4 Gifting Techniques for Today’s Market

Record low interest rates and the risk of tax changes make today the perfect time to put gifting strategies into action.

Two broadly accepted maxims can be applied to estate planning today: It’s better to give than to receive, and there’s no time like the present. In an environment where assets may have increased in value and federal tax hikes are on the horizon, expediting the gifting decision could reduce your exposure to gift and estate taxes. Gifting can remove assets from your estate (and thereby prevent further appreciation of those assets), while also exhausting less of your $11.7 million lifetime gift tax exemption.

Another powerful timing consideration in terms of gifting is today’s record-low level of interest rates. With some estate planning vehicles, lower interest rates can reduce the value of gifts. Gifts of lesser value could result in greater use of the annual exclusion (currently $15,000 per grantor per year) and greater use of the gift tax exemption.

Four potential gifting strategies for consideration in times of low interest rates are:

  • Intrafamily loans
  • Spousal Lifetime Access Trusts (SLATs)
  • Grantor Retained Annuity Trusts (GRATs)
  • Charitable Lead Annuity Trusts (CLATs)

INTRAFAMILY LOANS

An intrafamily loan is a loan from one family member to another. If correctly drafted and administered, this type of loan can be a powerful tool for transferring wealth, free of gift and estate tax, from one generation to the next. Every intrafamily loan should be governed by a loan note that details the loan arrangement. The specifics can include whether the loan is a term or a demand note; its maturity, the interest rate, the amount borrowed and the frequency of payments.

Typically, once a note is created the lender (most often a parent or grandparent) transfers funds and the borrower begins making payments based on the agreed-upon schedule. Interest payments are treated as taxable income to the lender. If the loan is used to purchase a home and is properly collateralized, the interest payments are deductible by the borrower. If the borrower is unable to repay the loan, or if interest rates drop, a note can be refinanced, or principal can be forgiven and treated as a gift. However, the recipient might incur income tax consequences if the lender forgives or refinances the debt without intending such action as a gift.

Intrafamily loans are especially attractive in a low-interest-rate environment, as they create a low hurdle for successful gift-tax-free transfer. If a grandparent loans cash to a grandchild and the grandchild invests the funds at a rate of return greater than the applicable federal tax rate, any funds remaining after the loan is repaid become the property of the grandchild, without the grandparent having used any gift tax exemption to cover the transfer. For example, if the grandchild is paying 0.75% annual interest to the grandparent, but the asset owned by the child is appreciating on average 6% per year, the 5.25% difference in return accretes to the grandchild, free of gift tax.

SPOUSAL LIFETIME ACCESS TRUST (SLAT)

A SLAT provides spouses an opportunity to transfer assets to an irrevocable trust, use some or all of their $11.7 million gift tax exemption and maintain an indirect interest in the trust’s assets.

In effect, a SLAT allows spouses to use their gift tax exemption before it reverts to a lower amount when it expires in 2026, yet still receive distributions from the trust.A SLAT is an irrevocable trust whereby one spouse names the other spouse and perhaps others, like the couple’s children, as discretionary beneficiaries.

The transfer of assets into the SLAT is a completed gift for estate and gift tax purposes, allowing the assets in the SLAT to avoid estate taxation in the grantor’s taxable estate. The trustee has discretion to make distributions to the trust’s beneficiaries, which includes the grantor’s spouse. As long as the couple remains married and the non-grantor spouse is alive, the couple has indirect access to the trust assets because of the trustee being able to make discretionary distributions to the non-grantor spouse.  

A SLAT can be set up by each spouse with the other spouse as a discretionary beneficiary. For example, a husband can set up a SLAT with his wife as a discretionary beneficiary of his SLAT and the wife can also set up a SLAT with her husband as the beneficiary of her SLAT. However, the SLATs cannot be identical. The husband’s SLAT must have materially different terms than the wife’s SLAT – otherwise, the IRS will deem the husband and wife to have retained an interest, causing the trust assets to be included in the grantor’s estate for federal estate tax purposes.

