Investor Education: Tax and Estate Planning – Minimizing Taxes in a Taxable Estate

By Wayne Cooper

Today we are going to discuss minimizing taxes in a taxable estate. The two transactions we are going to discuss are low interest rate loans to children and Grantor Retained Annuity Trusts or GRATs.

For purposes of these transactions, the IRS establishes a monthly hurdle rate. If these rates or greater are used in these transactions, then the amount transferred to children will not result in a gift. For purposes of loans to children, the IRS hurdle rate is the applicable federal rate or AFR. This is broken down to three categories based upon the length of the loan. The short-term rate, which is for 0-3 years, is .32% for October 2013, less than 1%. The mid-term rate for loans 3-9 years is 1.93% and the long-term rate for loans longer than 9 years is 3.5%.

To illustrate the strategy, assume you made a one million dollar loan to a trust for your children. This trust would have the same exact terms as your current estate plan would provide in trust for children at your death. In this way you are not changing the manner in which children inherit money or when they actually have access to the wealth. We are just setting it aside off of your taxable balance sheet so it will not be taxed at your death. If those assets were invested by the trust at a 5% return, over a three year period that trust would earn and retain $147,000 more than the interest paid on the amount. Using a 40% estate tax rate, that would result in a savings of $59,000. If those assets were invested at 10% for the three year period, the potential tax savings would over $128,000. Illustrating this for longer term notes at the AFR using a nine year loan at a 5% return the tax savings would be over $117,000 and at a 10% return, almost $370,000. So you can see very powerful tools for transferring excess growth out of your estate while retaining all of the assets you currently own.

The Grantor Retained Annuity Trust is a similar strategy in that it uses an IRS hurdle rate known as the 7520 rate. The current 7520 rate for October 2013 is 2.4%.  In this strategy you would transfer assets into a GRAT. The grantor would retain an annuity from the GRAT. The IRS values that annuity based on the present value of the annuity payments using the 7520 rate. Accordingly we would SEP the annuity so that the present value of the payments, at a 2.4% discount rate, equaled the amount that we contributed. In this way there would be no gift because the remainder interest would be valued at zero. If those assets grew at a rate greater than the 7520 rate, all of the excess appreciation would pass gift and estate tax free. The two risks of this transaction are one, the grantor must survive the term of the GRAT, that’s why you will see that most GRATs being of a short term 2-5 years. Secondly the assets must appreciate beyond the IRS hurdle rate in order to have any wealth transfer.

The nice thing about the GRAT is that even if either of those two risks occur, the tax payer is no worse off than if they had done nothing at all because they did not make an initial gift and pay gift taxes and they just received the assets back or they are included in their estate as if they did not make the transfer. The only cost is potentially some attorney’s fees that may be incurred.

We encourage our clients to be diligent in considering estate planning issues to minimize taxes at their death provided those transactions do effect their lifestyle. Thank you for listening and I look forward to our next podcast.