Estate planning during turbulent times.

Low interest rates, especially when coupled with depressed stock and real estate markets, can create wealth transfer opportunities. For various wealth transfer techniques, the Internal Revenue Service assumes that a certain minimum interest rate is in effect. To the extent that an investment return can be earned that is greater than the minimum interest rate, wealth can be transferred to the next generation tax-free.

This article will discuss, in general terms, various wealth transfer opportunities, such as intra-family loans, outright gifts, sales to intentionally defective grantor trusts (IDGTs), grantor retained annuity trusts (GRATs) and charitable lead annuity trusts (CLATs), that may be appropriate during this turbulent economic environment.

Interest Rate Determination

For purposes of GRATs and CLATs, the relevant interest rate is the interest rate promulgated under [section]7520 of the Internal Revenue Code, as amended. For purposes of intra-family loans and sales to IDGTs, the relevant interest rate is promulgated under [section]7872 of the Internal Revenue Code. The 7520 rate and the 7872 rate are promulgated by the IRS on a monthly basis and released to the public via a revenue ruling. (1)

Because the revenue ruling is published prior to the end of a particular month (usually around the third week of the month), it is possible to choose from among two different rates (i.e., the current month and the upcoming month). Someone wishing to choose the rate for the upcoming month would have to defer the transaction until the desired rate was actually in effect. With regard to CLATs (and other charitable gifts), the taxpayer may select the lowest 7520 rate for a three-month period up to and including the month the CLAT is created and funded. (2) Therefore, for a CLAT, it is possible to choose from among four different rates (i.e., the two preceding months, the current month, and the upcoming month).

Intra-family Loans

Section 7872 of the Code allows family members (i.e., senior family members such as a parent or grandparent) to make loans to family members (i.e., junior family members such as a child or grandchild) at lower rates than those charged by commercial lenders without such loans being deemed gifts. (3) If the interest rate on the loan is below the 7872 Rate, the IRS will impute a gift from the lender to the borrower in an amount equal to the foregone interest. (4) Moreover, imputed interest will be taxable income to the lender. (5)

Generally, there are two types of loans--a term loan and a demand loan. A term loan will not be treated as a gift loan if the interest rate applicable to the term loan equals or exceeds the 7872 rate, compounded semiannually, as of the day on which the loan was made. (6) The interest rate will depend on the term of the loan (i.e., the federal short-term rate applies to term loans with a maturity date of three years or less, the federal mid-term rate applies to term loans with a maturity date in excess of three years but not more than nine years, and the federal long-term rate applies to term loans with a maturity date in excess of nine years). (7) A demand loan will not be treated as a gift loan if the interest rate applicable to the demand loan is at least equal to the short-term applicable federal rate, compounded semiannually, for the period in which the loan is outstanding. (8)

Loans can be structured in a variety of ways. For example, they can be self-amortizing with interest and principal being paid over the term or they can be interest-only with principal due at maturity. The latter is often referred to as a balloon loan. To ensure that the IRS will respect the validity of a loan, the note evidencing the loan should contain a fixed maturity date, a written repayment schedule, a provision requiring periodic payments of principal or interest, and a provision regarding collateral, if applicable. In addition, actual payments on the note should be made. With regard to demand loans, if the lender never demands payments or if the borrower does not have the ability to satisfy the loan, an inference can be made that the lender never intended the loan to be made. If the IRS does not respect the loan, the transfer from the lender to the borrower could be reclassified as a taxable gift. (9)

If the property loaned from the senior family member to the junior family member appreciates at a rate faster than the prevailing interest rate and/or earns income in excess of the prevailing interest rate, then assets can be shifted from one generation to the next tax-free. And when interest rates are low and/or markets are depressed, there is a greater chance that this will occur.

When structuring a loan, the impact of federal and state income taxes on the senior family member and junior family member must also be considered. More specifically, the senior family member will generally have interest income to recognize as part of his or her taxable income, but the junior family member will generally not be able to deduct the interest paid from his or her taxable income. To ameliorate the impact of income taxes, instead of senior family member loaning directly to junior family member, senior family member can create a "grantor trust" for income tax purposes for the benefit of junior family member and make a loan to the grantor trust. However, as discussed in further detail below, the grantor trust should be "seeded" with sufficient assets so that the trust is respected by the IRS.

