Historically Low Interest Rates Present Planning Opportunities Amidst the COVID-19 Crisis        

Due to historically low rates combined with potentially depressed asset values due to the recent market decline, now may present an unparalleled opportunity to take advantage of wealth transfer techniques to shift significant wealth downstream with little to no use of gift tax exemption.1

As I write the article, the United States and the rest of the world are in the midst of dealing with and trying to reign in the COVID-19, also known as the coronavirus. This is an unprecedented time with unprecedented actions being taken to stop the rapid spread of COVID-19. With many businesses and schools being, the pain is being felt near and far, with some feeling it much more so than others. The economic ripple of COVID-19 will be life-altering for many and the effects will likely be felt much longer than the COVID-19 scare persists. The President and Congress are actively drafting legislation to provide emergency relief and aid in a manner that has not been seen before.

The markets have seen large losses almost daily the past few weeks, though there have been a few positive days mixed in. As of the close of trading on Friday, March 20, 2020, the Dow Jones Industrial Average is down 32.81% for the year. Whether these large losses are directly related to COVID-19 or the result of recession that was just waiting for a trigger but was bound to happen, or perhaps a combination of both is anyone’s guess. I am not a financial planner, market analyst, or have any other credentials that would make me competent in terms of discussing market trends, and I do not pretend to be a market analyst here.

Interest rates have also seen big moves up and down the past few weeks. Mortgage rates were near historical lows a few weeks ago and then made a big move back up. The 10-year Treasury rate has also fluctuated a good bit, dropping below .4% for a time and currently sitting at .885% as of the close of business on Friday, March 20, 2020. The Federal Reserve has also taken emergency measures and cut its benchmark interest rate to 0%.

On the tax side of things, the IRS recently published its interest rates for April 2020 and they are at historical lows. Currently, the Applicable Federal Rate (“AFR”) for long term lending with annual compounding sits at 1.44%.2 The Section 7520 Rate (“7520”) sits at 1.2%.3 These rates are currently at historical lows. Twenty years ago, in April, 2000, the long term AFR was 6.49% and the 7520 was 8%.4 Ten years ago, in April, 2010, the long term AFR was 4.4% and the 7520 was 3.2%. The 7520 briefly touched 1% in August, September and November of 2012 as well as in January of 20135and the long term AFR dropped below 2% from August to October of 2016, and then again in October and November of 2019 as well as January and March of 2020.6 Currently, the AFR of 1.2% is near its all-time low and the long term AFR of 1.44% is at its all time low.7

Planning Opportunities in a Low Interest Rate Environment

With rates currently sitting at historical lows, planning opportunities abound for wealth transfers and now may be the time to act. I previously wrote an article found here discussing planning opportunities when rates are low as well as planning opportunities when rates are high. At the time of writing of that article, the IRS interest rates were exhibiting a rising trend with the 7520 sitting at 3.4%8, still fairly low from a historical context. Rates have since reversed course with the 7520 being a full 2.2% lower for April 2020. Combined with the recent market decline, there may not be a better time to take advantage of wealth transfer techniques to shift significant wealth downstream with little to no use of gift tax exemption.

Two popular planning techniques that can be a home run when rates are low are the grantor retained annuity trust (the “GRAT”) and sales to intentionally defective grantor trusts (“IDGT”). I previously discussed both of these techniques in my article above so I will refrain from going into depth, but please see my previous article for a brief description. However, I would like to duplicate my discussion of how rates affect each technique.

For a GRAT, the present value of the annuity is determined using the 7520. If the assets in a zeroed-out GRAT outperform the 7520, the GRAT will be successful and assets will remain in trust after paying the annuity. If the assets in a zeroed-out GRAT fail to outperform the 7520, then the assets of the GRAT will be exhausted paying the annuity and no assets will be left in trust. This is referred to by many planners as a heads I win, tails I do not lose strategy since no exemption is used for a zeroed-out GRAT.

For a sale to an IDGT, in order to avoid any part of the sale being treated as a gift or partial gift, all the proper steps should be taken in valuing the assets to be sold and ensuring the price paid by the IDGT to the grantor for such assets is the fair market value. For the note to be treated as having a fair market value equal to its principal amount, the note must carry interest equal to or in excess of the AFR at the time the note is issued. Accordingly, the lower the AFR at the time of the transaction, the lower the interest payable to the grantor will be and more assets can remain in the IDGT. Note that an intrafamily loan, another wealth transfer technique which is also briefly discussed in my prior article, works in the same manner as a sale to an IDGT with regard to how interest rates effect this technique.

Examples9

For all these examples, we will assume the transaction takes place in April 2020 using the long term AFR of 1.44% or the 7520 of 1.2%, as the case may be, in effect for April 2020.

Hypothetical 1

Let us hypothetically assume that, based on market fundamentals, the market was properly valued at their fair market value as of January 1, 2020 and the 32.81% decline is not representative of fair market value of the current market, but rather due to other factors. Under this assumption, one would be able to currently transfer assets whose value is market based at a 32.81% discount. In Hypothetical 1,  the taxpayer believes such to be the case and the taxpayer is transferring assets at a discount of 32.81%.

