Taking Advantage of Low Interest Rates

The Federal Reserve’s interest rate cuts have
affected two important interest rates used in
estate planning – the “applicable federal rates”
(“AFRs”) under Internal Revenue Code §1274
and the “7520 rate” under Internal Revenue
Code §7520. AFRs are calculated and published
by the IRS every month and represent the
minimum rates of interest that must be charged
on debt instruments to avoid imputed interest
for gift and income tax purposes. The 7520 rate
is also calculated and published each month by
the IRS and represents the interest rate used to
calculate the present value of term interests, life
interests, annuities and remainder interests.
The AFR rate for January for a mid-term note is
only 2.06%. The 7520 rate for January 2009 is
2.4%.
The current environment of low interest rates
presents unique opportunities for clients to make
gift and estate tax-free transfers to children,
grandchildren and charities.

Grantor Retained Annuity Trust

During times of low interest rates, a Grantor
Retained Annuity Trust (“GRAT”) enables
individuals or married couples to shift growth

and appreciation of assets to a lower generation
without significant, if any, gift tax cost.
A GRAT is structured by transferring appreciating
property to a trust to last for a specified duration
of two to five years. In return, the person who
established the trust receives an annuity
payment for each year that the GRAT is in
existence, calculated based on the 7520 rate. At
the end of the GRAT term, any remaining assets
are transferred to the GRAT’s remainder
beneficiaries (usually a grantor trust for the
benefit of the children). If the assets in the GRAT
appreciate at a higher rate than the 7520 rate,
the excess appreciation is transferred to the
GRAT’s remainder beneficiaries free of gift tax.
Thus, the lower the 7520 rate, the greater the
potential appreciation that can pass to the
remainder beneficiaries.
A GRAT can be structured as a “zero-out” GRAT
to eliminate gift tax at formation. To accomplish
this, the terms of the GRAT state that all of the
assets contributed to the GRAT plus earnings at
the 7520 rate must be returned to the
parent/grantor. Thus, for gift tax purposes, the
remainder interest will have a zero value (or a
number close to zero) when the GRAT is formed,
and there will be no taxable gift on formation.
There are several risks that must be considered
in choosing a GRAT transaction. First, if the
parent/grantor dies during the term of the GRAT,
some value of the GRAT’s assets may be
included in the parent/grantor’s estate. Second,
if the assets contributed to the GRAT lose value
or do not outperform the 7520 rate, there will be
no remainder interest at the end of the GRAT to
pass to the remainder beneficiaries. Under that
scenario, the parent/grantor remains in no worse
position than if he or she had not established the
GRAT in the first place (with the exception of
transaction costs). Finally, a parent/grantor
normally cannot allocate generation-skipping
transfer (“GST”) tax exemption to a GRAT until
the end of the GRAT term. As a result, GRATs
are not preferred vehicles to transfer assets to
generation-skipping trusts or directly to grandchildren.

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