Financial Planning Strategies for Today’s Environment

If you’re looking for a silver lining in the current market downturn, there are several. We have already written about some timely investment ideas and will continue to present what we think is compelling. But did you realize there may also be financial planning opportunities that look especially attractive right now?

Wealthy families often need vehicles for passing their wealth to the next generation without paying enormous amounts in taxes. Traditional methods include maximizing the annual gift exclusion amount, taking advantage of specialized trust provisions, relying on cost basis step-ups at death, etc. In this article, we discuss how in the current moment of low interest rates and depressed asset values you can take advantage of the gifting rules and grantor-retained annuity trusts (GRATs).

The below thoughts may help you determine whether such strategies will add value to your financial plan. But we caution you to consult a professional before actually putting either into practice, as you must do everything correctly to get the benefits.

How things stand today

Before we begin, it’s important to recognize that we stand at a historic low point in interest rates and have just undergone the most rapid decline in financial asset prices in recent history. As of this writing, we still do not know the long-term effects of our collective response to the coronavirus pandemic. But we can be sure there will be consequences.

One possible consequence may include higher interest rates eventually, as we have had to borrow huge amounts in government bond markets to support the crisis response. Inflation may rear its head eventually, as well. For now, low interest rates and depressed asset prices can help you make transfers more effectively, provided you believe that asset values will recover. One way to do this is through a gift-plus-note transfer to beneficiaries.

When a gift is not a gift

The IRS current limits the amount that can be transferred untaxed from an individual to a non-spousal beneficiary. For tax year 2019 (current-year rules are in flux due to the government response), that amount was $15,000 per year, subject to a lifetime limit of $11.4 million per donor. We realize this amount seems far, far out of reach to be any concern for most of us. But it’s not unheard of for highly successful families, who can easily exceed this amount in their estate planning. In such cases, the givers must turn to other strategies to mitigate the tax burden on their eventual estates.

Say you either did not want to use the gift tax exclusion in a given year or you had already maxed out the lifetime transfer amounts. It turns out that if you combine a gift with a promissory note, it’s no longer a gift, but a loan, and thus not subject to any limitations as to the amount. Let’s flesh out how this strategy might look.

Even family loans must charge interest

When you use a promissory note to make loans within your family, the IRS requires that the interest rate be at least the Applicable Federal Rate (AFR). (You can see rates for May 2020 on this table: https://www.irs.gov/pub/irs-drop/rr-20-11.pdf.) If you charged too little, the IRS might “look through” your promissory note to call it an effective gift, and you would lose the protection. Obviously, making a loan to your children with a 6% interest rate would not work out well for them; however, today’s rates are under 1% for many terms! That means it can be very easy for your loan recipient to make the interest payments.

Say you made a $100,000 loan at 1% annual interest (please check with your tax advisor for the correct rate). If the recipient can make 1.50% on a one-year FDIC-insured CD, there is already a net 0.50% gain for the beneficiary, with minimal risk. Further, if the heir (or you, on behalf of the heir) were to invest in today’s depressed asset values and enjoy a recovery during the term of the loan, all those gains would accrue to your beneficiary as well as escape the gift tax. Of course, gains are still taxable as income to your heir, so make sure to consider the tax rate of heirs in planning.

In a loan/gift strategy, the beneficiary gains all the income and can eventually return the borrowed amount to you. But if the maximum lifetime gift amount continues to increase, you can potentially also begin “forgiving” the loan up to the new limit each year to reduce the principal that comes back to your taxable estate. And remember the loan is an asset of your estate, so simply creating a promissory note does not remove the assets from your estate. It just gives you the chance to pass along additional income on assets whose earnings could be taxable to you at a higher rate at this moment.

What could go wrong?

Of course, there are risks to any planning strategy. If the beneficiary’s investments don’t do well, or if the beneficiary spends the principal down, loan repayment can become a problem. It may become necessary to forgive the remaining loan eventually and pay the tax on excess gift amounts. However, under current conditions, with interest rates low and asset prices depressed, the odds for such a strategy working as intended are probably better than in a peak market with high rates.

Remember also that the interest rate on your note can be fixed. Even if rates go up to 10% after the loan is in place, you will lock in the benefits of low rates at implementation throughout the term of your note. If you pass away during the term of the loan, the note remains an asset of the estate and the beneficiary would still have an obligation to pay interest and principal to the estate. Thus, keep in mind the term of the loan when drafting it. Perhaps you would only want to do this for a few years rather than ten years.

If you happen to “loan” shares of a family company or other assets that are not in cash form, this strategy becomes trickier because the interest payments (and any interim principal payments) must be made to keep the note valid. For loan/gift strategies involving non-cash assets, please consult with an advisor to make sure you don’t create a cash flow problem for the beneficiary.

GRATs in a crash

A grantor-retained annuity trust (GRAT) is a trust where you, as grantor, place assets irrevocably into a trust for your eventual beneficiaries but continue to receive fixed regular payments (an “annuity”) from the trust for its duration. You might elect a GRAT if you have exhausted your gifting maximum but would like to provide additional income and assets to beneficiaries without incurring gift tax and don’t follow the above loan/gift approach. Doing so now could make the entire transaction less costly due to low interest rates and low asset prices.