SLATs work best when assets that are expected to significantly appreciate are used to fund the trust. That allows the appreciation in those assets to occur inside the SLAT and not in the grantor’s taxable estate. A SLAT is a great vehicle for those who want to use their gift tax exemption before it decreases in the year 2026 but also retain an indirect access to the trust’s assets.

GRANTOR RETAINED ANNUITY TRUST (GRAT)

A GRAT is an irrevocable trust that may permit the transfer of wealth to others with little, if any, gift tax and with no estate tax. It is established by an individual grantor, and is essentially a wealth transfer technique governed by Section 2702 of the Internal Revenue Code.

The grantor transfers assets to an irrevocable trust and retains the right to receive an annual annuity for a term of years specified in the trust documents. The annuity paid to the grantor is usually fixed, but it can also be structured to “backload” so that annuity payments increase each year. At the expiration of the term, the trust usually terminates and the property remaining in the GRAT is distributed to a third party, known as the “remainder beneficiary”. Very often, the remainder beneficiary is the grantor’s children or grandchildren. (When a grandchild is the remainder beneficiary, the impact of the generation-skipping transfer tax should also be considered). The transfer of the property to the trust is a taxable gift by the grantor, but the annuity payments to the grantor are structured so that the value of the remainder interest and the resulting taxable gift to the remainder beneficiary will be minimized, if not eliminated.

The gift of the remainder interest is equal to the difference between the amount contributed to the GRAT and the present value of the annuity stream retained by the grantor. IRS regulations require that the annuity stream retained by the grantor be valued using the Section 7520 rate in effect on the date property is transferred to the GRAT. The Section 7520 rate is the amount the IRS assumes the GRAT will earn, and the rate is set monthly by the IRS.

The current low interest rate environment makes the GRAT a potentially attractive gifting vehicle. If your goal is to minimize the taxable gift to the remainder beneficiary, a GRAT can be very effective, provided the property transferred to or held in the GRAT appreciates faster than the Section 7520 rate. Presently, the Section 7520 rate is relatively low. So, this is a good opportunity for the growth rate of the GRAT to exceed the Section 7520 rate, and to transfer the excess growth to the remainder beneficiary free of transfer (gift or estate) tax.

Only assets that are expected to generate a strong return during the term of the GRAT should be considered for this kind of irrevocable trust. While the impact of losing access to assets in a volatile market, or any other market for that matter, should be considered, one of the major advantages of a GRAT is that the full original value of the asset may be re-paid to the grantor through the annuity.

CHARITABLE LEAD ANNUITY TRUST (CLAT)

A charitable lead annuity trust (CLAT) allows a donor to make contributions to a charitable entity for a specified number of years, while ultimately transferring assets to a future generation (at discounted transfer tax values). Depending on the terms of the trust, income generated by the trust may also be excluded from the donor’s income tax liability.

CLATs are an even more attractive gifting mechanism in this current environment. The CLAT is funded by transferring assets to the trustee of the CLAT. The trustee then invests the trust assets and makes annual payments of a fixed amount to the donor’s chosen charity. If the assets in the trust generate a higher return than the total amount of fixed payments, the remaining amount ultimately will transfer to the beneficiary free of gift or estate taxes. Therefore, to take advantage of the discounted transfer tax, a CLAT should be funded by an asset that is expected to produce strong returns during the CLAT’s term.

The recent double-digit returns in the stock market, proposed tax law changes, and record low interest rates have created a unique opportunity to benefit from a gifting perspective. Expediting the gifting decision can ultimately reduce your exposure to gift and estate taxes. Strategies such as intrafamily loans, SLATs, GRATs and CLATs can serve to capitalize on the ability to transfer property that is expected to have a resurgence in value, resulting in the transfer of a greater proportion of a grantor’s wealth for future generations.

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