Interest rates are at historic lows. This is good news for certain planning techniques and bad news for others.   

Specifically, low interest rates work extremely well if an estate “freeze” technique involves an annuity or a loan and work poorly if a freeze technique involves income and reversionary interests. In other words, low interest rates make this a good time for grantor retained annuity trusts (GRATs), sales to “defective” grantor trusts (Sales) and charitable lead annuity trusts (CLATs), but a bad time for qualified personal residence trusts (QPRTs) and charitable remainder annuity trusts (CRATs). 

Note that a CRAT is typically created for income tax reasons—for example, to diversify low-basis securities and defer capital gains—and is not considered a freeze. Unless the grantor is well into her 70s, the current low rates make it likely that the CRAT will flunk the requirement for no greater than a 5% probability that the trust will be exhausted prior to the termination of the grantor’s annuity. Thus, the CRAT will not be further discussed in this article.

Terms, Techniques, and Interest Rates

Here’s a brief explanation of the terms, techniques and interest rates mentioned above:

Estate freeze

An estate freeze doesn’t reduce an individual’s existing wealth but is designed to pass potential appreciation to heirs gift tax efficiently. The GRAT, Sale, and QPRT are all gift tax strategies, while the CLAT can be a gift or an estate tax strategy.

The gift tax calculation for GRATs, CLATs and QPRTs use the so-called 7520 rate, while the interest rate used for the note in the Sale transaction is the relevant applicable federal rate (AFR) that relates to the note’s term and payment frequency.

7520 rate

The 7520 rate is named after its own section of the IRC. It’s published in a monthly IRS revenue ruling and is used to determine the present value of annuities, income interests and life estates, and reversionary and remainder interests. (It scarcely affects a unitrust interest, which is not “frozen” and varies depending on the trust’s annual value.)

The 7520 rate equals 120% of the applicable federal mid-term rate, rounded to the nearest 2/10 of 1% (0.20% or 20 basis points). The August and September 2020 rates are the lowest they have ever been: 0.40% (40 basis points or 4/10 of 1%).

AFRs

These are in the same monthly revenue ruling as the 7520 rate and are based on the average market yield of outstanding marketable Treasury obligations with the following maturities:

• Short-term (zero to three years).
• Mid-term (more than three years and up to nine years).
• Long-term (more than nine years).

 The AFRs provide a “safe harbor” for the minimum interest rate a loan can carry and not be considered below market (such a loan can trigger gift and income tax consequences for the lender). The AFRs are also broken out for annual, semi-annual, quarterly, and monthly payments. The AFRs and 7520 rate represent a reasonable rate of return.

Annuity

An annuity is a fixed payment that never varies; in the context of the GRAT and CLAT, this frozen “upfront” interest means that appreciation only benefits the “remainder” interest. 

Income and reversionary interests

An income interest is the right to use property and is a key component of the QPRT, along with a reversionary interest (the trust grantor’s right to get the trust property back if the grantor dies during the trust’s term). Although this upfront income interest is also frozen, the lower the 7520 rate, the lower the interest’s present value (note that a reversionary interest is worth more than an income interest when rates are low).  

Remainder interest

A remainder interest is the “backend” interest in a trust (e.g., what passes to the next takers after the termination of the upfront annuity or income interest). The higher the present value of that upfront interest, the lower the present value of the remainder interest, or gift.

The Freeze Techniques

It’s helpful to understand the various freeze techniques discussed below.

GRAT

The grantor transfers property to the trust and takes back an annuity from the trust for say, two to three years. The present value of the annuity can equal virtually 100% of the transferred property, meaning that the remainder interest—or gift—is de minimis (a “zeroed-out” GRAT). 

As long as the property involved in the transfer to the trust outperforms the 7520 rate used to value the annuity, some of that property will be left for the remaindermen (typically, the grantor’s children). And the lower the 7520 rate, the smaller the annuity needed to zero out the remainder interest—meaning that more property may be left in the trust for the grantor’s children.

