Tax, Trusts & Estates Law Monitor : Estate Planning Lawyer & Attorney : Cole Schotz Meisel Forman & Leonard Law Firm : NJ, Mid-Atlantic Gift Tax & Trust Issues

The IRS recently released the Applicable Federal Rate, or “AFR,” for October, 2011.  The AFR is a key interest rate used in connection with a number of the more sophisticated estate planning techniques, such as grantor retained annuity trusts (“GRATs”), sales to intentionally defective grantor trusts, and qualified personal residence interest trusts (“QPRITs”).

The mid-term AFR for October is 1.4%, which is historically low.  This means that GRATs, sales to grantor trusts, and intra-family loans are even more attractive in October because the amount that is required to be paid back to the donor under these techniques is relatively lower due to the extremely low interest rate. 

On the other hand, techniques in which the value of the gift is dependent upon the value of the income interest retained by the grantor, such as QPRITs or charitable remainder annuity trusts (“CRATs”), are not as attractive.  For these techniques, the low interest rate leads to a lower value for the retained interest and a higher value for the remainder interest, thereby resulting in a larger taxable gift when the technique is implemented.

With the increased lifetime gift exclusion ($5 million in 2011 and 2012) and the possibility that the use of GRATs may be restricted in the future, now may be the time to explore some of the estate planning approaches that have been enhanced by historically low interest rates.

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One of the lesser known components of the 2010 estate tax repeal is that the gift tax rate in 2010 is 35%, as opposed to the 45% gift and estate tax rate that was in place in 2009. This presents a planning opportunity for a taxpayer to reduce his taxable estate and save a significant amount of taxes if the taxpayer believes that his estate will be subject to an estate tax in the future.

Absent new legislation, the 2010 estate tax repeal will sunset in 2011, with the estate tax reinstituted at rates as high as 55% and an exclusion amount equal to $1 million (adjusted for inflation). Gifts in excess of $1 million also will be subject to gift tax at rates as high as 55%. Thus, gifting assets in 2010 at a lower rate will ultimately transfer significantly more wealth to a taxpayer’s beneficiaries.

Assume that a taxpayer desires to gift $10 million to his children and has used his lifetime gift exclusion. In 2010, the gift tax on this gift, payable at a 35% rate, would be $3.5 million. Taxpayer would pay the gift tax so the total outlay for the taxpayer to get $10 million to his beneficiaries would be equal to $13.5 million. Assuming that the taxpayer survives three years from the date of the gift, the amount of the gift tax paid will not be included in taxpayer’s estate.

Now assume that the same taxpayer does not make the gift in 2010, and dies with $13.5 million in his estate in a year where the maximum estate tax rate is 55% (and said taxpayer also has used his full exclusion amount). The amount of estate tax due on the $13.5 million included in the taxpayer’s estate would be approximately $7.5 million, leaving approximately $6 million to pass to the taxpayer’s beneficiaries. On these facts, the 2010 gift of $10 million increases the net amount passing to taxpayer’s beneficiaries by almost $4 million.

The lower gift tax rate combined with the fact that the gift tax paid is not subject to estate tax (assuming taxpayer survives three years from the date of the gift) can produce dramatic savings for taxpayers inclined to make gifts in 2010 and pay gift tax.

Even more dramatic savings can be achieved in 2010 if the taxpayer’s beneficiaries are grandchildren. Due to the fact that the generation-skipping transfer (“GST”) tax is repealed in 2010, a gift in 2010 to grandchildren will not trigger a GST tax. If the same taxpayer dies in future years leaving these assets to grandchildren, the assets will be subject to both estate tax and a significant GST tax (up to 55%), further diminishing the amount ultimately passing to grandchildren.

There are less than three months remaining (assuming no retroactive application of new gift and estate tax laws) to implement this planning.

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The IRS recently announced in Revenue Procedure 2009-50 that the gift tax annual exclusion amount available to taxpayers in 2010 will remain unchanged at $13,000. The Tax Reform Act of 1997 tied the then $10,000 gift tax annual exclusion to cost of living adjustments based on increases in the Consumer Price Index. As a result, since 1998, the annual exclusion has increased from $10,000 to $13,000. The annual exclusion permits a taxpayer to gift $13,000 annually to any beneficiary without being required to use his or her $1 million lifetime gift exemption amount.

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The IRS has issued the Applicable Federal Rate (“AFR”) for September, keeping the AFR rate under Code §7520 unchanged from August at 3.4%. What this means is that GRATs are still very attractive estate planning devices for taxpayers. The AFR rate is the interest rate the IRS requires taxpayers to apply to the amount gifted to the GRAT to value the gift at zero. If the gifted assets appreciate at an amount greater than 3.4%, then notwithstanding any valuation discounts attributable to the gifted assets, the appreciation in excess of 3.4% would pass gift tax-free to the GRAT’s beneficiaries. Thus, the lower the AFR rate, the more attractive GRATs are to taxpayers.

In light of proposed legislation in Congress requiring only long term GRATs and limiting valuation discounts, now may be the time to implement a GRAT.
 

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