“Out of adversity comes opportunity.” This quote, attributed to Benjamin Franklin, holds particular relevance today as we navigate an unprecedented economic shock. High estate tax exemptions, low interest rates and a down market have all come together in a perfect storm that enhances the effectiveness of several tried and true wealth transfer strategies. In part three of our wealth planning blog series, we look at what these factors mean for individuals and families hoping to impart wealth to future generations or philanthropic passions.
Factor #1: Lifetime exemptions at an all-time high
The Tax Cuts and Jobs Act of 2017 doubled federal estate tax exemptions from $5.5 million (adjusted for inflation) to $11 million (adjusted for inflation). In 2020, an individual can transfer up to $11.58 million (or $23.16 million for a married couple) free from gift and estate tax. That is more than 17 times the exemption in the year 2000, which was $675,000 for an individual. The exemption level reverts back to $5 million (adjusted for inflation) if Congress fails to act before December 31, 2025. This window may also close sooner based on the outcome of the 2020 presidential election or revenue needs to offset federal stimulus efforts.
Factor #2: Interest rates at all-time lows
Current market conditions have driven interest rates to historic lows. Two key rates published monthly by the IRS are used in a number of wealth transfer strategies: the applicable federal rate (AFR) and the Section 7520 Rate. For June 2020, the AFR is .18 percent for short-term loans, .43 percent for mid-term loans and 1.01 percent for long-term loans. The same rates for June 2000 were 6.53, 6.62 and 6.39 percent, respectively. The Section 7520 rate for the month of June 2020 is .6 percent (60 basis points), compared to the June 2000 monthly Section 7520 rate of 8 percent (800 basis points).
Opportunity: Gift of exemption amount to irrevocable trust
The simplest way to transfer wealth is a straight forward lifetime gift (as close to the full exemption as possible) to an irrevocable multi-generational trust. Here are the main reasons why:
- It takes advantage of the high exemption amount and down economy.
- All future growth in the asset will occur outside of the donor’s estate.
- The trust will be exempt from estate tax for future generations.
- The trust will provide beneficiaries with protection from creditors, divorce, etc.
- If structured as a grantor trust for income tax purposes, the donor will pay the income tax liabilities of the trust (with no gift tax consequences), thereby further reducing the grantor’s gross estate and allowing the trust assets to grow income tax free.
- A donor’s spouse can be a beneficiary, which allows them to receive emergency distributions if needed.
The best assets to gift are generally those with the highest growth potential, since all growth will occur inside the trust and outside of the donor’s estate. Be sure to take into account the cost basis of an asset for income tax purposes, as gifted assets do not receive a step-up in basis upon the donor’s death.
Opportunity: Sale to irrevocable trust
To transfer assets in excess of the estate tax exemption, an effective strategy is to sell additional assets to the same trust described above after making lifetime gifts to the trust. With this transaction, the donor will sell an amount of assets to the trust in return for a promissory note. The interest rate on the promissory note must be equal to or greater than the AFRs for the month of the sale. Current historically low interest rates create a very low hurdle rate for the transaction’s success. Provided the asset sold outperforms the interest rate assigned to the note, the donor will effectively move all of the growth outside his or her estate. This strategy is particularly effective with closely held S Corporations. There are a number of variations of this strategy that may make sense depending on the facts and circumstances, which can be discussed with your RKL Wealth Management advisor.
Opportunity: Intra-family loans
If a gift is not desirable, a loan may be a suitable alternative. Frequently, intra-family loans are used to provide children or grandchildren with funds to purchase a home or invest in a business venture. The repayment terms are fully customizable with the exception of the interest rate, which must be at least the AFR in effect at the loan’s execution. Currently, the AFR for a 15-year loan executed in June 2020 is 1.01 percent, considerably lower than available commercial rates. To the extent the borrowed funds are invested in an appreciating asset that grows greater than 1.01 percent, all of the growth will benefit the borrower without estate or gift tax consequences. The current interest rate environment also presents an opportunity to refinance existing intra-family notes carrying higher interest rates.
Opportunity: GRATs and CLATs
A grantor retained annuity trust (GRAT) is a specific type of trust designed to pass the growth of an asset or assets to the grantor’s children. With a GRAT, the grantor transfers an asset to a trust which in turn is required to pay back the grantor an annuity for a period of years plus interest at the current Section 7520 rate. If the asset transferred to the GRAT outperforms the Section 7520 rate, all of the excess growth will pass to the grantor’s children (or a trust for their benefit) free of estate or gift tax if structured appropriately. GRATs can be funded with any asset that has growth potential including marketable securities.
A charitable lead annuity trust (CLAT) is similar to a GRAT except that the annuity is paid to a charity instead of the grantor. A CLAT functions essentially the same as a GRAT but is used when the grantor is charitably inclined and does not need the annuity payments.
As with any advanced strategy, be sure to discuss with your RKL Wealth Management advisor before implementing these strategies to ensure that they are a good fit in your overall wealth plan. In the next and final installment of our wealth planning series, we will explore how your wealth plan is incorporated into all aspects of your life and ensures that your financial wealth is being utilized to help you lead a more fulfilling life.