When a trust qualifies as a grantor trust for income tax purposes, all of the trust's income is taxed to the grantor (i.e., the senior family member), as opposed to the trust. In addition, when the trust is properly structured, even though the senior family member pays income tax on the trust's income, any gift to the trust by the senior family member is complete for estate and gift tax purposes, and, thus, the trust should not be included in the senior family member's estate upon his or her demise for federal estate tax purposes. (10)

There are two benefits in structuring a trust as a grantor trust for income tax purposes. First, the payment of income tax by the grantor on behalf of the trust should not be considered a gift for gift tax purposes. (11) Therefore, if the grantor pays income tax on income received by the trust, the grantor would be removing additional assets from his or her estate. Assuming an estate tax rate of 45 percent, for every dollar of income tax paid on behalf of the trust, an additional $.45 of tax is saved.

The second benefit of structuring a trust as a grantor trust is to enable the grantor to enter into transactions with the trust on an income tax-free basis. Because the trust is a grantor trust, any transaction between the grantor and the trust is treated as made between the grantor and himself or herself. Therefore, there are no income tax consequences. An intrafamily loan is an example of such a transaction.

Outright Gifts

Outright gifts were very popular prior to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). However, after EGTRRA was passed and the estate tax (but not the gift tax) was scheduled to be repealed, individuals became reluctant to pay gift tax and, thus, reluctant to make outright gifts. Now that it is virtually certain that estate taxes will not be repealed and rates will probably remain the same (or be reduced slightly), paying gift tax is back in vogue, especially while the real estate and financial markets are down.

The benefits of an outright gift may best be illustrated through a simple example. If an unmarried decedent has a $40 million estate and two children, upon his death, assuming a 50 percent estate tax bracket, $20 million will pass to his children (or $10 million per child). If, instead of waiting until death, decedent, four years prior to death, gifted $20 million (or $10 million to each of his children), decedent would have paid gift taxes of $10 million (assuming a 50 percent gift tax rate). After the gift, decedent would have been left with $10 million. Upon decedent's subsequent death, $5 million would pass to his children (or $2.5 million per child). By making an inter vivos gift, each child ends up with $12.5 million. By gifting, an additional $5 million was transferred from the senior family member to the junior family members, not to mention the appreciation that can be removed from the estate, as discussed below.

Outright gifts are most advantageous when market conditions are depressed (i.e., gifting when the stock market or real estate market is depressed). The above example assumes that the $20 million gifted to the junior family members did not appreciate in value. If, however, those assets appreciated by five percent annually, an additional $1 million per year would be removed each year from the senior family member's estate and pass to the junior family members, free of gift and estate tax.

The above example also assumes that the senior family member lives for at least three years subsequent to making the gift. If a donor dies during the three-year period subsequent to making the gift, any gift taxes attributable to the gift are added to the donee's gross estate for federal estate tax purposes. (12) Thus, if the senior family member survives for three years, the payment of gift taxes is tax exclusive, whereas if the senior family member dies within three years, the payment of gift taxes is tax inclusive.

As with intra-family loans, the impact of income taxes on the junior family members needs to be considered. However, through the use of grantor trusts, the income tax burden on the assets gifted to the junior family members can remain the responsibility of the senior family member, providing an additional transfer tax benefit.

In addition, the impact of the loss of the step-up in basis upon the senior family member's death must be considered. Upon a decedent's death, each asset of the decedent receives a step-up in basis to the fair market value of the asset as of his or her death of death (13) (or as of six months after his or her date of death if the alternate valuation date is elected). (14) With regard to gifts, the donor's basis in the asset generally carries over to the donee (i.e., there is no step-up in basis). (15) However, with capital gains rates at 15 percent and the top estate tax rate at 45 percent, in most situations, the inter vivos gift would be more beneficial from an overall tax perspective. Of course, practitioners must keep an eye on the rates, particularly with a new president and Congress.

Finally, the discussion regarding outright gifts has not considered the impact of minority interest and lack of marketability discounts. If, for example, a fractional interest in real estate or a limited partnership interest in a family limited partnership (FLP) is being gifted, the leveraging is magnified.

