THE EFFECT OF RISING INTEREST RATES ON ESTATE PLANNING STRATEGIES

This article’s author is Kenneth Rubinstein

The Federal Reserve Board raised interest rates at the end of 2015 and predicted that it will continue to raise rates several times in 2016.  Affluent taxpayers need to review their estate planning strategies to determine what strategies should be implemented before interest rates rise and what strategies will be most advantageous after interest rates rise.

Before Interest Rates Rise:

The most advantageous estate planning strategy to consider during a low interest rate regime is the use of intra-family loans.  Parents may lend investment funds to children or grandchildren and they may also sell assets (e.g., equity in private businesses, real estate) to children or to trusts for the benefit of children (e.g., Intentionally Defective Grantor Trusts), taking back promissory notes that will be repaid over time.  Future appreciation of the assets will inure to the children/borrowers while the repayment installments will provide a stream of income to the parents/lenders.  These strategies depend upon the assets earning sufficient income to support the repayment installments plus the interest.  Interest must be charged (and paid) to avoid an IRS claim that the loan is nothing more than a disguised gift, subject to gift tax.  The minimum interest rate that will avoid such an IRS claim depends upon the interest rate paid by the government on mid-term federal notes.  Obviously, the lower the interest rate, the easier for this strategy to succeed.  Taxpayers should therefore consider implementing such loan strategies now, before interest rates rise.

After Interest Rates Rise:

Strategies that provide a stream of annuity payments to a grantor will benefit most from a rising interest rate environment.  The two most common strategies are Grantor Retained Annuity Trusts (“GRAT”s) and Charitable Remainder Trusts (“CRT”s).

In a GRAT an asset that is expected to appreciate significantly is contributed to a trust for a term of (at least two) years. The grantor receives a stream of annuity payments for the term.  The annuity payments equal the value of the asset contributed to the GRAT plus a market based interest rate.  At the end of the term the asset (which has presumably appreciated) plus any income retained in the GRAT (i.e., income earned in excess of the annuity payments) go to the beneficiaries/heirs tax free.  Obviously, the higher the interest rate, the higher the annuity payments to the grantor and the lower the initial value of the asset contributed to the GRAT may be.

A CRT is a trust that is exempt from tax on income that it earns because it provides for a final remainder distribution to charity.  The grantor contributes an asset to the CRT (usually a highly appreciated asset) which the CRT may sell free of tax.  During the term of the CRT (which may be up to twenty years or for the lifetime of the grantor and/or his/her family members) the trust must make annual distributions to the term beneficiary (usually the grantor and/or his/her family members).  The idea is to structure the size of those distributions so that over the term of the CRT, 90% of the initial asset contribution plus its assumed appreciation is distributed to the term beneficiary and 10% of the initial contribution (the remainder) is left for charity.  The higher the prevailing interest rate is at the creation of the CRT, the higher the annual distributions will be to the term beneficiary.

Various combinations and permutations of the above strategies (GRATs, GRUTs, CRATs, CRUTs, SCINs, etc.) are available in order to maximize their effectiveness depending upon a particular taxpayer’s situation.  The above descriptions have been significantly simplified to provide general information about the strategies that are available. These strategies should be discussed and implemented with qualified tax counsel.

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