By Jan P. Myskowski
By Jan P. Myskowski
Following the dramatic changes in the economy, the Internal Revenue Code section 7520 rate required for valuation of retained interests plummeted from 5.0% in December, 2007, to 3.4% in December, 2008, and has dropped to the dramatic low of 2.0% for February, 2009, a rate never before seen since the enactment of section 7520 in 1989.
Acutely low interest rates make for interesting times in the estate planning world. Rare opportunities arise to shift wealth at reduced transfer tax burdens, but a larger than usual gap opens in the comparative utility of various planning techniques, placing greater emphasis on the importance of analyzing the appropriate technique for any given client. Planning vehicles such as Grantor Retained Annuity Trusts (GRATs) become particularly attractive, while others, such as Qualified Personal Residence Trusts (QPRTs) lose some of their appeal (although plummeting real estate values make this technique viable despite the effect of low rates).
GRATs offer a number of estate and gift tax advantages, not the least of which is relative simplicity, making them more likely to be implemented by clients than other more esoteric estate planning techniques. In a GRAT transaction, the donor conveys an asset to an irrevocable trust, the terms of which provide that the donor will receive an annuity payment for a fixed term. Because the donor retains the right to receive this stream of payments, the value of the asset donated to the trust is reduced for federal gift tax purposes by taking the present value of this retained interest into account. GRATs work particularly well for assets such as income-producing real estate that is expected to appreciate in value. The income produced by the real estate provides cash flow for the trustee’s annuity obligations. Future appreciation in the asset inures outside of the donor’s taxable estate, and is permanently removed from the donor’s estate so long as the donor survives until the end of the fixed period during which the annuity is payable (death of the donor prior to that point results in the asset being included in the donor’s taxable estate). Funding a GRAT when both interest rates and asset values are deflated is particularly advantageous.
Under the anti-freeze provisions of the Internal Revenue Code, gifts subject to retained interests are typically valued by assigning a zero value to the retained interest (resulting in a gift tax value equal to the full fair market value of the donated asset). However, GRATs are specifically carved out of the anti-freeze rules because valuation of the retained annuity interest using the rates proscribed by section 7520 prevents valuation abuse.
Because low interest rates result in the assumption that greater amounts of trust principal will be required to support the trustee’s annuity payment obligation, low rates result in a higher value being assigned to the retained interest, and a corresponding reduction in the value of the resulting gift for federal gift tax purposes.
For example, applying the January, 2009, 7520 rate of 2.4%, a donation by a donor aged 65 of an asset with a fair market value of $500,000, subject to a $25,000 annual annuity obligation for a 10-year term, would result in a taxable gift of only $302,935. Conversely, under the 5.0% 7520 rate in effect just one year ago, the same transaction would result in a taxable gift of $326,090.
However, the historically low 7520 rate has the inverse effect on QPRTs. If the same 65-year-old donor were contributing a $500,000 residence to a 10-year QPRT in January, 2009, evaluated under the 7520 rate of 2.4%, the value of the resulting gift would be $299,840. Had the donor funded the QPRT in December, 2007, when the 7520 rate was 5.0%, the resulting gift would have been only $233,345. This is because a QPRT has no cash flow obligation to the donor. The donor reserves only an in-kind occupancy right, and hence there is less “drag” on the value of the remainder interest. The only downward pressure on the remainder interest is the effect of inflation, which is greater when interest rates are high.
QPRTs and other similar techniques should not be disregarded in low rate environments, however. When rates are low, values are likely depressed as well, and seizing the opportunity to transfer an asset when its value is depressed can be more important than trying to time the rates. For example, if the donor above found that his residence had depreciated from $500,000 to $400,000 between December, 2007, and January, 2009, his opportunity to transfer the residence at an advantageous transfer tax cost would be approximately the same at both points in time. Whereas the December, 2007, transaction, at a market value of $500,000, yielded a gift of $233,345, a transaction in January, 2009, at a market value of $400,000, would yield a gift of $239,872. The decline in asset value almost entirely neutralizes the negative effect of the low 7520 rate.
The gap in the comparative utility of the various charitable planning vehicles also widens in a low rate environment. For example, charitable lead annuity trusts become more attractive, while charitable remainder annuity trusts lose some of their luster. A low 7520 rate drives up the value of the charitable lead interest in a charitable lead annuity trust, leading to greater income tax and gift tax charitable deductions and a lower resulting non-charitable remainder gift; but a low rate drives down the value of the charitable remainder interest in a charitable remainder annuity trust, driving down the resulting charitable deductions for gift and income tax purposes, and driving up the value of the non-charitable interest subject to gift tax.
Although the analysis will become a little more challenging, in general, the combination of an historically low 7520 rate and historically low asset values will make 2009 one of the best years in recent times to implement lifetime wealth transfer planning.
IRS CIRCULAR 230 NOTICE – To ensure compliance with IRS requirements, we inform you that any tax advice contained in this communication (or in any attachment included as part of this communication) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.