Sale to Intentionally Defective Grantor Trust

A sale to an IDGT combines the interest rate benefits of intra-family loans with the discounting benefits of inter vivos gifts. And, with outright gifts, this technique works especially well if the sale can be consummated when market values are depressed.

The first step would be for senior family member and junior family members to create an FLP. For example, the junior family members (i.e., the children) would create an entity, such as a limited liability company, which would be one percent general partner of the FLP. The senior member would be the initial 99 percent limited partner.

In addition, senior family member would create an irrevocable trust (which will be structured as a grantor trust for income tax purposes) for the benefit of junior family members. Senior family member then would sell his or her limited partnership interest in the FLP to the irrevocable trust in exchange for an interest-only promissory note with a balloon payment due upon maturity. (16) It is recommended that the promissory note be structured as a balloon note to maximize savings because the more principal that is paid back during the term of the note, the less transfer there is from the senior family member to the junior family member (i.e., the balloon note will cause all of the appreciation on the loaned asset to accrue to the trust for the benefit of the junior family members).

Because the irrevocable trust is a grantor trust, the sale is ignored for income tax purposes. (17) In addition, because the asset being sold is a limited partnership interest in an FLP, an independent appraisal company may apply a lack of marketability and minority interest discount to the value of the limited partnership interest.

When the irrevocable trust is created, it should be seeded with assets.

Although there is no formal guidance, common practice dictates that the trust should be seeded with 10 percent of the face value of the promissory note. Many times an existing grantor trust can be used which already has sufficient assets. If there is an existing grantor trust but the provisions of the grantor trust are not ideal (i.e., the grantor trust does not contain "dynasty trust" provisions, which would allow the trust to continue for the senior family member's children, grandchildren, and remote descendants), it may be possible to "decant" the grantor trust to a new grantor trust under Florida's new decanting statute. (18)

Sometimes it just may be impractical for a trust to be seeded with the appropriate level of assets (i.e., the senior family member is unwilling to incur a sizable taxable gift). Instead of seeding the grantor trust, the beneficiaries of the grantor trust could personally guarantee the promissory note. However, the beneficiaries should independently have sufficient net worth to cover the amount of the guarantee. There is an element of risk with this approach because the IRS might take the position that the guarantee constitutes a gift from the beneficiary to the grantor trust. One way to reduce this risk is to have the trust pay the guarantor a reasonable fee for the guarantee.

On an annual basis, the irrevocable trust could service the debt using the property that was initially transferred to it. In addition, the grantor trust could use any distributions it receives from the FLP, as an owner of a 99 percent limited partnership interest, to service the debt. Because the trust is a grantor trust for income tax purposes, the senior family member does not have to recognize the interest payments as interest income. With regard to servicing the interest payments on the promissory note, the sale to the IDGT works especially well when rental real estate is contributed to the limited partnership because the distributions of the rental income to the grantor trust can be used to service its interest payments.

Upon the maturity of the balloon note, the outstanding principal balance can be repaid from the irrevocable trust to the senior family member. The note can be satisfied in cash or in-kind (i.e., with property owned by the IDGT). Alternatively, it may be possible for the terms of the promissory note to be renegotiated into a new balloon note.

Grantor Retained Annuity Trusts

With a GRAT, a senior family member transfers assets to a trust which provides that he or she is to receive an annual annuity payment for a fixed number of years. The annuity amount is typically a stated percentage of the initial fair market value of the trust. It can be stated as a fixed percentage or as a percentage that can increase by as much as 20 percent each year of the trust's term. By increasing annuity payments each year of the GRAT term, payments can be minimized in early years, leaving more principal in the GRAT for a longer period of time and allowing the principal to generate additional appreciation. The annuity need not be paid in cash--it can be paid in-kind (i.e., with a portion of the assets initially contributed to the GRAT). At the end of the annuity period, the property remaining in the GRAT (after paying the senior family member the annuity) passes to the ultimate beneficiaries (typically the senior family member's children, either outright or in further trust) with no further gift tax liability.

The creation of a GRAT constitutes a gift to the ultimate beneficiaries equal to the initial value of the trust assets, reduced by the present value of the annuity payments retained by the senior family member. The most popular use of GRATs has been the short-term, "zeroed-out" GRAT, in which the term of the GRAT is limited to no less than two years and the annuity amount is structured to produce as small a taxable gift as possible.

