Recently released Applicable Federal Rates (“AFRs”) for the month of August create significant estate planning opportunities. The combination of the low Internal Revenue Code Section 7520 rate (“7520 rate”) and the proposed tax increases in the campaign platform of former Vice President Joe Biden present a critical time for clients to evaluate tax savings opportunities.
The IRS has established a 7520 rate for August of 0.4%, with short-term, mid-term, and long-term AFRs of 0.17%, 0.41%, and 1.12%, respectively. With the extended tax due date of July 15th finally past and with the low interest rate environment continuing unabated, clients should now be looking to take advantage of the gift tax planning opportunities the low rates afford.
Time is particularly of the essence for gift tax planning as 2020 is an election year and the Biden campaign’s tax proposal includes several provisions that would undo the current advantageous rules for gifting. Most prominent among these is Biden’s proposal to eliminate the step-up in basis for property transferred by gift or by death and treating such transfer as a realization event, creating an immediate tax on all appreciation. This tax would be further increased by an elimination of the favorable capital gains tax rates for taxpayers with income of $1 million or more. Biden is also likely to seek a substantial reduction of the current estate and gift tax exemption of $11.58 million, creating even less leeway for planning centered around lifetime gifts.
In anticipation of these possible changes and recognition of the low interest rate environment, clients may wish to consider using their current exemption to fund a split-interest trust such as a grantor retained annuity trust (“GRAT”) or charitable lead annuity trust (“CLAT”). By funding such a trust with an investment expected to appreciate and ensuring that the value of that investment plus a return equal to the 7520 rate is paid out to the grantor or a charity respectively, any remaining value in the split-interest trust will be passed out to the remainder beneficiaries free of gift tax. Unlike GRATs, CLATs will be able to take advantage of the August 7520 rate of 0.4% in September and October as well, mitigating the risk of a rise in rates. Although GRATs and CLATs are not advantageous for transfers to skip persons, as the estate tax inclusion period (“ETIP”) set at the end of the term requires generation skipping tax exemption to be wasted on annuity payments, these difficulties can be mitigated for a GRAT by selling the appreciated GRAT property to a separate dynasty trust at the end of the GRAT’s lifetime. Due to the sophistication of the dynasty trust sale strategy, working closely with tax and legal advisors is recommended.
An additional planning opportunity to consider is the sale of property to an intentionally defective grantor trust. By selling property to such a trust in exchange for a promissory note with interest set at the prevailing AFR rate, income tax consequences to the grantor are avoided and the beneficiaries of the trust are able to harvest the gains obtained when the investment beats the AFR rate. The low AFR rates make most investments likely to clear this threshold and also limits the cost to trust beneficiaries.
With the 7520 and AFR rates continuing to reach historic lows, clients who face estate tax exposure should consider utilizing these planning strategies now before the estate tax environment changes. Those who act quickly stand to pass on significant wealth tax-free and to enjoy the benefits of highly favorable estate tax and capital gains tax provisions as they currently exist.
Please reach out to FGMK with any questions.
Charles F. Schultz
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