Consider this example: Grantor creates a two-year GRAT in September 2020 when the 7520 rate is 0.40%. Grantor funds the trust with $5 million worth of stock from his privately held company that he intends to sell in about six months. The grantor’s two zeroed-out annuity payments—a little over $2.5 million each—total just over $5 million. If the stock goes up 50% in value each year, nearly $5 million worth of property will pass to Grantor’s children at the end of two years. The taxable gift of the remainder interest at the trust’s creation is $0.01.

Sale to a defective grantor trust

The grantor creates a multigenerational trust and seeds it with 10% of the value of the asset to be sold to the trust. Some time later, the grantor sells the asset to the trust and takes back a balloon note. If the note is for nine years or less, the note’s interest rate will be at least 0.20% (20 basis points) lower than the 7520 rate used to value the annuity in the GRAT and is therefore a lower “performance hurdle.” 

Because the grantor “owns” the trust for income tax, but not estate tax, purposes (that’s what makes this trust “defective”), the grantor doesn’t recognize gain on the sale nor income on the trust’s interest payments to the grantor.

Consider this example: Grantor creates a defective grantor trust for children and grandchildren and funds it with $500,000 (this gift requires use of Grantor’s current exclusion amount of $11.58 million). Grantor intends to take Grantor’s company public next year, and in September 2020, sells $5 million worth of his company’s stock to the trust.

Grantor takes back a nine-year balloon note that carries interest of 0.35% (the mid-term AFR) and makes interest payments of $17,500 per year. At the end of nine years, Grantor has received total payments $157,500; the trust pays off the note. Assuming the trust property has doubled in value over this period (and that the interest payments were made with trust earnings), the trust still has $5 million worth of property— for an original gift of the $500,000 used to fund the trust.

CLAT

Charity gets the upfront annuity interest for, say, 20 years, and the grantor’s heirs get the balance after this period is over. As with the GRAT, it is possible to zero out the present value of the remainder interest and effectively eliminate the gift.

Consider this example: Mother funds a CLAT with $5 million worth of securities in September 2020, when the 7520 rate is 0.40%. For 20 years, the trust will pay charity an annual annuity of $260,632 (about 5.2% of the trust’s initial value); the gift of the remainder interest is zero. Assuming the trust grows at 6% per year, at the end of 20 years, it will have almost $6.45 million worth of property that will pass to Grantor’s heirs.

QPRT

The grantor transfers a personal residence to the trust and uses it for a period of years. If the grantor survives the term (that’s the goal), the residence passes to the remaindermen; if the grantor doesn’t survive the term, the property reverts to the grantor’s estate.

Consider this example: Widowed Father, age 60, wants Daughter to have his $2.5 million vacation home. In September, when the 7520 rate is 0.40%, Father transfers the home into a QPRT that will last for 15 years. Father’s retained income and reversionary interests are collectively worth about 30% (the income interest is about 5% and the reversionary interest about 25%); the remainder gift to Daughter is therefore about 70% or $1.75 million and requires use of Father’s $11.58 million exclusion. 

Note that with the exclusion amount currently so high, there is little reason to create a QPRT, particularly with interest rates so low. Assuming the QPRT is “successful,” as in Father survives the 15-year term, he will have passed along the built-in capital gains to Daughter. If she wishes to later sell the property, these income tax consequences could outweigh any of Father’s potential gift or estate tax benefit.

Implications

With interest rates at historic lows, now is an exceptionally good time to consider GRATs, sales to defective grantor trusts, and CLATs for your clients, assuming they have what could be highly appreciating assets.

Also keep in mind that the November elections could bring substantial changes to the tax laws if there is a Democratic “sweep”—as in Democratic control of the White House, House, and Senate. Those changes could drastically reduce the exclusion amount, raise gift and estate tax rates, and eliminate various planning techniques, including the zeroed-out GRAT and sale to the defective grantor trust. If that scenario occurs, clients might regret not having acted sooner.

Blanche Lark Christerson, JD and LLM (taxation), is a wealth planning consultant in New York City and was previously with Deutsche Bank Wealth Management, where she wrote “Tax Topics.”

The opinions and analyses expressed herein are those of the author, and any suggestions contained herein are general, and do not take into account an individual’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change.  The information contained herein is not intended to be, and does not constitute, legal, tax, accounting or other professional advice, and is not intended to offer penalty protection. Readers should consult their applicable professional advisors prior to acting on the information set forth herein.