The year 2022 may have marked the end of historically low interest rates for the foreseeable future. Multiple increases to the federal funds rate by the Federal Reserve have resulted in interest rate increases generally across the board. Estate and wealth-transfer planning will be affected, as many commonly used planning strategies have an interest component that can have a significant impact on the success of the strategy. As we move through 2023 and beyond, we will likely see a shift from strategies that are more effective in a low-interest rate environment, to planning ideas that may benefit from higher rates.
The recent interest rate increases stem from the Federal Reserve’s decisions to increase the federal funds rate. As the federal funds rate increases, which increases the amount banks charge each other for overnight loans, banks pass along this additional cost by increasing the rates they charge their customers. We’ve seen the chain reaction — an increase in the prime rate, followed by increases in mortgage rates, auto-loan rates and other types of lending arrangements.
One of the rates impacted by these increases that is important to estate planning is the applicable federal rate (AFR). Among other things, the AFR provides the minimum interest rate to be charged on a loan to avoid the creation of a gift. The IRS publishes the AFR each month, usually around the middle of the immediately preceding month for which the AFR applies. The AFR is broken down into short-term, mid-term and long-term rates and is based on the yields of Treasury obligations of a similar duration. During 2022, the mid-term AFR rose from a low of 1.30% in January to 4.27% in December.
How Rates Impact Estate Planning
A variety of estate and wealth transfer planning techniques are impacted by interest rates. Some techniques benefit from lower rates, while others benefit from a higher interest rate environment.
Planning with Low Interest Rates
When interest rates are lower, intra-family loans become more common. The low rates can enable family members to access funding from parents or grandparents, for such things as purchasing a home or starting a business, at rates likely much lower than what third-party banks charge. Intra-family loans allow the money to stay in the family. When family members invest the borrowed funds, there’s a greater chance their investments will outperform because of the low interest rates.
Intentionally defective grantor trust (IDGT)
An installment sale to an IDGT is also a popular technique in an a low-interest rate environment. The grantor sells assets (such as closely held business interests) to a trust in exchange for an installment note. A grantor does not pay income tax on a sale to an IDGT.
The installment note that will be held by the grantor typically has an interest rate equal to the AFR. Thus, to the extent that the assets in the trust produce income or increase in value in an amount greater than the interest payments due to the grantor under the note, such increase will accrue to the benefit of the beneficiaries of the trust. The lower the AFR, the greater the likelihood that the trust investments will outperform the interest due under the note.
Grantor retained annuity trust (GRAT)
A GRAT allows the grantor of the trust to retain a stream of annuity payments for a fixed period. At the end of the term, the remaining assets in the trust, or the “remainder,” passes to the beneficiaries of the trust gift-tax free. The value of the remainder, or the gift, is reduced by the value of the annuity retained, as calculated for tax purposes. Depending on the structure of the GRAT, it is possible for the remainder to have little to no value for gift-tax purposes.
IRC Section 7520 determines the value of the retained annuity. The IRS publishes the 7520 rate each month. It is 120% of the mid-term AFR, rounded to the nearest two-tenths of 1%. With a GRAT, the higher the 7520 rate, the higher the annuity payment.
To be successful, the income or appreciation within the trust must exceed the annuity payments, so that a remainder passes to the beneficiaries. If the growth is less than annuity payments, the annuity payments to the grantor can exhaust the GRAT assets.
High-Interest Rate Planning Opportunities
Planning options that have previously gone out of fashion in a low-interest rate environment are likely to see a resurgence. Here’s a look at a few of these tools.
Qualified personal residence trust (QPRT)
A QPRT allows a grantor to transfer their personal residence to a trust for a term while continuing to live there during that time. At the end of the term (which could be many years), the home passes to the remainder beneficiaries. If the grantor wishes to continue to use the residence, he or she will typically lease the residence for fair-market rent.
The remainder interest is a gift to the trust. The higher the 7520 rate, the higher the value of the grantor’s retained right to use this residence. In turn, this reduces the value of the remainder when the trust is created, and therefore, reduces the gift to the trust. Consequently, the QPRT strategy benefits from a higher 7520 rate.
Charitable remainder annuity trust (CRAT)
With a CRAT, the grantor transfers assets to a trust and retains an annuity payment for a term of years or for life. Following the term, the remainder passes to a charity.
A CRAT must meet certain requirements when it’s created. For example, after the annuity payment, the value of the charitable remainder must meet a minimum threshold (generally 10% of the value of the assets placed in the trust). The value of the charitable remainder is determined using the 7520 rate, which is deemed to be the CRAT’s earnings rate. A higher 7520 rate will result in a higher-value charitable remainder and therefore a greater likelihood of meeting the minimum threshold. Also, the higher the charitable remainder, the higher the possible charitable income-tax deduction.
As we move away from historically low interest rates, estate and wealth planning strategies will continue to evolve and shift to those that work better in a higher interest-rate environment.
Keith Grissom, an officer at Greensfelder, counsels businesses and individuals on matters including estate planning and closely held business succession planning. Keith’s experience includes addressing income, estate, generation-skipping transfer and gift tax issues related to estate planning and trust administration.