Most of us enjoy the idea of having the best of all possible worlds, although this notion is not one that is often associated with tax and estate planning. However, by combining common wealth transfer vehicles with the unique opportunities afforded by our current market environment of low valuations and historically low interest rates, it is possible for married couples to maximize the benefits gained by wealth planning.
These strategies may be especially valuable at the current time because the lifetime gift tax and Generation- Skipping Transfer (GST) tax exclusions are scheduled to be reduced by half after 2025. Reductions in the exclusion amounts could of course occur sooner should political tides shift in the upcoming elections, or the financial exigencies of the recently passed CARES Act legislation could require revenue be raised in the near future following the passage of our current crisis. The IRS has confirmed that individuals who "use" their full exclusion before it is reduced will not be subject to a retroactively assessed tax.
Beyond the necessity of using lifetime gift tax and GST tax exclusions before they "sunset" in 2026, if not sooner, the current generally low valuations of marketable securities offer an ideal opportunity to transfer even more value per dollar of exclusion, particularly if the transferred assets are expected to "rebound" and appreciate further.
Optimal conditions exist for transferring current and future value from your taxable estate while preserving access to transferred assets as needed for the balance of your life. For those who are married, there is a way to accomplish this "best of both worlds" planning with awareness of the right strategies and execution.
Transfer the Assets
The first task is to establish and fund a vehicle to transfer assets to heirs. Intrafamily loans and Grantor Retained Annuity Trusts (GRATs) are widely used for this.
An individual can make a loan to another family member (e.g., parent to child) or trust and avoid treatment as a taxable gift if sufficient interest is charged. The intrafamily loan rate, known as the Applicable Federal Rate (AFR), is adjusted monthly by the IRS and varies based on the term and prevailing market interest rates — thus they are currently quite low. For example, for family loans entered into in June 2020, the short-term (up to three years) rate is 0.18%, the mid-term (three to nine years) rate is 0.43% and the long-term (more than nine years) rate is 1.01%. Should the rate decrease, or if it is desirable to extend the loan, it can be refinanced at the prevailing intrafamily rate at that time. If the loan proceeds are invested and enjoy an investment rate of return in excess of the designated interest rate, then the excess return is retained by the transferee family member without any gift tax consequences. Further, if the loan is instead made to an irrevocable family trust that is considered a grantor trust for income tax purposes, then no adverse income tax consequences result from the lender's receipt of interest. In addition, if the family trust is structured as exempt from GST tax, then the excess return can bypass the federal (and state where applicable) estate tax system for multiple generations.
Grantor Retained Annuity Trusts (GRATs)
A GRAT is an irrevocable trust with similarities to a family loan. The grantor transfers assets to the GRAT, which then pays an annuity back to the grantor for a fixed term that can be as short as two years. The GRAT can make equivalent payments or they can vary by as much as 20% annually.
The present value of the annuity is subtracted from the amount transferred to the GRAT to determine the amount of the gift made to the remainder beneficiaries of the GRAT at the time of the GRAT's creation. The GRAT annuity's present value is calculated based on the term and the interest rate determined monthly under Section 7520 of the Internal Revenue Code. This rate fluctuates with prevailing market interest rates. The lower the rate, the higher the value of the retained annuity, which correspondingly reduces the amount of the taxable gift. The Section 7520 rate for June 2020 is a historically low 0.6%.
The Section 7520 rate is often referred to as the "hurdle rate" because any investment return on the GRAT's assets in excess of that rate will result in the excess value passing to the remainder beneficiaries, resulting in a successful GRAT. Because the annuity payments are based on the initial value of the assets contributed (which in current market terms may be low) and the Section 7520 rate, the opportunity to transfer substantial value to the remainder beneficiaries is significant.
In a typical GRAT, the annuity's present value equals the amount transferred into the GRAT, resulting in a zero gift amount. This is known as a "zeroed-out" GRAT. With a zeroed-out GRAT, any remaining amount in the GRAT at the end of the annuity term will pass completely gift tax-free to the remainder beneficiaries. There are two significant advantages of a zeroed-out GRAT: First, because there is no taxable gift, there is no risk of the GRAT "failing." If investment return is lower than the "hurdle rate" described above, then the grantor will just receive back all of the GRAT assets as annuity payments — which is what would have been the case had he or she not established the GRAT — with no gift tax consequences. Second, because there is no taxable gift, if the grantor has already exhausted his or her lifetime gift tax exclusion on other gifts to family, there will not be any gift tax liability to be paid, even if a remainder is left at the conclusion of the annuity term to pass to the remainder beneficiaries.
