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Tax planning during historically low interest rates

  • September 14, 2020 by hamiltontharp
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The unprecedented global pandemic and record unemployment has resulted in a dramatic drop in interest rates. Many people focus on the Fed rate and mortgage rates, and rightfully so, but for some, the focal point should be on the historically low IRS interest rates.

The IRS posts various interest rates, generally on a monthly basis. The Applicable Federal Rate (“AFR”) and the Internal Revenue Code Section 7520 Rate (“7520 Rate”) are among the most important. Many tax strategies are a function of calculations driven by the AFR and 7520 rates. Some strategies work best in high rate environments while other work best in low rate environments. Accordingly, any time the IRS rates dramatically rise or fall, we should take notice and consider tax planning.

The May 2020 IRS Rates include:

Short-Term AFR: 0.25%

Mid-Term AFR: 0.58%

Long-Term AFR: 1.15%

7520 Rate: 0.80%

These rates are exceptionally low. To provide some context for comparison, the May 2019 Rates were: Short-Term AFR 2.39%, Mid-Term AFR 2.37%, and Long Term AFR 2.74%. Viewing this from a historical perspective, the May 2019 rates were low in their own right, but clearly the rates today, just one year later, are materially lower.

The remainder of this paper outlines three strategies that work particularly well in low interest rate environments. Although we have elected to highlight three strategies specifically, low interest rate tax strategies are not limited to just these three. Accordingly, we encourage you to contact our office to discuss your specific set of circumstances.

Charitable Lead Trusts

A Charitable Lead Trust (“CLT”) is a split interest trust, meaning there are two categories of beneficiaries: (1) a current beneficiary and (2) a remainder beneficiary. The current beneficiary receives distributions from the CLT for a period of time (the “Term”) and must be a charitable organization, such as a public charity, a church, most schools and universities, and even a private foundation operated by the donor. The remainder beneficiary receives all the assets remaining in the CLT after the Term expires and is generally the donor or the donor’s children. Depending on the design of the CLT, the donor may receive an income tax deduction in the tax year the CLT is established in an amount equal to the present value of all payments that will go to charity during the CLT’s term. Accordingly, it can generate a substantial income tax deduction for gifts that have not yet gone to the charity. This gives the donor the ability to continue investing and growing the CLT assets, thereby ultimately benefiting the donor who will receive the assets back upon expiration of the CLT term.

Why CLTs during low interest rates?

The donor’s income tax deduction is a present-value calculation. We take the sum of all scheduled future charitable distributions and discount that number to present value using a calculation based on the 7520 Rate. The lower the 7520 Rate, the lower the discount. The lower the discount, the greater the deduction. Accordingly, in today’s environment, all other factors being exactly the same (i.e. same growth rate, same amount to charity, etc.), a CLT today will generate a significantly higher income tax deduction, than the same CLT when interest rates are higher.

Grantor Retained Annuity Trusts

Grantor Retained Annuity Trusts (“GRATs”) are estate planning trusts that provide a tremendous opportunity to transfer wealth from one generation (“Generation 1”) to the next (“Generation 2”), often without incurring gift or estate taxes. GRATs are established with Generation 1 assets for a period of time (the “Term”). During the Term, the GRAT makes distributions to Generation 1. At the end of the Term, if designed properly, the assets remaining in the GRAT transfer to Generation 2 free of gift, estate, or transfer taxes. Many individuals will establish a series of GRATs in order to provide necessary lifetime cash flow to Generation 1.

Why GRATs during low interest rates?

Payments made from the GRAT to Generation 1 are based on the IRS rates. The donor makes the “bet” that the assets inside the GRAT will grow at a rate higher than the IRS rates. Lower rates mean a lower hurdle, a lower hurdle means more wealth can transfer to Generation 2 tax-free.

Sales to Intentionally Defective Grantor Trusts

Intentionally Defective Grantor Trusts (“IDGTs”), are irrevocable estate planning trusts that are generally utilized by high net worth business owners and those with assets likely to significantly increase in value (such as stock and real estate). The IDGT will purchase the asset from the individual primarily in exchange for a promissory note (there are no income taxes due on the sale because the IDGT is disregarded for income tax purposes). The IDGT will make installment payments to the individual for the term of the promissory note. The assets in the IDGT are outside of the individual’s estate, therefore any growth in the asset from the time it is sold remains outside of the individual’s estate for estate tax purposes.

Why IDGTs during low interest rates?

Similar to any traditional lending arrangement, the IDGT promissory note must yield interest. Because this is a related-party transaction, the IRS mandates a certain minimum interest rate, which is based on the AFR. The lower the AFR, the lower the required monthly payments, and thus more taxable wealth remains outside of the Grantor’s estate.

Next Steps?

Don’t let this exceptionally low interest rate environment get away. Please contact your Heritage financial advisor, CPA, or attorney to schedule a planning session.

This article has been edited by Hamilton Tharp LLP. This article originally appeared on the HWM newsletter.

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