Morrison & Foerster LLP: Doing the Math: Interest Rate Trends and Common Estate Planning Techniques

Morrison & Foerster LLP: Doing the Math: Interest Rate Trends and Common Estate Planning Techniques

By Wendy M. Greenberg, Esq.Morrison & Foerster LLP

The interest rate used to determine actuarial valuations of certain retained or remainder interests for purposes of federal gift and estate tax, commonly referred to as the "7520 rate" and defined as 120% of the applicable federal midterm rate (compounded annually) for the relevant month, has fallen to a record low of 1.2% for transfers completed in June, 2012.   To put this in some perspective, Section 7520 rates reached as high as 6.2% only five years ago, and hovered around 10% in the early 1990s.

Exceptionally low interest rates clearly present some estate planning opportunities, but certain techniques actually benefit from higher interest rates.  This article provides a quick reference resource to determine whether the current interest rate climate is advantageous for the use of various common estate planning techniques.  Interestingly, it appears that certain estate planning techniques (grantor retained annuity trusts and charitable remainder trusts, specifically) are minimally affected by interest rates, where others (qualified personal residence trusts and charitable lead annuity trusts) are more dramatically affected.

1.         Grantor Retained Annuity Trust (GRAT)

Summary: Lower 7520 rates are better.

Reason:  Where a GRAT is "zeroed-out" for gift tax purposes, the grantor's retained annuity is purposefully exactly equal to the total actuarial value of the GRAT assets, assuming growth at the 7520 rate over the course of the annuity term.  If the assets of the GRAT outperform the 7520 rate, the excess assets over those required to pay the annuity amount pass to the remainder beneficiaries free of transfer tax.  The lower the 7520 rate, the easier it is outperformed, and the higher the potential for excess assets to remain after payment of the annuity amount.

Example:  Assume Donor transfers assets with an initial value of $3 million to a five-year GRAT:

7520 Rate

Retained annuity required to "zero out" the gift and the gift tax

1.2%

$621,775/year

3%

$655,065/year

5%

$692,921/year

2.         Qualified Personal Residence Trust (QPRT)

Summary: Higher 7520 rates are better.

Reason: The use (essentially, the entire income) of the property is retained by the transferor during the QPRT term.  The more the retained use is worth, taking into account growth over the course of the QPRT term, the less (actuarially) remains to be transferred to remainder beneficiaries.  The higher the 7520 rate, the more the retained use is worth, and the lower the value of the taxable gift to the remainder beneficiaries.

Example:  Assume 60-year-old Donor transfers a personal residence with a value of $3 million to a 10-year QPRT:

7520 Rate

Value of retained interest

Gift taxable value of remainder interest

1.2%

$726,450

$2,273,550

3%

$1,093,950

$1,906,050

5%

$1,427,400

$1,572,600

 

3.         Charitable Remainder Unitrust (CRUT)

Summary: Higher 7520 rates are better.

Reason: The higher the assumed growth rate, the less the unitrust payments to an individual are presumed to cut into the income (and principal) of the trust, leaving more for the charitable beneficiary in the end.  Keep in mind that the minimum unitrust payout allowable is 5% annually.

Example:  Assume 60-year-old Donor transfers $3 million to a CRUT with a retained 5% unitrust interest:

7520 Rate

Gift tax value of deductible charitable remainder

1.2%

$1,141,560

3%

$1,159,080

5%

$1,177,980

 

4.         Charitable Lead Annuity Trust (CLAT)

Summary: Lower 7520 rates are better.

Reason:  Here, the charity receives the lead rather than the remainder interest, so the CRUT reasoning, above, is expressed inversely: the lower the presumed growth rate, the more the annuity payments are presumed to cut into the income (and principal) of the trust, leaving less of an eventual taxable gift to remainder individual beneficiaries.  Thus, like the GRAT, a CLAT need only outperform the Section 7520 rate to result in a tax-advantaged transfer.

Example:  Assume 60-year-old Donor transfers $3 million to a CLAT paying charity $150,000 annually for Donor's life, residue to Donor's children:

7520 Rate

Gift tax value of deductible charitable interest

Estate taxable value of remainder interest

1.2%

$2,765,115

$587,437

3%

$2,239,755

$800,547

5%

$1,822,155

$1,177,845

The results described above are not necessarily intuitive, and of course it makes sense to run the numbers before recommending any specific trust strategy. 

Additionally, in this interest rate climate, the simpler estate planning techniques of sales and loans to family members of lower generations are hard to beat.  Any promissory notes remaining in the seller or lender's estate will bear interest at astoundingly low rates: the mid-term applicable federal rate for June (for notes with terms between three and nine years) is 1.07% (compare to 2.27% one year ago, and 4.64% five years ago), and the short term applicable federal rate (for notes with terms of less than three years) is just 0.23% (compare to 0.46% one year ago, and 4.84% five years ago).  Interest paid on the notes will likely make little impact on the holder's estate, or may even be forgiven with no or very little gift tax consequence (depending on the size of the note).

Morrison & Foerster's Trusts and Estates group provides sophisticated planning and administration services to a broad variety of clients.  If you would like additional information or assistance, please contact Patrick McCabe at (415) 268-6926 or PMcCabe@mofo.com.

© Copyright 2012 Morrison & Foerster LLP.  This article is published with permission of Morrison & Foerster LLP.  Further duplication without the permission of Morrison & Foerster LLP is prohibited.  All rights reserved.  The views expressed in this article are those of the authors only, are intended to be general in nature, and are not attributable to Morrison & Foerster LLP or any of its clients.  The information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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