If the senior member survives the annuity term, none of the remaining GRAT assets will be includible in his or her gross estate for estate tax purposes. If the senior family member dies during the annuity period, the GRAT assets, or the amount necessary to yield the remaining annuity payments (using the date of death 7520 rate), will be included in the senior family member's gross estate.19

The calculation of the present value of the retained annuity is based, in part, upon the current 7520 rate. When the 7520 rate is lower, the annuity payments needed to zero out the GRAT will be smaller and, thus, at the end of the annuity term, more assets will be available to pass to the ultimate beneficiaries gift tax-free. Therefore, GRATs work best in times of low interest rates. GRATs also work best when the value of the assets contributed to the GRAT are depressed and the value is expected, during the GRAT term, to rebound to or exceed their former value. Therefore, the GRAT is a valuable technique when markets are depressed.

As indicated above, the use of short-term (i.e., two-year) GRATs have traditionally been more popular than using longer-term GRATs. The reasoning behind the preference for short-term GRATs is twofold. First, a short-term GRAT minimizes exposure to the risk that the senior family member will die during the term, which, as stated above, would cause all or a portion of the value of the GRAT assets to be included in the senior family member's gross estate. Second, a short-term GRAT minimizes the possibility that a year or two of poor performance of the GRAT assets will adversely impact the overall effectiveness of the GRAT. However, notwithstanding these benefits, in times of low interest rates, a longer-term GRAT may be more desirable because it allows the senior family member to lock in a low 7520 rate for the duration of the GRAT term. Therefore, in a low interest rate environment, it is extremely important to consider the potential effects of using different GRAT terms.

Charitable Lead Annuity Trusts

With a CLAT, the senior family member transfers assets to a trust (either during his or her life, or upon his or her death), and the trust pays a fixed dollar amount or a fixed percentage of the value of the assets contributed to the CLAT to one or more charities (including a private foundation)20 for a specified number of years. Alternatively, the CLAT may be structured to last for the life or lives of the senior family member, his or her spouse, or a lineal ancestor (or spouse of a lineal ancestor) of all of the remainder beneficiaries (or a trust in which there is less than a 15 percent probability that individuals who are not lineal descendants will receive any trust corpus). (21) At the end of the annuity term, the assets remaining in the CLAT pass to one or more noncharitable beneficiaries, such as the senior family member's children or other family members (and/or to one or more trusts for their benefit).

When the senior family member contributes assets to a CLAT, he or she makes a taxable transfer equal to the present value (based on IRS tables) of the remainder interest that will pass to the noncharitable beneficiaries. Like zeroing out a GRAT (discussed above), CLATs can be structured so that the gift or estate tax on the remainder interest will be small or nonexistent. The value of the noncharitable beneficiaries' remainder interest is calculated by using the 7520 rate. As discussed above, the senior family member may use any of the 7520 rates in effect during the three-month period up to and including the month the CLAT is created and funded. (22) If, over the annuity term, the CLAT generates total returns higher than the chosen 7520 rate, the excess growth passes to the noncharitable beneficiaries transfer tax-free.

An inter vivos CLAT may be structured as a grantor trust for income tax purposes, in which case, all items of income are taxed to the senior family member as grantor. Furthermore, the senior family member is entitled to receive an income tax charitable deduction equal to the present value, based on IRS tables, of the interest passing to charity; however, the charitable deduction is subject to certain limitations based on the type of assets used to fund the CLAT and the type of charitable beneficiary.23 If the CLAT is not structured as a grantor trust, then the senior family member is not entitled to an income tax charitable deduction for amounts paid to charity. However, the CLAT is responsible for the payment of the income taxes attributable to any income earned by the CLAT Moreover, the CLAT receives a deduction for the annual amount paid to charity.

