Estate Planning Opportunities in the COVID-19 Environment

06/26/2020 / Patrick Kratz

Due to a convergence of recent tax changes and the economic upheaval caused by the COVID-19 pandemic, there are a handful of particularly effective opportunities available for transferring wealth from one generation to the next. By taking advantage of the current environment, you can increase the likelihood your loved ones will pay lower estate taxes upon your death.  It is a common misconception that gift planning is limited to those individuals who are willing to part with control and the economic benefits or their property.  Depending on the situation, it is many times possible to structure a gift plan that retains control and economic benefit in the family unit.

Recent Tax Changes

In December 2017, Congress passed the Tax Cuts and Jobs Act (“TCJA”) which, among other things, temporarily increased the federal lifetime gift and estate tax exemption (“Lifetime Exemption”).  As a result of the TCJA, in 2020, the individual Lifetime Exemption is set to $11,580,000. By comparison, the lifetime exemption was as low as $675,000 in 2000, $1,000,000 in 2005, $3,500,000 in 2009, and $5,000,000 in 2011.  However, unless there is another change in the law, after 2025 the Lifetime Exemption is set to revert back to the previous amount of $5,000,000, which is adjusted each year based on inflation since 2011.

For estates that exceed the Lifetime Exemption amount, the federal estate tax rate is 40% on everything over that amount. Combined with Minnesota, which has a threshold of $3,000,000 for a state estate tax, there can be a significant tax associated with transferring wealth at death. Recent regulations published by the IRS have clarified that if individuals use their entire $11,580,000 Lifetime Exemption by making gifts during their lifetimes prior to the amount reverting back to $5,000,000 (increased for inflation) in 2026, they will not retroactively lose the benefit of using the full current Lifetime Exemption. This creates an incentive for families with wealth over $5,000,000 to transfer that wealth to younger generations using lifetime gifts rather than waiting until a death that occurs in 2026 or beyond, so that less is owed in estate taxes.

Current Economic Landscape

The current economic downturn, and the reactions to it by the IRS, create additional opportunities for transferring wealth.  Each month, the IRS issues various prescribed rates for federal income tax purposes. These rates, known as “Applicable Federal Rates” (“AFRs”), are regularly published as revenue rulings and serve as the minimum interest rate that must be charged on private loans of various lengths.  The IRS also issues the “Section 7520 Rate”, which is 120% of the midterm AFR. The 7520 Rate is used to determine the present value of annuities, life estates, remainder interests, or interests for a term of years. 

The downturn has had the effect of pushing both the AFRs and the Section 7520 Rate historically low. For July 2020, the Short Term (loans of three years or less) AFR is 0.18%, the Mid Term (loans of three to nine years) AFR is 0.45%, and the Long Term (loans over 9 years) AFR is 1.17%. The Section 7520 Rate is 0.6%.

Strategies

Taken together, the historically high Lifetime Exemption under the TCJA, and the historically low AFRs and Section 7520 Rate provide unique wealth transfer opportunities to families looking to minimize their eventual estate tax liability. The most effective options include new intra-family loans, refinancing existing intra-family loans, a sale to a Grantor Trust, and the creation of a Grantor Retained Annuity Trust.

Intra-Family Loans

Intra Family Loans are an easy, accessible way to give a cash boost to younger generations. These loans are subject to certain requirements in order to avoid being classified as a gift with potential gift tax consequences.  While Intra-Family Loans must charge interest at a minimum of the AFR Rate, other terms of the loan can be flexible, such as the frequency of payments of both principal and interest and the duration of the loan. The duration of the loan will determine which AFR Rate applies. Since the AFR Rate is generally lower than what commercial banks typically charge for a similar loan, this will result in lower overall interest on the loan.  If the younger generation is able to use the loan proceeds to invest in an asset that appreciates or generates income faster than the loan’s interest rate, this results in a direct benefit without further gift or estate tax implications on the transfer.

Although this technique allows you to classify the transfer as a loan rather than a gift, the current Lifetime Exemption amount is so high that there is typically little consequence in using some of that amount for such gifts during your lifetime.  Intra Family Loans are especially useful when a transfer of property in excess of remaining Lifetime Exemption is desired.  The Intra Family Loan can then be forgiven in subsequent years to utilize the annual gift tax exclusions.

Note that the interest component, though historically low, will be income to the donor/lender but may not be deductible by the recipient/borrower for income tax purposes.

Refinancing Existing Intra-Family Loans

It is not uncommon for families to already have existing loans among family members. To the extent the AFRs at the time such existing loans were created are higher than the historically low current AFRs, refinancing, the reduction in interest rates on the refinanced loan will benefit the borrower in the form of lower overall payments.  In exchange for refinancing the loan, the borrower could make a down payment of a portion of the existing balance, reduce the overall duration of the loan, or provide additional collateral as security for repayment of the loan.  

Sales to Grantor Trusts

A sale of assets to a Grantor Trust is a more advanced technique that can generate greater benefits when used correctly. If an individual does not already have a Grantor Trust, one can be created for the benefit of that individual’s spouse and descendants, with certain features built in that allow the individual to absorb the year to year income tax obligations of the trust while moving the assets in the trust out of their own estate.

To benefit from the current environment, the individual who created the trust (the “Grantor”) can sell assets to the trust in exchange for a promissory note bearing interest at the applicable AFR Rate. Similar to an intra family loan, so long as the assets sold to the trust generate a higher rate of return than the interest rate on the note, there is a direct benefit to the trust without further gift or estate tax implications. An additional benefit of using the Grantor Trust method is that the sale of the assets to the trust, and any interest payments from the trust to the Grantor, do not result in taxable income to the Grantor.

Grantor Retained Annuity Trusts

This technique is similar to the sale to a Grantor Trust, in that the Grantor is transferring assets to a trust. However, with the Grantor Retained Annuity Trust (“GRAT”), instead of taking a promissory note in return for the asset, the Grantor receives an annuity that pays out a fixed amount over a fixed period of time. At the end of the annuity period, the GRAT terminates and any assets remaining will pass to whoever is designated in the trust agreement as the remainder beneficiaries (typically descendants).  When creating and funding the GRAT by transferring assets into the trust, there are gift taxes based on the value of the asset when it passes to the remainder beneficiaries.  The value of this remainder interest is determined based on a combination of the initial value of the asset being transferred, the duration and amount of the annuity to the Grantor, and the Section 7520 Rate at the time the GRAT is created.

Many GRATs are created in a way that minimizes the value of the remainder interest, so that the amount of the gift is $0. These “zero-GRATS” provide annuity payments to the Grantor that equal the value of the transferred asset plus the Section 7520 Rate. Done properly, the transferred asset’s rate of return through income and appreciation will exceed the Section 7520 Rate during the GRAT’s annuity period, resulting in estate and gift tax-free transfers to the remainder beneficiaries at the end of that annuity period. Because the Section 7520 rate is currently so low, the assets do not need to perform exceptionally well in order to realize this benefit, and the more the assets outperform the Section 7520 Rate, the greater the benefit. This has particularly high potential in the current environment due to the volatility of the economy and lower market values of certain investments that are expected to recover in the relatively near future.

Conclusion

The upheaval caused by the current economic conditions, combined with the existing tax landscape, creates a variety of opportunities to use high-impact estate planning strategies to transfer wealth and minimize your estate tax. Contact us today to discuss these options and secure your future.