While it is clear that the pandemic has presented us with many challenges, it is not clear what will take place over the remaining months leading up to an unprecedented election in November. Our goal is to turn these present challenges into long-term opportunities.
In this article, we will address a few of the essential factors that will “supercharge” an advanced estate plan.
Over the last 24 months, we have discussed the Tax Cuts & Jobs Act, the SECURE Act, and the CARES Act. Please refer back to these resources or contact us if you have any questions regarding the significant tax law changes that are present under these recently passed Federal Laws.
Current AFR (Applicable Federal Rate) Advantage
The IRS requires that we apply the current federal interest rate for the particular month of the estate planning transaction, for purposes of calculating the gift on the transfer of wealth from our clients to their heirs.
This rate is called the AFR. In plain English, the AFR is an interest rate that the government (IRS, etc.) deems to be the amount of money that you should earn on your secure investments (based on what the government pays on their bonds, etc.). Because the AFR is extraordinarily low at this time, it is a beautiful opportunity to make planned gifts that use this AFR to calculate the transfer of wealth.
Let’s use an example of a common advanced estate planning technique to showcase how this works. The simplest one is an intra-family loan. You can loan money to a trust for the benefit of your heirs and charge a low AFR based on the length of time for repayment. Assume the loan interest rate is 2%, your heirs can invest the borrowed money and hope to earn far more than the 2%. The excess earnings would NOT be treated as a gift. This technique is a type of leverage; you borrow money at one rate (referred to as the hurdle rate) and earn at a much higher rate. The gains are not subject to gift tax because you paid back everything that was owed to you, the lender.
Albert Einstein is credited to having said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
If the estate planning transaction is between you, the Grantor, and an irrevocable “Grantor” Trust, then the income otherwise earned on the transaction over the tax year is treated as your income (the transaction is disregarded for income tax purposes). This means that the trust designed to benefit your heirs will not pay income tax during your life. You are taxed on all of the income instead. Essentially, the trust assets grow without the significant drag of income tax. The assets and income compound tax-free while you are living and the trust continues to be a grantor trust. The payment of tax by you, the Grantor, is not treated as an additional gift to the trust. This is an enormous benefit because it shrinks your estate without using your gift or estate tax exemption.
The Perfect Storm
This ‘perfect storm’ has been in effect over the past five months when asset values plummeted while interest rates went down as well. This means that advanced planning techniques can move a tremendous amount of wealth to your heirs without gift tax.
Some techniques work exceptionally well in low-interest and low-market value environments. They are as follows (examples not an inclusive list): Intrafamily-Family Loans, Grantor Remainder Trusts, Sales to Defective Grantor Trusts, and Charitable Lead Trusts. Conversely, Charitable Remainder Trusts and Personal Resident Trusts work very well in high-interest rate environments.
Timing is Everything
It is wise to establish a mid-term to long-term plan at this time. This will allow you to take full advantage of the advanced planning techniques while market values are low, interest rates are low, and the gift and estate tax exemption are still high. The estate and gift tax-free amount that can pass to your heirs free of the 40% Federal Tax is currently $11.58 million per person and is scheduled to be cut in half in 2026. A change in the political leadership will most likely increase this decline in the exemptions. Flexible and modifiable plans should use trust protectors and powers of appointment.
Regardless of the uncertain future tax law changes, it is wise to plan in the alternative, hope for the best, and plan for the worst-case scenario.
Plan now, and keep your options open.