One caution with GRATs is that it is only children, or a trust for children, who should be the intended remainder beneficiaries. The exemption against the GST tax must be allocated at the end rather than the beginning of the annuity period, providing no benefit for GST tax planning purposes and making the GST tax status of the remainder uncertain at the time of the GRAT's creation.
Another important consideration to keep in mind with GRATs is that should the grantor die prior to the annuity term ending, then all (or in some cases, most) of the GRAT assets would be included back into the grantor's taxable estate (although this would also be the case had the GRAT not been created).
Intrafamily Loan Versus a GRAT
As discussed above, both GRATs and intrafamily loans can be used to transfer substantial wealth without using any gift and/or GST tax exemption. However, logistical and quantitative factors may cause a loan to a family member to produce a greater transfer of wealth compared to a GRAT.
The AFR on which intrafamily loans are based is always less than the Section 7520 rate for GRATs, except in the case of a loan for nine years or more. In May 2020, the AFR for loans up to three years is 0.25%, and the 7520 rate is 0.80%. Each of these numbers reflect a "hurdle" or "floor" rate by which assets loaned or contributed to a GRAT must appreciate in order to successfully transfer wealth. For example, if the same taxpayer were to fund a $1 million, three-year GRAT and also lend $1,000,000 cash to a family member or SLAT in exchange for a three-year promissory note, which was then used to purchase the identical asset as held in the GRAT, then at the end of the three-year period and assuming a 10% annual return, the GRAT would have transferred $214,000 to family on a gift tax-free basis while the loan would transfer $325,000. If the grantor instead opted for a nine-year term, the GRAT would pass $803,000 while the intrafamily loan would pass $1.3 million.
The reason for this discrepancy is twofold: First, the "hurdle rate" is less, both on the short-term note as well as the mid-term (nine-year) note as compared to the 7520 rate used by GRATs. The interest on a three-year loan is 42 basis points less than that of a GRAT, so all else being equal, that much more appreciation can be transferred to beneficiaries using a loan. Second, GRAT annuity payments reduce the remaining trust principal, whereas only annual interest payments are due when using a loan (a "balloon" payment of the principal can be made at the end of the loan term). This allows the full amount of the principal to remain invested for the entire term of the loan, which can lead to a greater amount remaining in the trust (or with a family member) after the principal is finally repaid.
In addition, the time and cost of formalizing a loan will be significantly less compared to creating a new GRAT. With increased market volatility, even a brief delay in funding can have a meaningful — and potentially negative — impact on the wealth transfer outcome.
GRAT vs Loan
While both GRATs and intrafamily loans may be used to transfer wealth without using estate and gift tax exemption, this example demonstrates how the use of a loan can produce a more successful wealth transfer over short-term and long-term periods.
Establish the Right Vehicle for Fund Access
Retaining access to the transferred funds is the other key part of the proverbial having your cake and eating it too. Setting up a Spousal Lifetime Access Trust may be an attractive way to achieve this.
Spousal Lifetime Access Trusts ("SLATs")
A SLAT is an irrevocable family trust, the assets of which are held outside the grantor's taxable estate. In addition to family beneficiaries such as children or grandchildren, the grantor's spouse can be a beneficiary during his or her lifetime. Distributions of income and/or principal for an "ascertainable standard" such as health, support and maintenance can be made to the beneficiary spouse without appointing an independent trustee, and without causing inclusion of the SLAT assets in the spouse's taxable estate. Each spouse can establish a SLAT for the other spouse as long as care is taken to ensure that the SLATs are sufficiently different to be considered "non-reciprocal," and thereby avoid inclusion of the SLAT assets in their taxable estates.
SLATs allow spouses to utilize their lifetime federal gift tax and GST tax exclusions (currently $11.58 million per person, indexed annually for inflation) while retaining access to the assets and their growth as needed for the rest of their lives. In fact, it may be possible for the surviving spouse to have access to both SLATs established by the couple — even the one set up originally by the grantor — if the grantor's spouse exercises a power of appointment to have the assets of that SLAT pass to another trust for the benefit of the surviving spouse while keeping the assets outside of the survivor's taxable estate.
