Low interest rates in the United States provide an opportunity to transfer wealth with little to no gift tax cost.
In a low interest rate environment, U.S. investors may be able to take advantage of certain lending techniques, and trusts that leverage those rates, to transfer wealth with little to no gift tax consequence.1, 2 The minimum interest rate for loans of this nature that must be charged without there being a deemed gift is determined by the Internal Revenue Service, are based on U.S. Treasury yields, and change monthly.
The interest rate when the loan is made can be locked in for the term of the note. To the extent that an investment made with borrowed money returns an amount that exceeds the interest rate on the loan, the excess would belong to the borrower. The impact of a low interest rate can be magnified when lending non-cash assets whose value can be discounted, as the annual loan payments would be calculated based on the discounted value. (If payments on the loan are made “in kind"—that is, using the discounted asset—the benefit of the discount would be reduced. In addition, planning of this kind involving illiquid assets would almost certainly require, or at least benefit from, an appraisal.)
The techniques described below have enabled countless senior family members (lenders) to “freeze” the value of the assets that they lend by passing the assets’ “excess” appreciation to junior family members, or trusts for their benefit (borrowers). This planning could be especially beneficial for an individual who has already used up his or her exclusion from gift tax because, if structured properly, the loan can be made free of gift tax consequences. These strategies often involve complex tax and legal issues. Your own attorney and other tax advisors can help you determine if the ideas illustrated here are appropriate for your individual circumstances.
In recent years, legislation has been proposed to diminish or, in certain cases, eliminate the benefits of some of these techniques. And as interest rates rise, the effectiveness of these techniques presumably would be reduced. As a result, many individuals may want to capitalize on these opportunities while the legal landscape remains favorable and interest rates are low.
Intra-family loans
The simplest way for an individual to plan around low interest rates is to make a cash loan to the person whom he or she wishes to benefit. The loan should be documented with a note, which can provide for payments of interest (which generally will be taxable to the lender, and may be deductible by the borrower) for a set term of years, coupled with a “balloon” payment of the total amount borrowed when the loan comes due. It is a helpful fact for the integrity of the lending structure for the borrower to be creditworthy.
If assets purchased with the loan proceeds appreciate at a rate in excess of the interest rate on the note, the difference between the appreciation and the interest rate would inure to the borrower on a gift-tax-free basis. In addition, if the interest rates in effect at the time the loan matures remain low, the lender and borrower can refinance at that time, extending the benefits of this technique.
Example: Assume a $1 million cash loan to a child in exchange for a nine-year, 0.52% interest-only note with a balloon payment upon maturity. The cash is invested in an asset that generates a 5% pre-tax annual return. After full repayment of the $1 million loan nine years later, the child should have $493,990. In other words, the parent would have managed to transfer that amount to the child without gift tax consequence.
Installment sale to an irrevocable grantor trust (IGT)
An installment sale to an IGT functions much as an intra-family loan does, except that (i) the borrower is a trust, structured as a “grantor” trust for income tax purposes as to the donor of the trust, who is also the lender; and (ii) the assets sold often consist of non-cash assets. (See below for more information on grantor trusts.) Any appreciation in excess of the applicable interest rate would inure to the trust rather than the donor.
This technique is more complex than the intra-family loan because the lender needs to create the trust first, and then fund it with sufficient “seed capital” to ensure that it is considered a creditworthy borrower when the loan is made. A transaction involving a loan to an undercapitalized IGT could create an estate tax problem for the donor. On the other hand, the estate planning benefits of this transaction are greater than those of an intra-family loan described above because the assets in the trust would grow on an income-tax-free basis (because the grantor, not the trust, is paying the tax on trust income). These benefits would be even more significant in situations in which the sale includes illiquid assets whose value includes discounts and that may become liquid during the term of the note.
Example: Assume a sale to an IGT, seeded with a partnership interest with a net asset value of $1.5 million and a discounted value of $1 million. The sale is made in exchange for a nine-year, 0.52% interest-only note with a balloon payment upon maturity. The partnership interest generates a 5% pre-tax return. After nine years, the IDGT should have $1,269,654. In other words, the donor managed to transfer to the trust beneficiaries that amount with minimal gift tax consequence.
Grantor retained annuity trust (GRAT)
A GRAT is a grantor trust to which the donor transfers property and from which the donor receives a payment of a fixed amount each year for a term of years. Each annuity payment (whose value is set on the date the GRAT is funded) consists of both interest and principal. If any property remains in the GRAT after the final annuity payment is made (i.e., if the assets appreciate more than the relevant interest rate) and the GRAT is “zeroed-out” (meaning that no gift tax was paid when the GRAT was created), the property would pass to the remainder beneficiaries (outright or in trust) free of gift tax.
The transfer of property to the GRAT should not trigger any gift tax to the donor, and the annuity payments themselves from the trust to the donor will not be taxable. To the extent the GRAT generates taxable income and gain, the donor would have to pay tax on that income and gain.
Because the annuity payments are not “interest only” as they often are when a grantor sells assets to an IGT via an installment sale, the economic benefits of a GRAT are usually not as favorable as those involved with an IGT. As a result, individuals sometimes create a series of short-term, “rolling” GRATs (the donor funds a new GRAT each year with the annuity from the previous GRAT), rather than a single GRAT, to increase the wealth transfer benefits and capitalize on market volatility.4
Example: Assume a gift to a five-year GRAT of a partnership interest with a net asset value of $1.5 million and a discounted value of $1 million, with a 0.6% “hurdle” rate. The partnership interest is reinvested in an asset that generates a 5% pre-tax return. After five years, the remainder beneficiaries should have $789,315. In other words, the donor managed to transfer to the trust beneficiaries that amount with no gift tax consequence.
What is a “grantor trust”? A trust usually pays its own taxes, with highly compressed brackets. A trust can be structured so that the grantor—not the trust—is responsible for paying tax on income earned in the trust. This allows the trust assets to grow effectively income-tax-free. Grantor trust status also means that transactions between the trust and the grantor are ignored for income tax purposes. This means that sales by a grantor to his or her trust do not trigger capital gains tax, and interest paid on a note is neither deductible by the trust nor taxable to the grantor.
For more information and additional considerations related to any of these strategies, contact your J.P. Morgan team member.
1 The interest rates that apply to wealth transfer strategies are the applicable federal rate (which applies to intra-family loans and installment sales) and the §7520 rate (which is used to calculate annuity payments for GRATs).
2 This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal and accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any financial transactions.
3 Results calculated using “NumberCruncher” software and J.P. Morgan Private Bank calculations. These examples do not reflect the performance of any specific vehicle and are based solely on the hypothetical illustrations cited. Hypothetical examples are not intended to serve as a projection of any result.
4 If the annuity needs to be paid to the grantor “in kind,” the benefit of the discounted value will be reduced.
