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Every month, the IRS publishes “applicable federal rates” (AFRs) and a § 7520 rate. These are the rates prescribed by the IRS for use by taxpayers for various intra-family transactions and estate planning vehicles. Importantly, these rates have steadily increased over the last few years.

The July 2023 AFRs have been released. The current short-, mid-, and long-term AFRs are 3.63%, 2.91% and 3.01% respectively, for loans that compound annually, and the § 7520 is 4.6%. Comparing these rates to their counterparts one year ago — at 2.37%, 2.99% and 3.22%, and 3.6% respectively — the increase is staggering and likely a recurrent trend in the upcoming months.

Estate planning and wealth transfer techniques are impacted by economic drivers, including the prevailing interest rates. Certain strategies are most efficient in lower interest rate environments, while others are better suited to higher interest rate environments. Outlined below are estate planning strategies designed to lock-in lower interest rates before they rise, as well as separate estate planning strategies to be
utilized when interest rates soar.

Strategies to Lock-In Low Interest Rates

There are varied estate planning strategies designed to leverage low interest rates before they increase, namely Grantor Retained Annuity Trusts, Charitable Lead Annuity Trusts, intrafamily loans, and installment sales.

Grantor Retained Annuity Trust (GRAT)

A GRAT is an irrevocable trust into which you transfer property — typically property with high-growth or income-producing potential — and from which you receive back an annuity payment for a fixed term (typically two to five years). At the end of the specified term, any property remaining in the trust passes to remainder beneficiaries gift-tax free.

The calculation of the annuity amount payable to the creator is derived from the § 7520 rate. To the extent a GRAT’s investment performance exceeds the § 7520 rate (currently 4.6%), the excess will remain in the trust and will pass tax-free to the trust’s remainder beneficiaries. Thus, the lower the interest rate, the lower the “hurdle” for the strategy to be successful. Accordingly, funding a GRAT makes a lot of sense in a low interest rate environment. Depending on the type of asset being transferred, clients may also consider creating GRATs of various terms to hedge against the risk of rising rates.

Funding a GRAT is considered to be a “low-risk” strategy, because if the GRAT fails (because the assets that were transferred do not appreciate at a rate that is higher than the § 7520 rate), there are no adverse tax consequences — just the out-of-pocket costs associated with the creation and funding of the GRAT.

Charitable Lead Annuity Trust (CLAT)

A CLAT is a tax-efficient gifting technique that charitably-inclined clients may wish to consider. It is a trust with two types of named beneficiaries: a charitable lead beneficiary, which will receive a fixed annuity payment throughout the term of the trust, and remainder beneficiaries (typically children or other family members), who receive the assets remaining in the CLAT at the conclusion of the trust term.

A CLAT is a tax-efficient gifting technique that charitably-inclined clients may wish to consider. It is a trust with two types of named beneficiaries: a charitable lead beneficiary, which will receive a fixed annuity payment throughout the term of the trust, and remainder beneficiaries (typically children or other family members), who receive the assets remaining in the CLAT at the conclusion of the trust term.

Intrafamily Loans

Intrafamily loans are ideal for parents and grandparents who want to assist younger generations while diminishing his or her own lifetime estate and gift tax exclusion. The parent or grandparent can transfer wealth to the younger generation either through a direct loan to him or her individually or as a loan to a trust for the family member’s benefit. Going forward, the lending family member may forgive a portion of the loan each year using his or her annual gift tax exclusion amount (currently $17,000 per individual, and $34,000 for a married couple), without making a taxable gift.

In order to avoid having any part of an intrafamily loan considered a gift for tax purposes, it must bear interest at a rate greater than or equal to the AFR, as published each month by the IRS.

The IRS publishes three tiers of AFRs depending on the repayment term of the loan:
(1) Short-term rates, for loans with a repayment term up to three years.
(2) Mid-term rates, for loans with a repayment term between three and nine years.
(3) Long-term rates, for loans with a repayment term greater than nine years.

As explained above, for July 2023, the short-, mid-, and long-term AFRs are 3.63%, 2.91% and 3.01%, respectively, for loans that compound annually. Thus, for an intrafamily loan made in July 2023 with a term of less than three years, annual interest of only 3.63% must be charged to avoid any portion of that loan being treated as a gift.

