Reap the Estate Planning Benefits of Today's Low Interest Rate Environment

This current low interest rate environment provides taxpayers with several attractive estate planning options, which may result in little or no gift and estate tax liability. Here’s how it works.

Interest Rates

The news regularly reports on the “Fed” and what it will do with the “Rate”, but rarely is there any discussion on what the Fed is and how the Rate is determined. The Fed is the Federal Reserve System, the central bank of the United States. It is a quasi-public entity, meaning that it is a government entity with private components. The Fed is comprised of a board of governors, the Federal Open Market Committee, 12 regional Federal Reserve Banks, numerous private banks, and various advisory counsels.

The original motivation for the creation of the Fed was to control banking panics or runs, which occurred at various times during the first 100 years of this nation. Since its creation, the Fed’s function has grown to include a national check clearing system, and acting as a lender of last resort when banks need to borrow funds, the central bank for the U.S. Treasury, and a reserve for private banks. It’s the Fed acting in its capacity as a reserve where the Rate part of the equation comes in.

The Federal Funds rate is the rate that the federal government charges private banks to borrow money from its reserve on a short-term (usually overnight) basis so that these banks can meet their reserve requirements and clear transactions. At publication, the Federal Funds rate is currently less then .25 percent, the lowest it has ever been. The lower the rate, the easier it is for private banks to do business. Since it costs the private banks less money to borrow from the Fed, savings are passed on to the consumer through lower interest rates on loans.

The U.S. Treasury, which uses the Fed as its bank, determines a group of rates each month to be used in certain tax calculations.  These rates are known as the Applicable Federal Rate (AFR). While there is no direct “dollar for dollar” correlation between the Federal Funds rate and the AFR, historically, as the Federal Funds rate moves up and down, so does the AFR.

For most estate planning purposes the ARF to be looked at is the “mid-term” rate. This is the rate for U.S. obligations between three and nine years. One hundred twenty percent of this rate is known as the Section 7520 rate. This is the rate used by the IRS for valuing life interests, annuities and remainder interests. The current Section 7520 rate is 2.6 percent and a low Section 7520 rate is favorable for several estate planning strategies including Grantor Retained Annuity Trusts (GRATs), Charitable Lead Trusts (CLT’s) and Qualified Personal Residence Trusts (QPRTs).

Estate and Gift Tax

In the United States, the federal estate tax is payable to the U.S. Treasury upon the death of a person who has a “taxable estate.” Whether someone’s estate is taxable is based on several variables. In 2009, a person will owe federal estate tax if their net taxable estate is $3.5 million (exemption amount) or greater.  The rate of tax to be paid is based on a sliding scale depending on the size of the net taxable estate and can be up to 45 percent. The current estate tax scheme was enacted as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Under EGTRAA, the federal estate tax is due to completely disappear in 2010, and come back in 2011  for net taxable estates greater than $1 million. While it is likely that some form of estate tax legislation will pass during 2009, it is unclear as of now what that legislation will include.

A person’s gross taxable estate is comprised of various items including, but not limited to, all assets held in their name, certain insurance proceeds and certain transfers made prior to their death. This amount is then reduced by allowed deductions, including debts, expenses related to the administration of their estate, and amounts passing to their spouse or an allowed charity. The current exemption amount is then applied and adjusted for certain transfers made during their lifetime. What’s left over is then taxed at the required rate. As an example, the estate of an unmarried woman with $4 million in assets, no debt and administration expenses of $100,000 will owe federal estate tax of approximately $122,000.

To make matters even more complicated, many states have their own estate and/or inheritance tax, which must be paid in addition to the federal estate tax. In Connecticut, the exemption amount is only $2 million, so in the example above, the estate will also owe approximately $242,000 in Connecticut estate tax. For Massachusetts, in the example above, the estate will owe approximately $270,000 in estate tax. This gets even more complicated when a person has property in more than one state. Some states, like Florida and Virginia , do not impose any state estate tax.

The United States also imposes a gift tax on certain gifts. Every person may give up to $1 million during their lifetime. Some gifts, like those to pay for education or medical expenses, or annual exclusion gifts, are not counted towards the $1 million lifetime gift amount. For example, if a person makes a gift of $1.5 million in 2009, and no part of that gift can be excluded from gift tax, then a tax in the amount of approximately $156,000. Connecticut allows a $2 million exemption for gifts so in the example above, no gift tax would be due. Massachusetts does not impose a gift tax. An annual exclusion gift is a gift from one individual to another that is less than or equal to the federal annual exclusion amount. For 2009, that amount is $13,000.  These gifts are in addition to the $1,000,000 lifetime gifts.

