November 30, 2010

Interest rates have continued to fall, hitting a historic low in December 2010. While that may sound like a bad thing to many readers, this economic environment presents significant opportunities for leveraging tax savings and transferring wealth to descendants on a tax-advantaged basis. Below are a few techniques worth considering:

Minimal-Interest Intra-Family Loans

A simple but attractive option is an intra-family loan. This can be done independent of other techniques and without adverse gift tax consequences—as long as the loan is made at the Applicable Federal Rate (AFR). These rates are currently at historic lows. For December 2010, the AFR is .32% for loans of three years or less, 1.53% for loans of three-plus to nine years, and 3.53% for loans of nine-plus years. Although your family member/borrower will owe you interest on the loan, if the funds are invested with a return in excess of the AFR, the wealth is transferred to the family member/borrower on a tax-free basis.

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Refinancing Existing Loans

Many parents may have made loans either to their children or to trusts for their children's benefit (e.g., outright loans, loans issued in connection with sales of assets or otherwise). The interest rate being charged on these loans may be significantly higher than the current AFR. If the loans can be prepaid without penalty, and if the parent/lender does not need the cash flow, consideration should be given to refinancing at the lower current interest rate. This technique will reduce the child's cash outflow, allowing the wealth to grow for his or her benefit outside the transfer tax regime.

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Grantor Retained Annuity Trust (GRAT)

A GRAT is a grantor trust whereby the trust pays the creator a predetermined annuity for a given term in exchange for the creator's contribution of property to the GRAT. At the expiration of the term, the assets remaining in the GRAT pass to the named beneficiaries (e.g., descendants or trusts for their benefit). When a GRAT is established, the creator makes a gift that is equal to the value of the transferred property, less the value of the retained interest, actuarially determined based upon 120% of the AFR, rounded (the IRS "imputed rate"). If the creator survives the term, any assets remaining in the GRAT pass to the named beneficiaries without further gift taxation (whatever the value is at that time). However, if the creator dies during the GRAT term, the assets are fully included in the creator's estate (in essence unwinding the transaction). 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 GRAT produces transfer tax benefits when the return on the assets transferred exceeds the IRS imputed rate (1.8% for December 2010).

Many factors affect the value of the gift upon creation of a GRAT, including the AFR, the value of the property being transferred, the term of the GRAT and the annuity percentage. Because the creator can control the term and annuity rate, the GRAT is typically structured to produce no taxable gift (e.g., a two-year term with an annuity equal to approximately 53% of the value of the property contributed). Such a "zeroed-out" GRAT would allow investment returns (interest, dividends and appreciation) of the assets in excess of the IRS imputed rate (1.8% for GRATs created in December 2010) to pass to descendants free of transfer tax.

The GRAT has been referred to as a "no lose situation." If the GRAT's investment return beats the IRS imputed rate, assets are transferred to descendants free of gift tax. If the return is less than the IRS imputed rate, then the assets simply return to the creator, in essence putting the creator back in the same position as if he or she had not created the GRAT.

However, time may be limited for this zeroed-out GRAT technique. There has been talk of Congress changing the law to require GRATs to have a minimum 10-year term and a minimum gift (e.g., potentially 10% of the value of the GRAT).

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Charitable Lead Annuity Trust (CLAT)

In a low-interest-rate environment, the CLAT is an effective technique to achieve philanthropic goals (i.e., annuity payments to a charity) combined with the ability to transfer assets to descendants free of gift tax. A CLAT is similar to a GRAT but with the term annuity payments going to a charity (e.g., a private foundation). At the expiration of the CLAT term, the remaining assets pass to the named beneficiaries (e.g., children). The value of the charitable lead interest would not only pass free of transfer tax but can also be structured to provide the creator with a current income tax deduction. When a CLAT is established, the creator makes a gift to the remainder beneficiaries equal to the value of the remainder interest (actuarially determined, but with an option to use the IRS imputed rate for the month of the transfer or either of the prior two months). The annuity payment is typically designed to fully offset the value of the contributed property, so that there is no taxable gift upon creation of the CLAT. The CLAT produces transfer tax benefits when the return on the assets transferred exceeds the IRS imputed rate.

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Grantor Trusts and Installment Notes

If a person creates a trust (e.g., for the benefit of his or her descendants) and includes certain grantor trust provisions, the income tax laws treat the trust and the creator as the same person (i.e., ignores the trust's existence). The creator, not the trust, then reports the trust income and pays the tax thereon. In essence, this allows the creator to make tax-free gifts to the trust for his or her descendants. Because the law requires the creator to pay the income tax on the trust's income, the grantor trust grows tax-free for the benefit of his or her descendants. As the creator's other assets are used to pay the income tax, this technique also reduces the assets that would otherwise be subject to transfer taxation. The tax-free compounding of the grantor trust may create the greatest of all estate tax leveraging.

As the AFR is at an all-time low, creating and selling appreciating assets to a grantor trust for an installment note is currently quite attractive. Under the applicable rules, no gain or loss on the sale would be recognized. Although the grantor trust would be required to make payments on the note, the growth on the asset sold would inure to the trust beneficiaries. In essence, the grantor would be freezing the value of the transferred assets. The sale to the grantor trust produces transfer tax benefits when the assets sold appreciate more than the rate of the promissory note. With current interest rates at historic lows, this can likely be accomplished.

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For More Information

As there are many nuances to these techniques, we recommend that you speak to your Much Shelist attorney or contact a member of our Wealth Transfer & Succession Planning practice group to determine if one or more of these strategies are appropriate for you.

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Circular 230 Notice. To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.