Installment Sales to Grantor Trusts

A grantor trust is a trust which is recognized for federal estate tax purposes, but ignored for income tax purposes. That means that property transferred to such a trust will not be included in the grantor’s taxable estate at death, but the grantor will be taxed on all of the trust’s income. This is, in fact, advantageous for many reasons. One benefit is that the grantor can sell assets to the trust in exchange for a promissory note, which essentially freezes the value of the assets at the amount of the note. Since the trust is not distinct from the grantor for income tax purposes, the sale of assets to the trust does not result in recognition of capital gain. This makes the strategy especially effective for highly appreciated property as any appreciation of assets over the (low) interest rate, accrue to the beneficiaries gift tax free.

Effective Strategies When Interest Rates Rise

As interest rates rise, there are estate planning techniques — such as QPRTs, CRATs, and GRITs — that take advantage of high interest rates by either reducing the value of a taxable gift by the transferor or by increasing the amount that ultimately passes to a remainder beneficiary.

Qualified Personal Residence Trust (QPRT)

A QPRT is used to pass a primary residence to remainder beneficiaries — usually children — with reduced gift tax consequences. The grantor of the QPRT retains the right to live in the house rent-free for a set number of years (typically ranging from five to twenty-five years) called the “QPRT term,” and then gifts the remainder interest to the beneficiaries. The taxable gift is equal to the appraised value of the residence minus the value of the grantor’s right to live in the residence, as determined by a calculation involving the applicable interest rate, the grantor’s age, the value of the property, and the length of the QPRT term. The longer the term, the more tax advantageous to the transferor.

A high interest rate environment means a lower present value, a lower gift value, and lower gift and estate taxes. Note, however, that in order to remove the value of the residence from the grantor’s estate for estate tax purposes, the grantor must outlive the QPRT term. (Like the GRAT, this is also a “low-risk” strategy as the transferor will be in no worse position if he or she does not survive the QPRT term.) Additionally, the taxable gift resulting from the transfer of the property into the QPRT will reduce the grantor’s unified exemption from estate and gift tax.

Charitable Remainder Annuity Trusts (CRAT)

A CRAT is the reverse of the previously mentioned CLAT, insofar as the annuity from the trust is payable to a noncharitable beneficiary and the remainder is payable to a charitable beneficiary. The noncharitable beneficiary receiving the annuity can be anyone, but if it is not the grantor or the grantor’s spouse, the present value of the annuity — which must be between 5% and 50% of the initial value of the assets — is considered a taxable gift when the CRAT is created. The present value of the remainder that will pass to the charity — which must be at least 10% of the value of the transferred assets as determined using the § 7520 rate — is deductible as a charitable contribution for income tax purposes. The current § 7520 rate is 4.6% (an increase from July of 2022 in which the § 7520 rate was 3.6%).

As with installment sales to grantor trusts, transferring highly appreciated assets to a CRAT will make it most effective, since a CRAT’s tax status will allow the deferral of capital gain recognition. However, unlike installment sales, higher interest rates are preferable since they result in a higher annuity payout to the noncharitable beneficiary.

Grantor Retained Income Trusts (GRIT)

A GRIT is an irrevocable trust to which the grantor transfers assets and retains an interest in all of the net income of the trust for a set term of years. When the term of years ends, or upon the death of the grantor, the remaining assets in the trust pass to the remainder beneficiaries. The value of the grantor’s retained interest in the trust reduces the value of the trust for gift tax purposes, but only if the beneficiaries are not members of the grantor’s family. However, “members of the grantor’s family” include only the grantor’s spouse and lineal descendants of the grantor or grantor’s spouse and any sibling of the grantor or the grantor’s spouse. Therefore, a GRIT is effective for gifts to nieces, nephews, distant relatives, friends, or others that do not fit into the definition of “members of the grantor’s family.” As the § 7520 rate increases, the value of the remainder interest conversely decreases and the value of the taxable gift decreases as well.

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If you have questions about gifting strategies in various interest rate environments, please contact your Wiggin and Dana attorney.