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Low Interest Rates Promote Leveraged Wealth Transfer Opportunities

A. A. Ponda, C. C. Curtis, L. N. Mingolla, D. J. McLaughlin and K. E. Woodman

There are a number of wealth transfer techniques that allow you to siphon off for your family's benefit, free of additional estate or gift taxes, the investment return on assets in excess of a set interest rate. Each month the Internal Revenue Service issues a set of minimum interest rates, and the rates for August 2003 are in general some of the lowest since the IRS began issuing rates in 1989. A key rate is at 3.2%, which is nearly as low as it has ever been. Although the ultimate benefit to your family depends on the investment performance of the assets transferred, the use of leverage in making gifts could have extraordinary results at little or no gift tax cost. It is possible to lock in the current low rates for many years, so you should consider using these techniques soon in case rates increase.

Loans to Family Members. You can make direct loans at low interest rates to family members or trusts for their benefit without incurring a gift tax cost, provided you charge sufficient interest. For August 2003 the minimum rate on a long-term loan of nine years or longer is 4.36%, assuming annual compounding, and lower rates are available for loans with shorter terms. You can make the loan a demand loan and obtain an even lower rate currently, but one that will increase if future rates are higher. By contrast, a term loan requires a higher rate now, but can lock in what are in general very low rates for a long period of time. If the loan proceeds can be invested for a return that exceeds the interest rate, your family will reap the excess without estate or gift tax. You must report the interest as income, and the payer will generally be able to take an investment interest expense deduction if the loan proceeds are invested in investments that produce taxable income. If your income tax rate is higher than the borrower's, there is a potential net income tax cost which must be weighed against the potential wealth transfer tax benefit.

Grantor Retained Annuity Trust ("GRAT"). With a GRAT, you transfer assets into an irrevocable trust. By the terms of the trust instrument, the trust must pay you an annuity at least annually for a fixed term of years which is based on the value of the property you transfer. Your goal is to set your annuity, as a percentage of the assets transferred, so that the present value of your annuity using the relevant federal interest rate is equal to the value of the property you transfer. There is then no present value for the remainder interest in the GRAT, which you can leave to your children, and you have minimized the gift tax cost of the transfer to the GRAT. Lower interest rates allow you to use a lower annuity amount to satisfy this condition. Your family receives (outright or in trust) whatever balance is left in the trust at the end of the annuity term, so a transfer to a GRAT is like a nonrecourse loan to them and does not cause them any income tax consequences during the term of the annuity. If the assets perform well, your family could receive substantial wealth, but if the assets do not perform at least as well as the federal interest rate at the time of the transfer, your annuity would exhaust the GRAT and you would receive all of the assets back. During the annuity term the trust is a grantor trust for income tax purposes (that is, you are subject to income tax on all of its income or gains) so the transfer of its assets back to you does not require you or the GRAT to recognize any taxable gain. If you die during the annuity term, it is likely that the entire remaining balance of the trust would be included in your taxable estate, which eliminates the potential estate and gift tax savings. If you survive the annuity term, the downside is that a transfer to a GRAT has historically involved a relatively small taxable gift, so if the assets do not perform well, you could make a taxable gift that does not provide any net benefit to your children; however, recent tax cases have indicated that you have some options to reduce or eliminate any taxable gift. One other benefit (and potential drawback) to a GRAT is that because it is a grantor trust for income tax purposes, you must pay income tax on income and gains that accrue for the benefit of your children, and payment of the tax is not at this time considered a gift to your children (the potential drawback is that if the GRAT performs very well, income taxes on income and gains could cause you liquidity problems unless the terms of the GRAT provide for extra distributions to you for income taxes). One other disadvantage is that you generally cannot provide that a GRAT can make generation-skipping distributions to grandchildren without material generation-skipping transfer ("GST") tax consequences.

Charitable Lead Annuity Trust ("CLAT"). A standard CLAT resembles a GRAT except that one or more charitable beneficiaries would receive the annuity instead of you, but any remaining balance at the end of the term would still be payable (outright or in trust) for the benefit of your family. The charitable annuitant can be a private foundation, an account with a donor-advised fund (for example, the Fidelity Investments Charitable Gift Fund) or a charity to which you would otherwise make substantial periodic contributions. You can establish a CLAT without any current gift tax cost, because the present value of the charitable annuity, which is generally equal to the value of what you transfer, offsets any taxable gift. However, you would not get any charitable income tax deduction for the transfer; rather, the CLAT would get an income tax deduction for making payments on its annuity obligation. Alternatively, you could set up the CLAT as a grantor trust to get the income tax deduction for the transfer, though you would then be taxed on income earned by the trust even though the charity would ultimately receive it. As with a GRAT, you generally cannot make a generation-skipping transfer to grandchildren via a CLAT without material GST tax consequences.

Charitable Lead Unitrust ("CLUT"). A CLUT resembles a CLAT except that instead of an annuity, the charitable beneficiary receives a unitrust interest, which is a payment based on a set percentage of the value of the CLUT's assets, usually determined as of the beginning of each year. Because of the variability of the payments, it is unlikely that the CLUT will ever be exhausted, but the charitable beneficiary also shares in increases in value. It is not possible to set the unitrust percentage to avoid incurring a taxable gift upon the transfer. The potential benefits are that there is more likely to be at least some balance remaining at the end of the unitrust term, and you can use a CLUT to make a generation-skipping transfer with minimal current GST tax and no additional GST tax upon termination of the unitrust term.

Installment Sale to an Intentionally Defective Grantor Trust ("IDGT"). You can "freeze" the estate tax value of an appreciating asset by having an irrevocable grantor trust purchase the asset from you with a note. Because the sale is between you and your grantor trust, for income tax purposes you would not recognize gain on the initial sale, and you would not recognize interest income or expense. The note will be payable at a low interest rate, and appreciation beyond that rate will stay in the trust to pass to the remainder beneficiaries free of transfer tax. If structured properly, only the note and not the IDGT's assets should be included in your estate if you die during the term of the note, whereas all of the trust assets of a GRAT would likely be includible in your estate if you die during the GRAT's annuity term.

(If you have any questions regarding these interest-sensitive estate planning techniques, please contact any member of our Tax or Trusts and Estates Departments, including one of the co-authors, Ameek A. Ponda at (617) 338-2443, Christopher C. Curtis at 617) 338-2839, Lisa N. Mingolla at (617) 338-2431, David J. McLaughlin at (617) 338-2833 or Keith E. Woodman at (617) 338-2956. Because sound legal advice must necessarily take into account all relevant facts and developments in the law, the information you will find in this memorandum is not intended to constitute legal advice or a legal opinion as to any particular matter. )

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