Arbitraging interest rates to transfer wealth

August 2, 2011
| By Dan Fuller |
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Although it appears we are not out of the economic storm that started in late 2008, family-owned businesses are returning to profitability. As such, families are looking at ways to transfer the value of their businesses with the least amount of tax cost.

Since values are still below pre-2008 levels and interest rates are historically low, now is a good time to engage in estate and gift tax planning for your family business and other assets you may wish to transfer to future generations. Remember, this is a process and you do not have to transfer all of your assets, and the transfer can be made effective for years down the road.

Many individuals who are planning their estates are aware of the lifetime gift exemptions of $5 million (in 2011 & 2012) and the annual gift tax exclusion of $13,000. There are many strategies that maximize the value of these exemptions/exclusions. However, with interest rates at a four-year low, there are certain wealth transfer strategies that are more powerful in this type of an environment. Grantor Retained Annuity Trust

GRATs are probably the more common strategy in the current low interest rate market as they have virtually no downside risk other than the cost to set them up. One of the more powerful versions of a GRAT — a two-year term GRAT used where an asset is expected to have a dramatic increase in value — has been on Congress’s hit list. In June, the House passed legislation that would set a minimum 10-year term for a GRAT. These are the same provisions the House passed in 2010 but were rejected by the Senate. This revenue-raising provision alone is expected to raise $5 billion, illustrating how effective this technique can be. Will they be successful in getting the provisions passed this year? Will they try to make them retroactive to the beginning of 2011? One can only speculate.

To set up a GRAT, a person or grantor contributes an appreciating asset into an irrevocable trust for a stated period of time in exchange for an annuity. In order to maximize the benefit of a GRAT, the asset placed in trust should be one that is expected to appreciate in value over the term of GRAT greater than the annuity interest rate (currently 2.4 percent). One of the best assets is closely held stock or partnership/LLC units, since additional tax savings can be realized through valuation discounts. These discounts are typically for lack of control or marketability. The discounts reduce the value of the assets placed in the GRAT, which reduces the principal of the annuity, thus allowing you to pass more wealth. During the term of the GRAT, the grantor is considered the beneficial owner of the assets, which allows the grantor to vote the stock. As a beneficial owner, the grantor also retains the tax obligation on any income or gains generated by the trust. Once the term of the GRAT is complete, the remaind
er of the assets pass to the determined beneficiary.

Assume that a grantor in the highest tax bracket places stock worth $10M with a growth rate of 10 percent into a 20 percent stepping payment two-year GRAT. This scenario would result in a transfer of more than $1.3M tax free.

Charitable Lead Trust

For those who are charitably inclined, the Charitable Lead Trust strategy allows an owner to transfer an asset to his or her beneficiary, and, in the process, have the income generated given to a qualified charity. Oftentimes, this technique can be used to transfer wealth to the next generation that could be used as “seed money” to purchase the shares in the family business through direct purchases or seed other estate-planning techniques. Given that a CLT allows the flexibility to designate multiple/different beneficiaries each year, this technique works well for persons who have pledged money to a charity or have charities they give to on a regular basis. 

To set up a CLT, a person would make a lifetime transfer of cash or property in trust for the benefit of charity over a fixed term of years, lives of one or more non-charitable beneficiaries, or the shorter or greater of either. Additionally, the grantor has the choice of payout to charity as a fixed, increasing, or a “balloon” amount that is determined on the basis of the trust’s fair market value at time of funding. At the conclusion of the defined time period, the assets remaining in trust after expiration of annuity interest revert to the donor or pass to heirs. Like the GRAT, the wealth transfer benefit is greater as the spread on the growth rate increases.

Assume that a grantor in the highest tax bracket places stock worth $5M with a growth rate of 6 percent into a 10-year zero-out CLT. This scenario would result in a transfer of more than $1.M tax free, with the charity receiving $6M through annual payments of $600,000.

Intra Family Loan

With the minimum interest rates required by the Internal Revenue Service (called the Applicable Federal Rates) being so low, many times families can set up loans with interest rates much lower than what can be found commercially. Outside of pure cash savings on lower interest rates, this technique can be used to fund the purchase of high growth rate assets, resulting in a benefit of the arbitrage.

Assume a parent loans $100,000 to his child for 10 years at the current AFR so he or she can start up an investment fund. The child is to pay back principal and interest over the 10 years based on the terms of the loan.

If the child invests this money in a fund that has a return rate of 6 percent, then at the end of the 10 years, it will be worth $168,948. In comparison, the total basis for the loan at this time is $121,458, which the principal and interest will have been paid annually at the end of the 10 years. Any gains that are earned from the fund are not subject to gift tax, so in essence the parent has transferred the difference, $47,490, tax free to the child.

With interest rates so low, it can be seen that vehicles for passing on wealth to the next generation are now capable of offering even greater tax benefits. It would be worth discussing all the possible opportunities with your financial advisor and soon, as who knows how long the rates will stay this low or when congress may limit some of the techniques.

Dan Fuller is a senior tax director in the Grand Rapids office of BDO USA LLP. He can be reached at (616) 802.3406 or

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