Taxpayer sets up a GRAT transferring $1 Million worth of assets to the GRAT. The GRAT provides for annual annuity payments equal in value over a two year period, and is zeroed out such that no part of the transfer is considered a taxable gift. Let’s also assume the market comes back to it’s proper value as of January 1, 2020 in year 1 and also appreciates at rates of 5%, 10%, 20%, and 30% annually.

As you can see, even at 5% growth, under the hypothetical assumption that assets whose value is based on the market are heavily discounted due to the market drop so far in 2020, the taxpayer has managed to transfer $403,535,73 of wealth without any use of his or her gift tax exemption. Further, any future appreciation on these amounts is also passed down and out of the client’s estate, compounding the wealth transfer effect these transactions can have.

Hypothetical 2

Now, let’s compare Hypothetical 1 where the taxpayer believes he or she is transferring discounted assets based on the market to the same scenario but without the additional year 1 growth of 32.81%. Taxpayer sets up a GRAT transferring $1 Million worth of assets to the GRAT. The GRAT provides for annual annuity payments equal in value over a two year period and is zeroed out such that no part of the transfer is considered a taxable gift. The assets in the GRAT appreciate at a rates of 5%, 10%, 20%, and 30% annually.

Under this scenario, even at 5% growth, the taxpayer managed to transfer $59,030 of wealth and future appreciation on the same without any use of his or her gift tax exemption. A 30% return may not be realistic, but if one assumes that the current markets is undervalued, but maybe not to the full extent of 32.81%, then a 30% return, at least in year 1, may be more realistic than under normal circumstances.

Hypothetical 3

Same as Number 2 but the taxpayer the GRAT calls for annual annuity payments equal in value over a five year period.

Annual Growth 5% Annual Growth 10% Annual Growth 20% Annual Growth 30% Annual Growth
Beginning Principal

 

1,000,000.00 1,000,000.00 1,000,000.00 1,000,000.00
Year 1 Growth

 

50,000.00 100,000.00 200,000.00 300,000.00
Year 1 Annuity

 

207,258.10 207,258.10 207,258.10 207,258.10
Ending Balance Year 1

 

842,741.90 892,741.90 992,741.90 1,092,741.90
Year 2 Growth

 

42,137.10 89,274.19 198,548.38 327,822.57
Year 2 Annuity

 

207,258.10 207,258.10 207,258.10 207,258.10
Ending Balance Year 2

 

677,620.90 774,757.99 984,032.18 1,213,306.37
Year 3 Growth

 

33,881.04 77,475.80 196,806.44 363,991.91
Year 3 Annuity

 

207,258.10 207,258.10 207,258.10 207,258.10
Ending Balance Year 3

 

504,243.84 644,975.69 973,580.52 1,370,040.18
Year 4 Growth

 

25,212.19 64,497.57 194,716.10 411,012.05
Year 4 Annuity

 

207,258.10 207,258.10 207,258.10 207,258.10
Ending Balance Year 4

 

322,197.93 502,215.16 961,038.52 1,573,794.14
Year 5 Growth

 

16,109.90 50,221.52 192,207.70 472,138.24
Year 5 Annuity

 

207,258.10 207,258.10 207,258.10 207,258.10
Ending Balance Year 5 131,049.73 345,178.57 945,988.12 1,838,674.28

As illustrated, extending the GRAT out to 5 years can multiply the amount that can be transferred estate and gift tax free, all else being equal. Of course, a 30% annual return over 5 years may be unrealistic, but even at a lower annual return rate, the GRAT still provides a powerful technique to shift significant wealth downstream.

In Hypothetical Number  1,2, and Number 3, we assumed the assets appreciated. But what happens if the market slide continues and the assets actually depreciate in value? In that case, the GRAT would exhaust all assets in making the annuity payments and there would be nothing left at the end of the GRAT term. What happens in this case? No harm, no foul, other than administrative and legal costs incurred by the taxpayer in setting up the GRAT, which may include initial valuations and additional valuations for annuity payments made in kind.

Hypothetical Number 4

Same as Number 2 except rather than a GRAT, Taxpayer sells $1 Million of assets to an IDGT in exchange for a 10-year promissory note at long term AFR, with annual payments of interest and a balloon payment of principal at the end of year 10.

Annual Growth

 

5% Annual Growth 10% Annual Growth 20% Annual Growth 30% Annual Growth
Beginning Principal

 

1,000,000.00 1,000,000.00 1,000,000.00 1,000,000.00
Year 1 Growth

 

50,000.00 100,000.00 200,000.00 300,000.00
Year 1 Interest

 

14,400.00 14,400.00 14,400.00 14,400.00
Ending Balance Year 1

 

1,035,600.00 1,085,600.00 1,185,600.00 1,285,600.00
Year 2 Growth

 

51,780.00 108,560.00 237,120.00 385,680.00
Year 2 Interest

 

14,400.00 14,400.00 14,400.00 14,400.00
Ending Balance Year 2

 

1,072,980.00 1,179,760.00 1,408,320.00 1,656,880.00
Year 3 Growth

 

53,649.00 117,976.00 281,664.00 497,064.00
Year 3 Interest

 

