Article by Donald A Hamburg and Steven G Chill

To our clients and friends:

As you know, the Federal Reserve Board has been reducing interest rates during the year bringing the prime rate to 5.0%. Not only have interest rates on commercial loans, mortgages and consumer borrowings dropped to the lowest levels in more than a decade, but there is another interest rate that has been affected as well. We are referring to the interest rate that the IRS sets every month for determining the minimum rate of interest required to be charged on loans to family members. This is known as the "Applicable Federal Rate". In the IRS Revenue Ruling released on November 21, 2001, the IRS set the rate for December transactions at 2.48% for short term loans (that is, loans of up to 3 years) where the interest is payable annually. For mid-term loans (i.e. from 3 to 9 years) the annual rate is 3.97% and for loans of more that 9 years, the annual rate is 5.05%.

This dramatic drop in interest rates reminds us to dust off several tried and true estate planning opportunities. For example: parents making low interest loans to children or grandchildren. By making a loan to a family member who will pay you interest at these low rates, the borrower can use the funds to earn more income or achieve capital gains from his or her investments. At the end of the term of the loan, the principal must be repaid to the lender, and for security the lender may want to take back a mortgage or other collateral (such as a lien on whatever investments are made by the borrower).

Since the loan will be made using the prescribed Applicable Federal Rate, there will be no gift aspect to the transaction, as long as the interest on the loan is paid at least annually and the loan is repaid when due. The result of utilizing this technique is simply that the difference between what the borrower earns on the loaned monies and the amount the borrower pays in interest will be a "gift-tax-free gift" from the lender to the borrower.

Illustration: Parent loans child $100,000 for 3 years and child invests the loan proceeds and achieves a 9% annual return from investments in stocks and bonds. Child's gross profit would be $27,000, his interest payments to parent would be $7,440 and child's profit (before income taxes) would be $19,560. If the loan was for $1,000,000, the gift-tax-free transfer of wealth from parent to child would be $195,600 at the end of 3 years.

The low Applicable Federal Rates also encourage estate planning through the use of Grantor Retained Annuity Trusts ("GRATs"). Here the interest rate (known as the Section 7520 rate) is 4.8% for the month of December, 2001. To the extent that one can achieve investment performance greater than that rate, the remaindermen (children or grandchildren) of the GRAT will receive the "profit" free of estate and gift tax.

Illustration: Parent transfers $1,000,000 to a 5 year GRAT and he retains an annuity of $237,287 per year for the 5 year term. Parent will get back a total of $1,186,436 over the 5 years. There is no gift tax on the creation of the GRAT since the actuarial value of the annuity the parent retained (using the 4.8% rate in the actuarial computation) is equal to the amount he transferred to the trust. If the investments of the trust achieve a 9% annual return, when the trust ends, the remaindermen (children or grandchildren) will receive the entire balance of assets in the trust which, in this example, will amount to $118,529.

The only possible adverse tax consequence to using a GRAT is if the creator of the trust dies before the end of the term. In that event, a portion of the assets of the GRAT would be included in his estate and be subjected to estate taxes (which would have been the case if the GRAT had not been created).

The foregoing are just two estate planning techniques that benefit from low interest rates. Other techniques include: charitable lead trusts, installment sales of assets (including family limited partnership interests) to family members or trusts for their benefit.

If you would like to learn more about these or other estate planning techniques that could be appropriate for your family, please give us a call.

 

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.