The IRS has announced the new §7520 rates for certain gifts. The §7520 rate, named for the appropriate Internal Revenue Code Section, is 0.80% for May of 2020, fully 73% lower than the rate in February of 2020. The rate has a huge effect on the value of certain gifts, notably, gifts to charity and certain trusts used to transfer assets. The rate is also used in loans between family members. The current rate is at an all-time low. By reference, the rate was 3.4% in January of 2019, and was 8.2% in March of 2000. The rates are used to compute the present values that are used in certain charitable gifts, as well as a transfer mechanism (like the one used by the Walton Family and Trump family) called a Grantor Retained Annuity Trust (GRAT).
Why is this important? First, it gives a prime opportunity for wealthy (or even not-so-wealthy) families to transfer assets while asset values are down, locking in the low values. Second, the estate tax exclusion reverts to its old level at the end of 2025, if not sooner. With the monstrous COVID-19 stimulus, the Federal government is moving into a remarkable deficit. It is entirely possible that taxes will go up sooner, and the estate tax is low-hanging fruit, since it is primarily imposed on wealthier taxpayers (and dead ones, at that).
Promissory Notes. Here’s an easy example with an intra-family loan. Let’s suppose Grandma has money and wants to help her grandchildren financially. Grandma can gift a grandchild (or anyone) $15,000 a year, and $15,000 each to a grandchild and their spouse, if they are married. However, Grandma could also loan the grandchild funds at the current very low rates. The IRS is required to provide a set of floating interest rates on a monthly basis called Applicable Federal Rates (AFRs). These rates provide the minimum rate of interest to be charged for both demand and term loans. The rate is based on the term of the loan as follows:
•Short-term — Three years or less. May 2020 rate is 0.25%
•Mid-term — More than three years and less than nine years. May 2020 rate is 0.58%
•Long-term — More than nine years. May 2020 rate is 1.15%
If our granddaughter wanted to buy a house and was considering a 15-year mortgage, she might pay a current rate of 2.875%. On a $140,000 15-year mortgage, what would be a payment of principal and interest of $958.42. Grandma could write her granddaughter a mortgage at 1.15%. The payment on that note would be $847.16. This saves the granddaughter a little over $20,000 over the life of the loan.
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GRATs. On the bigger money front is the Grantor Retained Annuity Trust or GRAT, a significant planning tool for larger estates. In a GRAT, the donor transfers assets to an irrevocable trust and receives an annuity payment back from the trust each year. The rate used by the trust to calculate the value that must be returned to the donor is the current IRS rate from Table 5 of the Revenue Ruling, which for May of 2020 is 0.8%. If the assets make at least that rate of return (0.8% for May 2020), any additional appreciation in the assets that have accumulated at the end of the trust term goes to the beneficiaries. If the trust fails to make the required rate of return, principal is invaded to make the payments and the donor may receive back most of their assets without penalty.
As an example, let’s suppose there is a family with assets worth $25 million; the value is down from $30 million before the crisis. They have real estate, investment assets, and a family business. The family wants to keep the business in the family. The older generation transfers $10 million worth of the business into a GRAT when the §7520 rate is 0.8% (May 2020), with the right to receive an annuity of $1 million a year for 10 years. At the end of 10 years, the remainder will be distributed to the grantor's children. Using the IRS Table B factor of 9.5737, the annuity stream is valued at $9,573,700, and the remainder interest is valued at its present value of $426,300. If the assets grow by 5% and have distributed income of 5%, the grantor will receive a stream of 10 payments of $1,000,000, and the beneficiaries will receive $10,200,416 at the end of the10-yearterm (the future value of $10 million, minus 10 annual payments of $1,000,000, and growing at 5% per year after income distributions of 5%). If the assets in the GRAT did not appreciate, the GRAT would invade principal, but would be paying the assets to the grantor.
If the parents make a gift of $426,300 (the value of the remainder interest at this low rate), this would use up some of their estate exemptions, but the kids get more than $10.2 million. That is amazing leverage on the use of the estate exemption that might be expiring at the end of 2025. As always, there is a bunch of caveats and observations (this is high level estate planning, after all):
•In a GRAT, the grantors make an incomplete gift of a future interest. This is not subject to the annual exclusion of $15,000. Also, as an incomplete gift, a GRAT is not optimal for a ‘Generation Skipping’ transfer.
•In our example, the grantors (parents) made a gift of $426,300. They would use part of their unified federal estate and gift exclusion of $130,742. The estate and gift exclusion is $11.58 million per person for 2020, or $23.16 million for a couple.
•The exclusion reverts to half that level on 12/31/2025. By funding the GRAT, the parents saved potentially about $3.8 million or more of estate and gift taxes.
•The basis of assets in a GRAT is the same as the basis of the grantor, or a ‘carryover basis.’ The parents would ideally want to use assets that do not have substantial appreciation. If assets have declined in value (like business assets or real estate), they are ideal candidates for a GRAT.
•This is VERY complex, and there are a wide variety of GRAT strategies in use like the ‘rolling GRAT’ and the ‘zeroed-out GRAT.’
•In the past, GRATs were targeted as a tax loophole to close. With the massive budget deficits, soon DC will be looking for revenue. Taxing the children of wealthy people is a likely place to start.
The lower rates provide other opportunities, particularly in charitable trusts. Estate planners are ramping up their calculations in the face of reduced value, record low valuation opportunities, and the prospect of tax law changes coming sooner rather than later. Jennifer Savage, estate planning partner at Schneider, Smeltz, Spieth, Bell, LLP in Cleveland summed it up this way, “Market downturns and volatility brought by this crisis, coupled with incredibly low rates used for calculating the gift tax value for GRATs, charitable lead trusts, and family loans create opportunities for wealth transfer at extremely low tax cost.While we can’t know for sure what future tax law will look like, we are definitely reviewing the estates of our clients.”
Before you dive into the rabbit hole of the internet, I’ll suggest a good article on GRATs by professor Megan Burke, CPA, PhD. The historically low rates mean a lot to families, big and small. I’m open for dialogue or questions: llabrecque@sequoia-financial.com. Stay safe, we’re all in this together.
