It’s an Unusually Opportune Time to Consider Transferring Wealth
Low interest rates and pending regulations that would limit discounts on gifts of closely held entities mean that the latter half of 2016 may be an unusually opportune time to initiate wealth transfer strategies.
Following the surprising Brexit vote, interest rates around the world have declined. As of this writing (September 2016), the 10-year U.S. Treasury rate is about 1.5% and, as a result, corresponding wealth transfer hurdle rates set by the IRS are near their all-time lows. The 7520 rate (which applies to grantor retained annuity trusts, or GRATs, and charitable lead annuity trusts, or CLATs) is at 1.4%, while the long-term applicable federal rate, or AFR (which applies to intra-family loans and installment sales) is at 1.9%.
The implication of these low hurdle rates is that wealth transfer planning is likely to be more effective than under “average” interest rate conditions. As shown in Figure 1, since the AFR was launched in January 1998, the 7520 rate has averaged 4.1% and the AFR 4.4%. In Figure 2 below, we show that the remainder amount (the money that could transfer to children free of gift or estate taxes) if investments earn a 6% return is more than double what we’d expect in a more typical interest rate environment.
Figure 2: Interest-Rate-Sensitive Planning Strategies Are Especially Effective Now
Source: Capital Group. All strategies funded with a $10 million, 20-year term and assume an after-tax investment return of 6%. All GRATs and CLATs have been “zeroed out” for gift tax purposes. GRAT and CLAT have level annuity payments. Currently, initial GRATs and CLATs are assumed to be funded at the September 2016 7520 rate of 1.4%. Installment sales are at the September 2016 long-term AFR of 1.9%. For “average” conditions, the initial GRATs and CLATs are assumed to be funded at 4.1% and the intra-family loan at 4.4%, which are the average rate since January 1998. Data do not represent past performance and are not a promise of actual future results.
For clients who wish to transfer wealth to their children, the first step is to make maximum use of the “freebies” currently provided by the government:
- Pay education and healthcare costs for children or grandchildren.
- Make $14,000 annual gifts per person (a couple can gift $28,000 per year to as many people as they wish).
- Use the $5.45 million lifetime exemption ($10.9 million per couple).
Families with estates that are (or project to be) greater than $10.9 million may become subject to a 40% estate tax and thus may wish to consider additional estate planning strategies that can help to reduce the taxable estate.
For liquid wealth, a GRAT may work well.
A strategy that works very well for liquid wealth (readily investable assets) is a GRAT. With a GRAT, you can essentially keep your assets while transferring much of their growth in value to your beneficiaries. Here’s how the strategy works: In a basic GRAT, you transfer assets to the trust and retain the right to a specified annuity payment from the GRAT for each year of its term. If you structure the GRAT so that it is “zeroed out” — in other words, the total annuity payments equal the amount contributed plus an interest “hurdle rate,” the 7520 rate set by the IRS — once the trust’s term ends, any value left over after making the annuity payments goes to your beneficiaries free of gift taxes.
You can see from Figure 2 that with a modest investment return of 6 percent, a $10 million, 20-year GRAT would have a remainder of $10.9 million, whereas under more normal conditions the expected remainder would be $4.8 million. The long-term GRAT locks in today’s 1.4% 7520 rate for the entire 20-year period. Thus, for every dollar you put in, you may be able to transfer a similar amount to your children.
If you are highly philanthropic and seek wealth transfer, consider a CLAT.
A CLAT can be a great vehicle for someone with both estate-planning and philanthropic objectives. A CLAT is similar to a GRAT except that the annuity payments are made to a charity instead of returning to you as the grantor. You can, in effect, add an estate tax kicker to the charitable giving you are doing already. Suppose you give $50,000 a year to charity and plan to continue that for 20 years. The gifts would total $1 million (20 years times $50,000 = $1 million). With a CLAT, you front-load the gift into a trust at a cost of $866,954 (the amount required is based on the Section 7520 rate) and the trust makes the $50,000 gifts for you. Any money left over at the end of 20 years goes to your children free of gift and estate taxes. As we saw in the GRAT analysis, the expected remainder is 9% higher than the CLAT’s original funding. By using this structure, you could preserve the legacy for your family while fulfilling your philanthropic goals. And for CLATs, you are able to use the lowest 7520 rate available over the prior three months, so the September 7520 rate of 1.4% will be available for CLATs until November 2016.
For illiquid wealth, consider an installment sale to a defective grantor trust.
GRATs tend to be easier to implement for liquid assets because assets need to be valued each year on the annuity date. This can be an expensive and cumbersome process for holders of illiquid wealth, such as a private business or commercial real estate. In an installment sale, a valuation only needs to be performed on the sale date. The sale is typically made to a defective grantor trust to avoid triggering capital gains taxes.
In order for parents to sell assets to a trust for the benefit of their children, the trust needs to have capital, which can be satisfied by seeding a trust using the lifetime gift exemption. Practitioners generally agree that you need to make a seed gift to the trust of 10% of the value of the sale. This gift can be made using a portion of your $10.9 million lifetime exemption or by paying gift taxes if that exemption has already been used. Thus, if a couple makes a $10 million gift to a trust, they could conceivably sell $100 million in assets to the trust in an installment sale. Installment notes are typically interest-only. So if the asset has an annual income of 6%, it will be able to cover the 1.9% interest payment on the loan, and will allow for the 4.1% in additional capital to be reinvested. We show in Figure 2 that at the end of a 20-year loan term, there will not only be enough money reinvested to pay off the principal of the loan, but there will also potentially be $15.1 million left over per $10 million of loan created — about 2.5 times more than would transfer under average interest rate conditions. Therefore, the gift plus installment sale can move up to $100 million of assets out of an estate, in addition to providing ongoing cash flow and potential future appreciation of those assets.
But it can get even better. Today, it may be possible to take discounts for a minority interest and lack of marketability on those assets if the children’s trust does not have full control of the assets. For example, suppose the parents are able to transfer assets with a 30% discount. Now the amount of assets they can move using a sale to a trust for their children is more than $140 million ($140 million less a 30% discount is about $100 million). Or when transferring $100 million of assets in the example above, the loan amount might be $60 million ($7 million seed gift + $63 million loan = $70 million purchase) instead of $90 million, significantly enhancing the likely wealth transfer. However, on August 2, 2016, the IRS proposed regulations that could substantially limit the ability of families to take these discounts. Hearings are expected to be held in December and it’s possible that any new rules could be enacted in early 2017. Thus, there could be a significant benefit to taking action before the end of this year.
Consult with your advisors about the next steps to take.
In this article, we have briefly summarized these strategies that clients seeking wealth transfer may consider. We’d encourage you to consult with your Investment Counselor to better understand if any of these could be appropriate given your personal situation. Your Investment Counselor, in collaboration with your CPA and trust and estate attorney, can perform a custom analysis to help determine whether you have gifting capacity, help identify an appropriate amount to commit to each strategy and, of course, advise on the investment strategy within each vehicle.