The lower the 7520 rate, the greater the potential for tax-free wealth transfers using a CLAT and the greater the transfer tax (and income tax, if applicable) charitable deduction. Therefore, CLATs are most attractive when interest rates are low. CLATs also work best when the value of the assets contributed to the CLAT are depressed and the value is expected, over the term of the CLAT, to rebound to or in excess of its former value. Like SCINs and PAs, CLATs work especially well when the charitable annuity is structured to last for the life of an individual who is not expected to live for the duration of his or her actuarially determined life expectancy, provided that he or she is not "terminally ill." (24)

CLATs are subject to the private foundation rules of I.R.C. [subsection] 4941 through 4945 (dealing with "selfdealing," "distribution of minimum return," "excess business holdings," "jeopardy investments," and "taxable expenditures"). (25) Those rules can cause particular complications when a CLAT is funded with interests in a closely held entity, such as an FLP

Conclusion

Times of low interest rates and depressed markets are a great opportunity to take advantage of the transfer tax savings techniques discussed above. Soon enough, these turbulent times will be behind us (let's hope). Don't pass up the opportunity while it exists.

(1) See Rev. Rul. 2008-49, 2008-40 I.R.B. (September 17, 2008), which contains the October 2008 rates.

(2) I.R.C. [section] 7520(a).

(3) I.R.C. [section] 7872.

(4) I.R.C. [section] 7872(a)(1).

(5) I.R.C. [section] 61(a)(4).

(6) I.R.C. [section] 7872(f)(2)(A).

(7) I.R.C. [subsection] 7872(f)(2)(A) and 1274(d)(1)(A).

(8) I.R.C. [section] 7872(f)(2)(B).

(9) See Estate of Baring v. Comm'r, 51 T.C.M. 113 (1985); see also Estate of Berkman v. Comm'r, 38 T C.M. 183 (1979).

(10) See Rev. Rul. 2004-64,2004-27 I.R.B. 7.

(11) Id.

(12) I.R.C. [section] 2035(b).

(13) I.R.C. [section] 1014.

(14) I.R.C. [section] 2032.

(15) I.R.C. [section] 1015, but note that I.R.C. [section] 1015(d) provides that the basis shall be increased by the amount of gift tax paid with respect to the gift.

(16) Another variation is a sale in exchange for a self-cancelling installment note or private annuity. These techniques also work particularly well in a low interest rate environment, particularly when the senior family member will probably die prior to his or her actuarial life expectancy, but is not "terminally ill," as defined in the Treasury Regulations. See TREAS. REG. [section] 25.7520-3(b)(3). A full discussion regarding these techniques is beyond the scope of this article.

(17) See Rev. Rul. 85-13, 1985-1 CB 184.

(18) See FLA. STAT. [section] 736.04117.

(19) TREAS. REG. [section] 20.2036-1.

(20) If a private foundation is a beneficiary during the lead term, the senior family member cannot participate in any decisions regarding the amount distributed from the CI-AT to the private foundation. In order to prevent any such participation, the foundation's organizational documents should be modified accordingly. See Priv. Mr. Ruls. 200108032, 200138018.

(21) TREAS. REG. [section] 1.170A-6(c)(2)(i)(A).

(22) I.R.C. [section] 7520(a).

(23) For example, if the charitable beneficiary is a public charity and long-term capital gain property is contributed to the CLAT, the amount of the charitable deduction is limited to 30 percent of the senior family member's adjusted gross income. Generally, unless the charitable beneficiary is a private foundation, any amounts in excess of the limitation may be carried over as a deduction in the five succeeding years.

(24) See TREAS. REG. [section] 25.7520-3(b)(3).

(25) A detailed explanation of those rules is beyond the scope of this article.

David Pratt is a partner in the personal planning department of Proskauer Rose, LLP, in Boca Raton. Mr: Pratt focuses on estate and gift, generation-skipping transfer; and estates. He is chair of the Tax Section, and a fellow of the American College of Trust and Estate Cousel and the American College of Tax Counsel.

Scott L. Goldberger is an associate in the personal planning department of Proskauer Rose, LLP, in Boca Raton. He received his J.D. from Georgetown University Law Center and a Master and B.S. in accounting from the University of Florida.

Robert Jacobowitz is an associate in the personal planning department of Proskauer Rose, LLP, in Boca Raton. He received his J.D. from the University of Florida and a B.B.A. in accounting from the University of Miami.

This column is submitted on behalf of the Tax Section, David Pratt, chair; and Michael D. Miller and Benjamin A. Jablow, editors.