Sean Kelly, CPA
Senior Tax Manager
June 8, 2020
Good news remains elusive these days, but low interest rates may be the good news we need right now. The low rate environment offers several opportunities to pass significant wealth down to multiple generations without eating into the annual gift exclusion or your lifetime gift or GST exemption, while also lowering your taxable estate. Here’s how to get it done.
First you need to create an Intentionally Defective Grantor Trust (IDGT). This is easily accomplished by inserting language in the Trust document giving certain rights to the grantor, such as the right to substitute assets, which cause the trust to be treated as a grantor Trust for income tax purposes, but preserves the irrevocable treatment for estate purposes. Put more simply, the IDGT allows assets to grow exponentially inside the Trust because the taxes are paid by the Grantor, leaving the Trust assets intact. Despite the right to substitute, gifts to the Trust avoid estate taxes for at least one generation.
While gifting to an IDGT is a common planning strategy, here’s a more interesting one. The Federal Reserve recently lowered interest rates to zero, resulting in a lower applicable federal rate (AFR) for related party loans. This provides a unique opportunity to make a low-cost loan to an IDGT. The low rate allows the Trust assets to grow more quickly.
The loan-term is important. You need to keep the term at nine years or less to qualify for the AFR mid-term rate – 0.58% for May 2020. Although interest is required to be paid by the Trust to the grantor, there is no tax deduction for the payment by the Trust and no income pickup for receipt by the grantor due to the defective structure of the Trust. It’s basically a loan to yourself.
You make an interest only $500,000 loan at 0.58% interest over a nine-year term to an IDGT (yourself). The Trust invests the proceeds and generates a return of 4% annually. Since all income taxes are paid by the Grantor (reducing his taxable estate), the Trust nets $206,000 of net appreciation (after annual interest payments) over the term of the loan, resulting in a 41% return on investment. The Trust repays the principal after nine years and keeps $206,000, which continues to grow tax-free to the Trust until the grantor dies. What you’ve done is made a $206,000 gift down to multiple generations without having to file a gift tax return or eating into your annual exclusion or lifetime gift/GST exemptions. Sweet, right? Let’s make it even sweeter.
If you haven’t used up your entire lifetime exemption, consider using your right to substitute assets of the same value, especially if the Trust is sitting on substantial unrealized gains. You can send high basis assets into the Trust, reducing future income taxes, and pull low basis assets back into your estate, where they will receive a favorable step-up to fair market value upon your death.
The low rate environment provides many estate planning opportunities. As always, you should work with your wealth advisor and estate planning attorney to maximize the results based upon your unique situation.