Assets to put into a GRAT include not only the stocks and bonds that got hurt in the downturn, but also shares of closely held businesses, which can be valued in light of today’s depressed values and reduced future expected income potential. You may also be able to structure a transfer to include a minority discount, though this concept is outside the scope of our article. Your tax burden on such a transfer can be much lower than if you were to make it when times were good. Once the transfer is made, any increases in value generally accrue to the trust and do not get taxed to your estate unless realized. Upon trust expiration, the trust assets pass to the beneficiaries free of gift tax.

7520-friendly

The IRS publishes a reference rate (called the 7520 rate) that is used by GRATs to calculate the minimum payments they must make to the grantor. Given today’s low interest rates, it may currently be easier to pass on the majority of the GRAT assets at expiration, since less will have been paid back to the grantor during its lifetime. In addition, GRAT income above the reference rate can also be passed on to beneficiaries free of gift tax. GRAT calculations may require the help of a professional familiar with tax rules, so please reach out to your advisor. Because the 7520 rate floats, your rate in a GRAT is not fixed for its entire life. Thus, it makes sense to act now.

The payments you receive from a GRAT can be in cash or in-kind, meaning they can be the same assets you contributed. In-kind distributions will not expose you to current taxation (as gains are not realized), but you as grantor will continue to pay tax on all income and realized gains on the assets in the GRAT. (See our article on intentionally defective grantor trusts for an explanation of why you might consider such an approach.)

GRATs are created with a certain term in mind. If you die while the GRAT is still active, the assets remain in your estate and become subject to estate tax, thus negating the strategy. Thus, you want to choose a term that you feel reasonably confident will expire prior to your death. You may then decide to pass the assets on to beneficiaries or to roll them into a new GRAT to average out your chances of funding one at an advantageous time.

Roll, roll, roll your GRAT

During a GRAT’s lifetime, you receive annuity payments. You may, if you wish, place these annuity payments into a new GRAT and start over. This strategy is informally called a “rolling GRAT.” Placing the assets from annuity payments back into a GRAT keeps them out of your taxable estate. Additionally, having several successive GRATs allows you the opportunity to fund the GRAT when it is advantageous but to take back the assets from the GRAT when you can fund it at a lower cost after the fact.

Again, your advisor will need to perform some modeling to see whether and how rolling GRATs might work out for you. But in an up-and-down market, using multiple GRATs may provide additional opportunities to minimize tax and maximize transfers to beneficiaries.

Charitable Lead Trusts

Finally, if you already give money to charity, you may wish to consider funding a charitable lead trust (CLT) in today’s environment for the same reasons given above. A CLT functions like a GRAT except the annuity payments go to a charity rather than to the grantor. Upon expiration, the assets pass to the non-charity beneficiaries as with a GRAT.

CLTs tend to have longer lives than GRATs, since there isn’t the concern about having assets revert back to your taxable estate. The goal isn’t necessarily to pass on the assets above the gift tax level but to pass what is left after making a series of payments to a charity. If you die during the term of a CLT, the trust assets go to the charity rather than the beneficiaries, which presumably is in line with your charitable giving goals anyway.

Wrapping up

Today’s low interest rates and depressed asset values have opened up significant estate planning opportunities for wealthy families who need to shield assets from taxation and who cannot take advantage of the standard transfer exclusion amounts. In the above article, we outlined the basics of gifts with promissory notes, GRATs, and CLTs, but we haven’t provided sufficient detail in this short article to ensure you carry out each strategy correctly and for maximum benefit.

Smart planning involves coordinating your estate plan, investment policy, and tax strategy and should include all relevant advisors. Alpha Fiduciary is proud to serve its clients as a fiduciary “quarterback,” bringing together all the professionals involved in making families successful. We’d love the chance to talk about what we can do for you.

Please click this link to schedule a short, no-obligation meeting to go over your situation.

 

About Arthur Doglione

Arthur is an industry veteran with more than 20 years of experience working with high-net-worth clients. He has an extensive background in wealth management with particular expertise in portfolio management. Before establishing Alpha Fiduciary, Art was a Senior Vice President with Merrill Lynch where he built his practice to be the largest of Merrill Lynch’s Arizona territory.

Art founded Alpha Fiduciary in 2006 and has completed two acquisitions since then. The firm currently serves clients across many states as a fee-only Registered Investment Advisor (RIA).

Art founded Alpha Fiduciary as a fiduciary advisory firm. This means it has a responsibility to its clients first and foremost.

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About Arthur Doglione

Arthur is an industry veteran with more than 20 years of experience working with high-net-worth clients. He has an extensive background in wealth management with particular expertise in portfolio management. Before establishing Alpha Fiduciary, Art was a Senior Vice President with Merrill Lynch where he built his practice to be the largest of Merrill Lynch’s Arizona territory. Art founded Alpha Fiduciary in 2006 and has completed two acquisitions since then. The firm currently serves clients across many states as a fee-only Registered Investment Advisor (RIA). Art founded Alpha Fiduciary as a fiduciary advisory firm. This means it has a responsibility to its clients first and foremost.