Articles & Alerts

Current estate planning has focused on utilizing a taxpayer’s historically large lifetime exemption because this amount is slated to decrease under the current law in a few years (and possibly sooner by government action). When the exemption has already been used, here are two more planning techniques that will also help the taxpayer benefit from the unusually low interest rate environment.

Interfamily Loans

Scenario: Martha wants to make an investment (e.g. a private company, a real estate opportunity) that she expects to appreciate greatly. She could make the investment, and upon her death, her estate would have to pay estate taxes on the (increased) value before her children could inherit the investment.

Alternative: Martha instead loans cash to her children, and the children make the investment. The result is that the family (as a whole) took advantage of the investment opportunity, but the appreciating asset was never part of Martha’s taxable estate

Loans by wealthy individuals are a way to provide liquidity to the next generation, and the borrower keeps the excess of the asset growth over the interest rate charged. Loans are not gifts, so no exemption is used and no gift tax reporting is required. In addition, loans of cash do not require appraisals. Interfamily loans have to be formal and documented (with promissory notes, stated interest rates, and maturity dates), and failure to respect the terms of the loan could result in re-characterization by the IRS into gifts.

Minimum interest rates are set monthly by the IRS and are much lower than rates charged by commercial lenders. (The use of rates lower than these minimums results in imputed interest income to the lender.) As a bonus, existing loans can often be modified to use the lower current rates. Here are the official Applicable Federal Rates (AFRs) published by the IRS for December 2020:

Sales to Defective Trusts

Scenario: Henry wants to transfer his closely-held business into a trust as part of his estate plan, but the value of the business exceeds his available exemption and a transfer would result in gift tax due.

Alternative: Instead of gifting the business to the trust, Henry could sell the business to a grantor trust in exchange for a down payment and a promissory note.

Under current tax rules, the grantor and the grantor trust are considered the same, and transactions between them are ignored: there is no income tax gain recognized when the assets are sold to a grantor trust, and no interest income needs to be recognized as interest is paid back on the note. There is no gift when the value of the promissory note matches the value of the assets.

This arrangement allows an individual to move appreciating assets to the trust in exchange for a note (repaid in cash) and some interest. As discussed above, the minimum interest rates required are very low. Further, the note can be structured as interest-only with a balloon payment at the end of the term.

An individual effectively exchanges the appreciating assets for cash, and reduces the future value of his taxable estate.  To make this work, the trust must have sufficient assets to justify the borrowing (10% is common) and this amount could be gifted to the trust if necessary (which would require some available exemption). Finally, an appraisal is required to support the value of the assets sold, which would likely show low valuations because of the current economy and valuation discounts.

While neither of these techniques provide for stepped-up basis in the hands of the younger generation, it is possible that this provision in the tax law will be eliminated under the next administration.

The current low interest rate environment allows for effective interfamily loans and sale to grantor trust planning for wealthy taxpayers. Either approach helps to remove appreciating assets from the taxpayer’s estate without any gift tax consequences. To discuss how loans or sales could be relevant for your estate plan, contact your Anchin Relationship Partner.