For married couples who would like to use their exclusion but cannot afford to lose access to the transferred assets without sacrificing financial security or peace of mind over the balance of their lifetimes, SLATs may offer an ideal solution.
Link the Structures Together
Pairing structures together can solve some of the common issues encountered when trying to tackle estate planning effectively as a married couple, thus giving that best of all possible worlds solution. One of the potential drawbacks of a GRAT is that the remainder at the termination of the annuity payments must pass to individuals other than the grantor (or his or her spouse), or to an irrevocable trust outside the grantor's taxable estate, in order to be excluded from the grantor's (and grantor's spouse's) taxable estate and thus accomplish the wealth transfer benefit of the GRAT. In some cases, the grantor (and spouse) may not want to part with access to income and principal from the potential GRAT remainder assets for the balance of their lives — even though they want that remainder, and any future growth afterwards, to be excluded from their taxable estates.
Similarly, with a family loan only the amount paid back to the lender is available to him or her for the balance of his or her life, whereas the amounts gained from investment returns on the loaned amount inure to the borrower, which may be a child, grandchild or a family trust for their benefit.
In the case of a married couple, the solution to the above obstacle for GRATs and family loans may be a SLAT. As discussed above, a properly structured SLAT is outside the taxable estate of both the grantor of the SLAT and his or her spouse. Nevertheless, the trustee of a SLAT can distribute the income or principal of the SLAT to the grantor's spouse for the balance of his or her life. In addition, the grantor's spouse may, via a testamentary power of appointment, have the assets pass to a new trust at his or her death that can benefit the surviving spouse (who created the original SLAT) for the balance of his or her life. (Alternatively, utilizing Delaware law can allow the Trustee or a Trust Advisor to add the grantor of the SLAT as a beneficiary at any time, such as at the grantor's spouse's death. Under either approach, the SLAT's assets — and any growth — are excluded from the taxable estates of both the grantor and grantor's spouse.)
One caution is that GRAT remainders generally should not pass to existing SLATs that are exempt from GST tax. Although GST tax-exempt SLATs are a tremendous vehicle for transferring wealth over multiple generations without death taxation, GRATs are not GST tax-efficient (as discussed above) and typically can only effectively transfer wealth one generation down on a gift and estate tax-free basis. Accordingly, it may be appropriate or necessary to have a separate SLAT that, following the death of the grantor and spouse, will vest in their children during their lifetime or at their deaths via testamentary general powers of appointment. In some instances, however, it may be possible and advisable for a GST-exempt SLAT to purchase a GRAT remainder prior to the conclusion of the GRAT term.
Pairing Structures with Balance Sheets
When engaging in tax and estate planning, be it wealth transfer, asset allocation or asset preservation, the focus often remains on one side of the balance sheet (namely assets) and the benefit of utilizing leverage in these scenarios may be overlooked. Current economic and market uncertainty and volatility combined with recent historically low interest rates make this one of the best times to utilize debt.
In the right situation, using liquid assets as collateral for borrowing at the present-day low rates can support an existing income stream while leaving the current asset allocation in place. Loans can also be used to leverage an investment portfolio or provide liquidity for short term needs. Depending on how SLATs are structured, leverage can provide incremental income to grantors (through their spouses) and loans can provide liquidity within trusts or allow for a greater value to be transferred into a GRAT or SLAT.
Utilizing leverage strategically while maximizing gift exclusions can provide a level of protection to income, lifestyle and assets. When considering loans to family members, borrowing short-term through the use of hedging strategies makes it possible to lock in a fixed rate for up to 10 years, protecting the estate, current assets and family from an unforeseen shift upwards in interest costs. This provides more planning certainty around cash flow, investment income and asset transfers.
By combining family loans or GRATs, or both, with SLATs (particularly in the current environment of reduced valuations and low interest rates), significant wealth transfer by a married couple is possible without sacrificing access as needed to the transferred assets for the balance of their lives. This strategy offers a potentially ideal approach for couples to take advantage of the family wealth transfer opportunities afforded by our current low valuation, low interest rate environment while maintaining critically important financial security and peace of mind, particularly during this challenging period.