The Internal Revenue Service recently released the Applicable Federal Rates (“AFR”) and the Section 7520 rate (“7520”) for August 2018. While the AFR remains low from a historical standpoint1, as do interest rates in general, there has been a recent trend of rising interest rates. The short term AFR has increased from .56% for August 2016 to 1.29% for August 2017, and up again to 2.42% for August 20182. The 7520 rate has increased a full percentage point in each of the last two years, starting at 1.4% for August 2016, up to 2.4% for August 2017, and up to 3.4% for August 2018.3
As a number of planning transactions are tied to either the AFR or the 7520 rate, and changes in interest rates can significantly change how these planning tools are used, advisors and clients should take note of rising interest rates and how the changing interest rates may affect the timing and corresponding benefit of transactions being contemplated. Below are some of the common planning techniques used and how they are affected by rising interest rates.
Act Now or Risking Paying for It Later
Grantor Retained Annuity Trust (“GRAT”)
A GRAT is a trust established by the grantor which pays the grantor an annuity, usually for a term of years, and upon expiration of the annuity term, any remaining assets of the GRAT remain in trust for the designated beneficiaries. GRATs can be structured in a variety of ways but one of the most common structures is the so called zeroed-out or near zeroed-out GRAT in which the present value of the annuity payable to the grantor is equal to the value of property transferred to the GRAT, and thus the GRAT is zeroed-out with no gift having been made by the grantor. In a non-zeroed-out GRAT, the grantor is treated as having made a gift of the value of the remainder interest less the present value of the annuity payments. The present value of the annuity is determined using the 7520 rate. If the assets in a zeroed-out GRAT outperform the 7520 rate, the GRAT will be successful and assets will remain in trust after paying the annuity. If the assets in a zeroed-out GRAT fail to outperform the 7520 rate, then the assets of the GRAT will be exhausted paying the annuity and no assets will be left in trust. The lower the 7520 rate, the lower the annuity payable will have to be to zero-out the GRAT, and the lower the assets of the GRAT will have to perform for the GRAT to be successful. For example, all other factors being equal for a $1,000,000 transfer to a two-year GRAT, the annuity payment would have to be $510,517 per period to zero-out the GRAT for a transfer made in August 2016 (7520 rate of 1.4%) and $525,652 per period to zero-out the GRAT for a transfer made in August of 2018 (7520 rate of 3.4%). Not only does the lower rate increase the value of assets remaining in trust at the end of the annuity term, but it also leaves more investable assets in the GRAT after year 1 which can increase the return on investment for year 2 thereby further increasing the value of assets remaining in trust at the end of the annuity term.
Sale to Intentionally Defective Grantor Trust (“IDGT”)
Another common planning technique which effectuates what is known as an “estate freeze” is a sale to an IDGT. The grantor sells assets to a previously established IDGT in exchange for a promissory note from the IDGT. The transaction does not have income tax consequences (at least while the grantor is living) since the trust is treated as a grantor trust for income tax purposes. The assets sold to the trust can appreciate in value inside the trust and outside of the grantor’s estate, while the grantor holds a promissory note which will be in the estate but which will not appreciate in value (other than by the amount of the interest payments). In essence, the grantor has replaced appreciable assets of the estate with non-appreciable assets, hence the term “estate freeze”. In addition to the benefit the grantor may receive from the “estate freeze”, the trust and its beneficiaries will benefit from receiving property that may (hopefully will) significantly appreciate in value. To avoid any part of the sale being treated as a gift or partial gift, all the proper steps should be taken in valuing the assets to be sold and ensuring the price paid by the IDGT to the grantor for such assets is the fair market value. For the note to be treated as having a fair market value equal to its principal amount, the note must carry interest equal to or in excess of the AFR at the time the note is issued. Accordingly, the lower the AFR at the time of the transaction, the lower the interest payable to the grantor will be and more assets can remain in the IDGT.
Similar to the sale to the IDGT, for an intrafamily loan to be respected and not recharacterized as a gift or partial gift, the loan must carry interest equal to or in excess of the AFR at the time the loan is issued. Accordingly, the lower the AFR at the time of the loan, the lower the interest payments will be, and more money will be available for the family member to use and/or invest (in hopes of getting a return on investment significantly higher than the AFR).
Patience May Pay Off
Charitable Remainder Trusts (“CRT”)
A charitable remainder trust can be structured as either a Charitable Remainder Annuity Trust (“CRAT”) or Charitable Remainder Unitrust (“CRUT”). There are numerous ways to structure a CRAT or a CRUT and a number of tax benefits both from an income tax perspective and from an estate tax perspective. The charitable deduction available to a grantor of CRT is equal to the actuarial value of the remainder interest of the CRT which passes to charity. This remainder interest passing to charity is valued at its present interest using the 7520 rate. The higher the 7520 rate is, the higher the actuarial value of the remainder interest is, and the higher the charitable deduction available to the grantor of the CRT is. While the nuances of structuring a CRT and the associated tax benefits of the different structures are beyond the scope of this article, in general, the charitable deduction for a CRAT will be more sensitive to changing interest rates and benefit more from rising interest rates than for a CRUT, all else being equal. Accordingly, the interest rates can generally determine which is the better choice for the taxpayer from a charitable deduction standpoint. The overarching point that a CRT will provide a greater tax benefit in the form of an increased charitable deduction when interest rates are higher will generally be true.
With the general trend of rising interest rates we are currently experiencing, advisors and clients should be aware of how a change in interest rates affects the tools in their planning arsenal. While the above list of planning techniques is by no means exhaustive, it does show how acting now or waiting to see additional rate changes may be beneficial. In addition to what’s listed above, there are a variety of other planning tools most of which are affected by changing interest rates. For those who benefit from low rates such as GRATs and sales to IDGTs, now may be the time to act before rates increase further. For those who benefit from higher rates such as CRTs, it may be prudent to wait and see what happens to interest rates over the next few months.