Tax and Estate Planning in Challenging Economic Times

Interest rates have dropped significantly in recent months and should remain low given the state of the economy. Sagging rates can have a significant impact on many tax and estate planning strategies. Lower interest rates affect the income, estate and gift tax value of many types of transfers. In many cases, the drop in rates produces more favorable results for taxpayers engaging in certain types of transactions. In other cases, however, the lower rates result in higher tax costs. Likewise, stock values generally have declined significantly and also have affected various time-tested tax moves.  Here we examine how low interest rates and the depressed stock market affect key tax and estate planning transactions and strategies.

The value of annuities (other than commercial annuities), life estates, term interests, remainders and reversions for estate, gift and income tax purposes is determined using tables issued by IRS under Code Sec. 7520 . The value in a given month under the tables may be higher or lower than the value in an earlier or later month because the interest factor under the tables changes monthly. For charitable transfers, the interest rate for the month of the transfer or for either of the two preceding months may be used. (Code Sec. 7520 (a))

The Code Sec. 7520 interest rate for February 2009 is 2.0%.

The 2.0% interest rate is an all-time low. In fact, it is lower than the lowest interest factor previously contained in IRS Publications, 1457, 1458 and 1459, which provide factors for valuing life estates, term interests, remainders etc. Those Publications utilize interest factors that range from 2.2% to 22%. Because of the lack of a 2.0% interest rate in the IRS publications, at the time this  was written, the examples below illustrate various planning strategies using an assumed interest rate of 2.2%. The IRS issued revised tables on February 11, to provide factors for rates ranging from .2% to 2.0%

The discussion that follows explains various non charitable financial and estate planning strategies and shows how they stack up under current falling rates.

Grantor retained annuity trust (GRAT). An individual can save transfer tax by setting up a GRAT. The individual retains an annuity interest for a specified term at the expiration of which the trust property goes to a child or other individual named at the outset. Gift tax is payable but only on the present value of the remainder interest, which is the value of the property transferred to the trust less the value of the retained annuity interest. The present value of an annuity that pays say $10,000 annually for 10 years would be $88,893 in today’s interest rate environment, compared with a value of $72,908 using the rates from August 29, 2007. The higher annuity value thus reduces the value of the gift of the remainder in a GRAT.

The post-transfer appreciation in the value of the trust assets will escape transfer tax. However, this is so only if the grantor survives the trust term. If the grantor dies during the trust term, the trust property will be included in his gross estate under Code Sec. 2036(a) , which provides that property transferred by an individual during his lifetime is includible in his estate if he retains an interest for any period that does not in fact end before his death. But an individual who sets up a GRAT and dies before the end of the term would be no worse off than if he had not entered into the transaction except that he will have incurred the costs of setting up and administering the trust.

Example: When the Code Sec. 7520 interest factor is 2.2%, Smith transfers $1 million to a trust, which is to pay him an annual annuity of $80,000 for 10 years. At the end of the 10 years, the trust property is to go to Smith's daughter. The value of Smith's retained annuity is $711,144. This figure is determined by multiplying $80,000 by 8.8893, which is the annuity factor from Table B of IRS Publication 1457 for a 10-year term and an interest rate of 2.2%. The value of the gift of the remainder to Smith's daughter is $288,856. By way of comparison, had Smith made the transfer when the interest factor was 6.2%, the value of the gift would have been $416,736.

Grantor retained income trust (GRIT). A  GRIT is like a GRAT except that the grantor retains an income interest instead of an annuity interest. Code Sec. 2702 generally treats the grantor as making a gift of the full value of the property. However, the value of the gift is determined as the present value of the donee’s future interest utilizing the valuation tables where the trust is funded with a personal residence of the grantor or the remainder goes to someone falling outside of the definition of family member, such as a nephew or niece. A lower interest rate results in a higher present value for the gift of the remainder interest in a residence GRIT or other GRIT, excepted from the Code Sec. 2702 rules.

Example: When the Code Sec. 7520 interest factor is 2.2%, Bailey establishes a personal residence GRIT, retaining a ten-year term interest. At the end of the 10-year period, the residence is to go to his son. The value of the residence at the time of the initial transfer to the trust is $400,000. The remainder factor from Table B of IRS Publication 1457 is .804435, making the value of the gift $321,774. Had Bailey engaged in the same transaction when the interest factor was 6.2%, the value of the gift would have been $219,187.  Thus, higher rates actually produce a better result for this strategy than when interest rates are lower. As a result, a person may want to wait until interest rates rise before engaging in this type of transaction.

Grantor retained unitrust (GRUT). The interest factor does not affect the value of a gift of a remainder interest in a GRUT because the retained unitrust interest is the right to receive a fixed percentage of the trust's assets and changes in rates inure uniformly to the benefit of the unitrust holder and the remainder person.

How declining rates affect various charitable planning strategies. The discussion that follows explains various charitable planning strategies and shows how they stack up under current declining rates.

Charitable remainder annuity trust (CRAT). With a charitable remainder annuity trust, the donor retains an annuity interest for himself or someone else such as a family member and names a charity to receive the remainder at the end of the annuity term. The donor gets a current income tax deduction for the present value of the charity's remainder interest. Now may not be a good time to establish a CRAT. That's because a lower interest rate produces smaller income, gift and estate tax charitable deductions and a higher gift tax value for a gifted annuity interest.

Charitable remainder unitrust (CRUT). A change in the rate does not affect income tax deductions for charitable remainder unitrusts or gift tax costs in connection with them.

Charitable lead unitrust. Estate and gift tax factors are essentially unaffected by changes in the rates.

Charitable lead annuity trust.  A lower interest rate results in a larger gift or estate tax deduction for the annuity interest going to the charity and a smaller value for any gift of the remainder interest going to a private beneficiary. Thus, it may be a good time to establish a charitable gift annuity if the grantor is going to give the remainder interest to a family member.

Now may be a good time to transfer stock to a junior family member. With prices as depressed as they are, in many cases blocks of stock can be transferred completely free of gift tax under the umbrella of the $13,000 annual exclusion for 2009. For example, 1,000 shares of stock that was previously worth, for example, $50 per share and that is now trading for $13 per share can be transferred to a single individual at no gift tax cost by virtue of the $13,000 annual exclusion. Here, too, if the stock bounces back to its earlier highs or beyond, the post-transfer appreciation will escape transfer tax costs.

The current economic environment, with significantly lower interest rates and depressed asset values, presents a number of unique planning opportunities and just as importantly, makes a number of traditional planning techniques questionable. Now would be a good time to revisit both long and short term plans to ensure they are still effective in these challenging times.