under current falling rates.

Grantor retained annuity trust (GRAT). An individual can save transfer tax by setting up a GRAT. The individual retains an annuity interest for a specified term at the expiration of which the trust property goes to a child or other individual named at the outset. Gift tax is payable but only on the present value of the remainder interest, which is the value of the property transferred to the trust less the value of the retained annuity interest. A lower interest rate increases the value of the annuity retained by the grantor and thus reduces the value of the gift of the remainder in a GRAT.

The post-transfer appreciation in the value of the trust assets will escape transfer tax. However, this is so only if the grantor survives the trust term. If the grantor dies during the trust term, at least a portion of the trust property will be included in his gross estate under Code Sec. 2036(a), which provides that property transferred by an individual during his lifetime is includible in his estate if he retains an interest for any period that does not in fact end before his death. In 2008, IRS issued regs for determining the extent to which the trust property would be included in a situation like this and in 2009, issued proposed regs that would fine-tune the rules in the final regs. In any event, an individual who sets up a GRAT and dies before the end of the term would be no worse off than if he had not entered into the transaction except that he will have incurred the costs of setting up and administering the trust.

Illustration: When the Code Sec. 7520 interest factor is 1.4%, Smith transfers $1 million to a trust, which is to pay him an annual annuity of $80,000 for 10 years. At the end of the 10 years, the trust property is to go to Smith's daughter. The value of Smith's retained annuity is $741,696. This figure is determined by multiplying $80,000 by 9.2712, which is the annuity factor for a 10-year term and an interest rate of 1.4%. The value of the gift of the remainder to Smith's daughter is $258,304.

By way of comparison, if the interest factor were 5.0%, the value of the retained annuity would be $617,736 ($80,000 times 7.7217) and the value of the gift would be $382,264.

Grantor retained income trust (GRIT). A GRIT is like a GRAT, except that the grantor retains an income interest instead of an annuity interest. Code Sec. 2702 generally treats the grantor as making a gift of the full value of the property. However, the value of the gift of the remainder is determined under the valuation tables where the trust is funded with a personal residence of the grantor or the remainder goes to someone falling outside of the definition of a family member, such as a nephew or niece. A lower interest rate results in a lower value for the retained interest and a higher value for the gift of the remainder interest in a residence GRIT or other GRIT excepted from the Code Sec. 2702 rules.

Illustration: When the Code Sec. 7520 interest factor is 1.4%, Bailey establishes a personal residence GRIT, retaining a 10-year term interest. At the end of the 10-year period, the residence is to go to his son. The value of the residence at the time of the initial transfer to the trust is $400,000. The remainder factor is .870203, making the value of the gift $348,081.

By way of comparison, if the interest factor were 5.0%, the value of the gift would be $245,565 ($400,000 times .613913).

A higher rate produces a better result for this strategy. Accordingly, a person may want to wait until interest rates rise before engaging in this type of transaction.

Grantor retained unitrust (GRUT). The interest factor does not affect the value of a gift of a remainder interest in a GRUT because the retained unitrust interest is the right to receive a fixed percentage of the trust's assets, and changes in rates inure uniformly to the benefit of the unitrust holder and the remainderperson.

Private annuity. Historically, private annuities have offered a number of income, gift, and estate tax advantages. They also can save estate administration expenses and offer other nontax advantages as well. In the typical private annuity transaction, a parent transfers property to his child in return for that child's unsecured promise to pay the parent a fixed, periodic income for life. If the fair market value of the property transferred equals the present value of the annuity under the Code Sec. 7520 valuation tables, there is no gift tax due.

Historically, one huge advantage of a private annuity has been the opportunity to transfer highly appreciated property and defer the gain over several years as annuity payments are received. Additionally, there was the possibility of being taxed on less than the entire gain if the annuitant died before the expiration of his tabular life expectancy. However, in 2006, IRS issued proposed regs that would knock out the income tax advantages of selling appreciated property in exchange for a private annuity. It would do this by causing the property seller's gain to be recognized in the year the transaction is effected rather than as payments are received. The regs generally would apply for transactions entered into after Oct. 18, 2006. However, certain transactions effected before Apr. 19, 2007 would continue to be subject to the historical rules.

Entering into a private annuity when interest rates are lower results in a lower annual payment amount that the younger family member will have to make to the older family member to prevent a gift from arising on the transfer.

Illustration: In October 2011, when the Code Sec. 7520 interest factor is 1.4%, Jones, age 70, transfers property worth $1 million to his daughter in exchange for a private annuity. She must make an annual payment of $79,879.22 to prevent a gift from arising on the transfer. This figure is determined by dividing $1 million by 12.5189, which is the annuity factor from Table S for a 70-year old and an interest rate of 1.4%.

By way of comparison, if the interest factor were 5.0%, the annual payment to prevent a gift would be $107,319.16 ($1 million divided by 9.3180).

A private annuity may be a good strategy for an individual with a short life expectancy who is not expected to survive for too many years. However, the mortality component of the valuation tables cannot be used to determine the present value of an annuity if the person with the measuring life is terminally ill when the gift is completed. Under Reg. § 25.7520-3(b)(3), an individual who is known to have an incurable illness or other deteriorating physical condition is considered terminally ill if there is at least a 50% probability that he will die within one year.

Someone who is considering setting up a private annuity may want to fund it with stock valued near its original purchase price. Such stock may be a good candidate for funding a private annuity because there would be little or no gain to report in the year of the transfer under the proposed regs, if they take effect. Also, if the stock takes off, the transaction could achieve considerable transfer tax savings. That's because the child will end up with a sizeable amount of property with no gift or estate tax cost imposed on the post-transfer appreciation in its value.

How low rates affect various charitable planning strategies.

The discussion that follows explains various charitable planning strategies and shows how they stack up under current declining rates.

Charitable remainder annuity trust (CRAT). With a CRAT, the donor retains an annuity interest for himself or someone else such as a family member and names a charity to receive the remainder at the end of the annuity term. The donor gets a current income tax deduction for the present value of the charity's remainder interest. Now may not be a good time to establish a CRAT. That's because a lower interest rate produces smaller income, gift and estate tax charitable deductions and a higher gift tax value for a gifted annuity interest.

Charitable remainder unitrust (CRUT). A change in the rate does not affect income tax deductions for CRUTs or gift tax costs in connection with them.

Charitable lead unitrust (CLUT). Estate and gift tax factors are essentially unaffected by changes in the rates.

Charitable lead annuity trust (CLAT). A lower interest rate results in a larger gift or estate tax deduction for the annuity interest going to the charity and a smaller value for any gift of the remainder interest going to a private beneficiary. Thus, it may be a good time to establish a CLAT if the grantor is going to give the remainder interest to a family member.

Charitable transfer of remainder interest in residence or farm. A lower interest rate provides higher income, estate and gift tax deductions for a transfer of a remainder interest in a residence or farm. Conversely, a higher interest rate provides lower income, estate and gift tax deductions for a transfer of a remainder interest in a residence or farm.

Pooled income funds in existence for more than 3 years. Charitable income, gift and estate tax deductions for transfers to pooled income funds that have been in existence for more than three years are not affected by changes in interest rates because values of respective interests are determined with reference to the funds' own rates of return. Any personal gift arising from the transfer also is not affected.
 

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