How low interest rates plus low valuations create extraordinary planning opportunities

Brian J. Jereb, Member, McDonald Hopkins LLC

Interest rates are at historic lows. Market values of many assets are lower than they were a few years ago. This juxtaposition creates potentially significant wealth transfer opportunities.

“The interest rates for loans to family members and related party transactions are lower than they have been in several decades,” says Brian J. Jereb, a member with McDonald Hopkins LLC. “These rates set the valuation rate used to determine the value of property transferred in certain types of gift strategies.”

In the valuation process, this is the assumed rate for valuing the taxable gift component. This rate is often referred to as the “hurdle-rate” in terms of the rate of return required for the strategy to perform as well as the valuation projection for tax purposes.

“While relative investment rates of return are low, the assumed rate is fixed at the time of the transfer, so when rates of return increase to more normal levels and market values increase as a result, the chance for success of these strategies should be greater than under normal circumstances,” Jereb says.

This juxtaposition also occurs at a time when the lifetime gift tax exemption is at an all time high of $5 million, which allows for larger taxable gifts while still having enough left to cover estate taxes or gift tax.

There are recent rumors that the so-called “Super Committee” could include in its plan a decrease in the gift tax exemption from $5 million to $1 million. “These rumors appear to be based on sheer speculation by various commentators about what the Super Committee may include in its plan if its members are ever able to reach an agreement,” Jereb adds. “By the time this article is published, we may have some indication concerning the possible future of the gift exemption should the committee agree to a plan.”

Smart Business asked Jereb how business professionals can take advantage of these opportunities now, as pending tax reform discussions loom on the horizon.

What is the simplest approach to capture this ‘double-barreled’ opportunity?

The simplest approach is a low interest loan to a family member. The borrower is not burdened by high interest charges and could use the loaned money for his or her desired purposes. If the lender dies, the loan is an asset, but will not disappear. If the borrower is a beneficiary of the lender’s estate plan, the loan balance can be distributed to the borrower or be offset against the inheritance.

What about trusts?

The Installment Sale to a Grantor Trust, sometimes referred to as an ‘Intentionally Defective Grantor Trust,’ or ‘IDGT,’ allows a senior generation member to sell an asset to a trust for the benefit of family members. An IDGT is designed so that the assets therein are treated as being owned by the trust’s creator for income tax purposes under the applicable federal income tax laws. While the assets are treated as owned by the trust’s creator for federal income tax purposes, they are owned by the IDGT and not the creator for federal estate tax purposes. The creator can sell assets to the IDGT without generating income tax; assets sold to the IDGT and appreciation are excluded from the creator’s taxable estate for estate tax purposes.

The IDGT generally benefits the creator’s family members. When the creator sells assets to the IDGT, the trust pays most of the purchase price with a promissory note at the current low interest rates. Because the creator and the IDGT are treated as the same taxpayer for federal income tax purposes, the interest paid on the note is not taxable to the trust’s creator. However, because the creator is deemed to own the assets in the IDGT for income tax purposes, he or she continues to be taxed on the ordinary income and capital gains realized by the IDGT’s assets. The payment of the income tax allows the assets in the IDGT to appreciate without reduction for income tax, and the payment of income tax is not a gift to the beneficiaries because the trust’s creator is merely paying his or her legal income tax liability.

With the low current market valuations, it is more likely than normal that the assets sold to the IDGT will increase in value from their depressed current values, and the current low interest rates make such a sale an efficient planning technique.

Another strategy is the Grantor Retained Annuity Trust (GRAT). Here, the senior generation contributes property to a trust in return for an annuity payment during the term of the trust. The term and the annuity rate determine the amount of the gift to the trust’s remainder beneficiaries. There are two limitations: (1) if the creator of the trust dies during the term, some or all of the trust assets will be part of the creator’s taxable estate and (2) the property transferred could be used up by the annuity payments, leaving no value for the remainder beneficiaries.

How can family-owned businesses benefit?

In the family business context, the low market valuations and the large gift tax exemption make it a good time to recapitalize C corporations with preferred and common shares and in the process make significant gifts to family members. Both C corporations and S corporations can be recapitalized into voting and non-voting shares. The non-voting shares can then be sold to family members or to an IDGT via a low interest rate note back to the senior generation. The current low tax and interest rates also currently provide an ideal opportunity for the business to borrow money to either pay a dividend or redeem shares owned by the senior generation.

How can charitable giving best be structured?

A related strategy with a charitable advantage is a Charitable Lead Annuity Trust (CLAT). In this strategy, the trust pays an annuity to selected charities over a term of years. At the end of the term, if the investment rate of return exceeds the valuation rate, the remainder that is available to the family beneficiaries will be greater than the amount projected using the IRS valuation rate. A CLAT is often used as a vehicle to fund ongoing annual gifts or to establish and fund an endowment gift through the annuity payments.

BRIAN J. JEREB is a member with McDonald Hopkins LLC. Reach him at (216) 348-5810 or [email protected]