The federal estate and gift tax are a unified system of taxation. What that means is that any part of a person’s $1 million lifetime gift exclusion that is used during life is deducted from that person’s federal estate tax exemption when they die. Thus, you cannot give away $1 million tax free during your life and then give an additional $3,500,000 tax free at your death. The total you can pass on free of tax is $3.5 million.

The best way to reduce your estate and gift tax liability is through comprehensive estate planning. Some estate planning strategies can be initiated at any time, but the sooner the better. These would include use of a credit shelter trust for married couples, creation of a life insurance trust and utilization of the annual gift exclusion. Other estate planning strategies are especially effective in low interest rate environments.

Estate Planning Strategies for Low Interest Rate Environments

Grantor Retained Annuity Trust (GRAT) – A GRAT is an irrevocable trust where the grantor transfers an asset into the trust while retaining the right to receive annuity payments from the trust based on a fixed schedule. The transfer, or gift amount, is determined by subtracting the value of grantor’s retained interest from the total amount transferred the trust. The grantor’s retained interest is determined by using the Section 7520 rates. The terms of the GRAT can be structured, so that there is no taxable gift.  This is done  by using a technique called “zeroing-out” the GRAT. In this situation the amount of the annuity paid back to the grantor is equal to the value of the trust. Since the annuity amount is determined, in part, by the Section 7520 rate, so long at the assets in the GRAT appreciate at a rate greater than the Section 7520 rate, the property will have been transferred to the beneficiary of the GRAT without any gift tax imposed.

For example, if a grantor contributes property into a GRAT with a value of $1 million with a current rate of 2.6 percent for a term of 10 years, the grantor will receive back $120,849 per year. This is equal to the amount contributed into the GRAT plus interest of 2.6 percent. At the end of the GRAT term, the remaining property in the trust will be distributed to the beneficiaries of the GRAT. All the trust needs to do is grow at a rate greater than 2.6 percent for the beneficiaries to receive property free of gift tax. In fact, if the trust grows at 8 percent per year, then the beneficiaries will receive $408,241 at the end of the GRAT period free of gift and estate tax. Even better, if the trust grows at 13 percent, the beneficiaries will receive over $1 million at the end of the GRAT term, completely free from gift tax.

In addition, the property originally contributed to the GRAT may be subject to a discount based on factors such as lack of marketability and lack of control. For example, if the property contributed to the GRAT consists of limited partnership interests, the value of the amount transferred into the GRAT may be originally $1.5 million, but after discounts its value is reduced to $1 million, and then processed through the GRAT to the beneficiaries. The only drawback occurs if the grantor does not outlive the GRAT term, which results in the property originally transferred to the GRAT being included in the grantor’s estate.

Charitable Lead Trust (CLT) – A CLT strategy benefits both your chosen beneficiaries as well as a charity. In this strategy the grantor creates a CLT, which provides an income stream to a charity for a term of years. At the end of the term, the balance of property in the CLT passes to the beneficiaries. Similarly to the GRAT, as long as the assets in the CLT grow at the higher rate than the 7250 rate, then assets have been transferred to the remainder beneficiaries free of gift tax.

Qualified Personal Residence Trust (QPRT) – A QPRT is another effective way to transfer assets to your beneficiaries with gift tax implications far less than if the property were to be transferred outright or through your estate. A QPRT is used to transfer your personal residence (this can be your primary residence or a vacation home, depending on your circumstances) to your beneficiaries at a highly discounted rate. The home is transferred into the trust, and your remainder interest is calculated using the current 7520 rate. The trust is for a set term of years, and you may remain in your home rent free during that term. At the end of the term, you will be required to pay a fair rent for the use of your home should you continue to live there.

For example, a home valued at $1 million is transferred into a QPRT with a 10-year term. At the time of the transfer the remainder interest in the home, (the amount subject to gift tax) is $365,320. If the lifetime gift exclusion has not been used, the transfer is tax-free. If your lifetime gift exclusion has been used, then a gift tax is paid on the remainder interest; however, the remainder interest is less than the value of the home and the appreciation in value is outside of your estate. Unfortunately, if you do not outlive the term, then the home is returned to your estate.

These are only a few of the many techniques available to help reduce or eliminate gift and estate tax. For more information on these and other estate planning strategies, contact   Kostin, Ruffkess and Company, LLC, 860-678-6000.