14,400.00 14,400.00 14,400.00 14,400.00
Ending Balance Year 3

 

1,112,229.00 1,283,336.00 1,675,584.00 2,139,544.00
Year 4 Growth

 

55,611.45 128,333.60 335,116.80 641,863.20
Year 4 Interest

 

14,400.00 14,400.00 14,400.00 14,400.00
Ending Balance Year 4

 

1,153,440.45 1,397,269.60 1,996,300.80 2,767,007.20
Year 5 Growth

 

57,672.02 139,726.96 399,260.16 830,102.16
Year 5 Interest

 

14,400.00 14,400.00 14,400.00 14,400.00
Ending Balance Year 5

 

1,196,712.47 1,522,596.56 2,381,160.96 3,582,709.36
Year 6 Growth

 

59,835.62 152,259.66 476,232.19 1,074,812.81
Year 6 Interest

 

14,400.00 14,400.00 14,400.00 14,400.00
Ending Balance Year 6

 

1,242,148.10 1,660,456.22 2,842,993.15 4,643,122.17
Year 7 Growth

 

62,107.40 166,045.62 568,598.63 1,392,936.65
Year 7 Interest

 

14,400.00 14,400.00 14,400.00 14,400.00
Ending Balance Year 7

 

1,289,855.50 1,812,101.84 3,397,191.78 6,021,658.82
Year 8 Growth

 

64,492.78 181,210.18 679,438.36 1,806,497.65
Year 8 Interest

 

14,400.00 14,400.00 14,400.00 14,400.00
Ending Balance Year 8

 

1,339,948.28 1,978,912.02 4,062,230.14 7,813,756.46
Year 9 Growth

 

66,997.41 197,891.20 812,446.03 2,344,126.94
Year 9 Interest

 

14,400.00 14,400.00 14,400.00 14,400.00
Ending Balance Year 9

 

1,392,545.69 2,162,403.22 4,860,276.17 10,143,483.40
Year 10 Growth

 

69,627.28 216,240.32 972,055.23 3,043,045.02
Year 10 Principal Plus Interest

 

1,014,400.00 1,014,400.00 1,014,400.00 1,014,400.00
Ending Balance Year 10 447,772.97 1,364,243.55 4,817,931.40 12,172,128.42

As can be seen from the chart above, taking advantage of the current long term AFR for sales to an IDGT can result in large wealth transfers depending on how the assets perform over the 10-year period. As with the GRATs, projecting an annual return of 30% may be unrealistic, but even with an annual return of 10%, the result is still well over $1 Million of assets transferred.

What happens if assets depreciate over time in a sale to an IDGT? Under the hypothetical above, with a 10-year balloon note, the IDGT will likely default on the final payment depending on what other assets are in the IDGT, how much of a seed gift was made to the IDGT, and the rate of depreciation of the assets. In this case, it is similar to the result of a GRAT that is exhausted making annuity payments. The IDGT is a grantor trust so there are no income tax consequences such as cancellation of debt income as result of the default, but the taxpayer is out the administrative and legal fees. And if a seed gift was made upon establishing the GRAT, that gift would likely use up some of the taxpayer’s gift tax exemption, so any exemption used may ultimately result in a waste.

Conclusion

If anyone has been contemplating wealth transfers, there may not be a better time to act than now. With historically low interest rates and potentially depressed asset values due the market downturn, there may some unequaled opportunities to hit a home run using one of the techniques discussed above. Additionally, historically, interests in closely held entities have been eligible for discounts for lack of marketability and/or lack of control under the right circumstances, and if so, these discounts combined with potentially depressed asset values could really result in a big win for a taxpayer who engages in wealth transfer planning based on the current rates.

Of course, the examples are above are purely hypothetical and rely on assumptions which cannot possibly be predicted to come true. The market could continue its downward slide for a few more months or even years, and if so, that would certainly change the effectiveness of the techniques discussed in this article and the examples presented based on the hypothetical assumptions made in such examples. But for taxpayers who believe there is opportunity for appreciation over the next few years, now may be as good a time as ever to transfer wealth downstream without using gift tax exemption.

Footnotes

  1. As noted above, I am not a financial analyst and don’t pretend to be one. Accordingly, I can not say whether the market values are currently depressed, inflated, or about right. That’s anyone’s guess to make. I do not offer any opinions or investment advice.
  2. Rev. Rul. 2020-09. For purposes of this Article, all rates referenced are rates for loans with annual compounding interest.
  3. Id.
  4. Rev. Rul. 2000-19.
  5. Rev. Rul. 2012-23, 2012-24, 2012-30, and 2013-01, respectively.
  6. Rev. Rul. 2016-18, 2016-20, 2016-25, 2019-23, 2019-25, 2020-1, and 2020-6, respectively.
  7. Leimberg.com has a great chart of historical AFR and 7520 rates which can be found here.
  8. Rev. Rul. 2018-21.
  9. Note the examples presented here are based solely on hypotheticals of the assumptions made in each respective example. I do not offer any advice or predictions that the assumptions will or will not come true and such is not to be construed as investment advice. As stated multiple times herein, I am in now way qualified to offer investment advice.