The Dow Jones reached an all-time high of 29,551.42 on February 12th. On May 12, it was 23,245. That is nearly a 20% drop in value. You might consider this quite disheartening and feel like it’s all bad news, however, in the area of wealth transfer planning, this can in fact be advantageous! By utilizing these depressed values, we can maximize gifts to our loved ones. Let’s examine two techniques to maximize the benefits of planning and leverage tax exemptions to achieve the ultimate goal of protecting your assets.
Grantor Retained Annuity Trusts (GRATs). GRATs are a very low risk but effective way to transfer assets with little impact on one’s taxable estate. Basically, the grantor would select a low valued asset that has significant growth potential, such as today’s stock. A trust is established for a fixed period of time (anywhere from two to ten years). On the anniversary date of the trust, the grantor receives an annual fixed sum of money from the trust, also called an annuity. The grantor also receives interest from the trust based on a rate set by the IRS, called the section 7520 rate. What makes the GRAT an exceptional plan is earnings accrued by the trust during this period, less the IRS rate, is passed to the beneficiaries tax free.
Understanding how a GRAT works can be difficult, so let’s look at an example. A parent places stock valued today at $1 million into a GRAT for two years, naming her three children as the beneficiaries. In two annual payments, the $1 million has to be repaid to the parent with the rate set by the IRS on the date the trust was established. Presently, for the month of May, this rate is 0.8%. This means on the first and second anniversary of the trust the parent would receive $504,000 totaling $1,008,000 at the two-year mark, paid by the trustee. During this time what is transpiring in the trust? Because the trust was initially comprised of stocks at extremely depressed values, history tells us earnings should increase. Since 1982, the one-year performance of US stocks in a year following a bear market averaged 41.1%. If the stock increase is similar to the response post previous bear markets, an increase of 40% would leave you with an additional value of $400,000 above the initial investment of $1 million. The $8000 due in interest due the grantor (the parent) will be deducted from the $400,000 leaving $392,000 to be split between the beneficiaries (the three children). The beauty of the GRAT is the beneficiaries of the trust (the three children) receive this sum tax free. The only real risk undertaken with the GRAT is if the $1 million of stock decreases, although the grantor would receive the assets back the beneficiaries would receive nothing.
Intrafamily Loans. The IRS Code and Regulations allows family members to make loans with interest rates lower than commercial lenders without it being deemed a gift, designating it as tax free. Currently, for a loan with a term between 3 and 9 years, the interest rate may be as low as 0.58%. The parent as the lender has the option to structure the loan as a balloon note, therefore the borrower child only pays interest during the term of the loan and repays the principal at the end of the term. In order for this to be effective, the child must have a higher rate of return than the interest rate (0.58%). For example, let’s suppose a parent makes a nine-year loan to a child for $3 million. If the child invests the $3 million for 9 years at an 8% annual rate of return, he or she will have approximately $5,997,014. Over the 9 years, the child would have to repay the parent lender $3,079,706 ($3 million + interest). As a result, the parent was able to transfer $2,917,308 (earnings over 9 years – (the original loan + interest)) to their child’s estate gift tax free.
Change is on the horizon which makes planning today paramount. An election is approaching, and depending on the ultimate outcome, estate and gift tax exemptions could be rescinded. Furthermore, we could see significant tax increases. Also, consider the repercussions of COVID-19, that $2 trillion stimulus package must be paid for, and one way to do this is rollback exemptions for the gift and estate tax.
COVID-19 has produced catastrophic effects globally. It will take time to recover and yet we will recover! This crisis is not indefinite, it will end. In the meantime, use this time to plan and utilize the downturn to grow and protect your assets. Once the crisis has passed this optimal opportunity for wealth transfer planning will not present itself again soon. And remember, most importantly, do what it takes to keep you and your loved ones healthy!