Insights Into Financial Management: Moving Wealth Downstream

Jeff Call

October 31, 2008

T he IRS published applicable federal rates (AFR) are near record lows, and these low rates present a number of planning opportunities for moving wealth downstream to younger generations with little or no gift tax implications.

The short-term AFR, which is the rate utilized to measure the tax implications of loans with a term not exceeding three years, was at 2.54 percent for August 2008. A year earlier, the rate was 5.00 percent.

For example, lending money to a child or grandchild to assist with the purchase of a home, starting a business or providing cash flow for any number of other purposes, is very attractive now. Intra-family loans may be made without gift tax implications as long as the lender charges interest at a rate no less than the AFR.

Example: Mr. Smith is in the 35 percent federal income tax bracket and lends $250,000 through a 30-year promissory note to his son and daughter-in-law for a new home purchase. The note is secured by a mortgage on the home so that the son can deduct the interest payments. The interest rate is at the 4.58 percent August 2008 long-term AFR and is payable on Dec. 31 annually, interest only, with the principal due at the end of the 30-year term. Mr. Smith decides on a year-by-year basis whether to forgive or collect the interest, depending on his own cash needs.

If Mr. Smith forgives the interest at the end of the first year, he will be forgiving a total of $11,450 in interest, which is less than the $24,000 combined total in annual exclusion gifts he can make to his son and daughter-in-law. The tax rules still require him to report the forgiven interest for income tax purposes, but the forgiveness results in a federal tax cost to Mr. Smith of $4,008 ($11,450 x 35 percent tax rate).

Because the tax rules treat the loan recipients as actually having paid the interest to Mr. Smith, they are entitled to a tax deduction in the amount of $11,450, which saves them $4,008 in federal income taxes, assuming they also are in the 35-percent tax bracket. If you view the family as a single economic unit, the transfer is a wash in that Mr. Smith has shifted the tax benefit to his son.

Other sophisticated planning ideas that work well during low interest rates are an installment sale to an intentionally defective irrevocable grantor trust (IDGT), a Grantor Retained Annuity Trust (GRAT) and a Charitable Lead Annuity Trust (CLAT). These techniques work well when the donor has an asset he or she thinks will appreciate dramatically over years. The IRS assumes the assets in a GRAT or CLAT will grow at the Section 7520 rate.

Therefore, if the investment performance of the assets in the trust exceeds the AFR rate used to measure the transfer tax costs, the beneficiaries of the trust will benefit from the economic spread. Additionally, the remainder benefit from these strategies, which is left in trust to the heirs, can be enhanced by using closely held stock or other assets (such as an FLP interest) to which valuation discounts apply.

Example: Mrs. Jones establishes a GRAT benefiting her daughter. She gifts $1 million of XYZ stock to the trust with a 20-year term. Assuming a 9 percent growth rate on the asset and creating a minimal remainder interest gift of approximately $1,000 upon formation would require annual payments of $74,816 back to the donor as her retained annuity. At the end of the term, the remainder interest left in trust for the daughter would be $1,776,820.

A CLAT would end up with the same $1,776,820 for the daughter but would substitute a charitable recipient of the 20-year annuity instead of the donor retaining the annuity.

Many people are predicting that interest rates will start to rise if the economic recovery gets underway quickly. Therefore, it is imperative to consider these planning techniques now so that you can maximize the estate/gift tax benefits of the current low interest rate environment.

Jeff Call is shareholder/managing director of personal financial services for Bennett Thrasher PC. Listen to Bennett Thrasher's bimonthly podcasts at www.btobmagazine.com.