What Does Estate Planning Have To Do With Interest Rates . . . Part II

Talk of interest rates seems inescapable as inflation hovers at a forty-year high and we feel that impact every time we open our wallets. Many sophisticated Financial and Estate Planning techniques derive their value from the prevailing interest rate. Certain techniques work better in low-interest rate environments, while others produce better results in high-interest rate environments. This second part will detail the use of techniques that work better in a high-interest rate environment, including the Charitable Remainder Trust (“CRT”) and a Qualified Personal Residence Trust (“QPRT”).

As the opening paragraph indicated, the techniques that I recommend should be influenced by the prevailing interest rate. As a reminder, to grasp the impact of interest rates on Estate Planning, you need to understand interest rates in general. Each month, the Internal Revenue Service (“IRS”) publishes the Applicable Federal Rate (“AFR”) under Internal Revenue Code (“Code”) §1274 for short-term loans (0-3 years), mid-term loans (3-9 years), and long-term loans (more than 9 years) along with the §7520 rate which is 120% of the mid-term AFR rounded to the nearest 2/10ths. Practitioners use the §7520 rate to calculate annual payments for certain estate planning techniques. Use of the appropriate AFR on a loan between related parties prevents imputed income or gift taxes. Note that if the IRS considers the loan a gift, the lender/donor still may apply their annual per donee exclusion (currently $16,000) to the gift as well as using any portion of their applicable exclusion amount (currently $12.06 million) to cover the gift. Use of the appropriate AFR prevents use of the annual per donee exclusion or applicable exclusion amount.

As noted above, certain estate planning techniques, such as CRTs and QPRTs, work better with higher interest rates. A CRT has two beneficiaries, the non-charitable beneficiary who takes the lead or income interest, and the charitable beneficiary which takes the remainder interest. A CRT may be set up as either an annuity trust or a unitrust. An annuity trust pays out a fixed dollar amount each year to the lead beneficiary. A unitrust pays out a fixed percentage of the trust each year to the lead beneficiary. With a unitrust, if the trust corpus grows, the amount going to the lead beneficiary grows right along with it. With an annuity trust, the lead beneficiary’s payment doesn’t change if the trust corpus increases or decreases.

Charitable trusts provide numerous benefits. For example, although the Code considers the CRT a tax-exempt entity, the CRT may distribute the annuity or unitrust interest to a non-charitable beneficiary without jeopardizing that status. In addition, the grantor receives an income tax deduction, subject to limitations under Code §170, upon funding the CRT for the present value of the charity’s right to receive the remainder. A CRT removes the assets from the estate for estate tax purposes. Finally, the CRT provides the most benefit for highly appreciated assets. By transferring the appreciated assets to the CRT well in advance of the sale, the later sale by the CRT produces an income stream (in the form of the annuity or unitrust payment) for the grantor or other designated individual. Only as the grantor or other designated individual receives the annuity or unitrust payment will he or she recognize the capital gain which occurred when the CRT sold the assets. The tax attributes of the income earned over the life of the CRT flavor the distributions to the lead beneficiary.

To achieve the desired tax consequences, a practitioner needs to follow specific rules when creating a CRT. Failure to follow them precisely will cause the CRT to fail. For example, split-interest trusts that distribute all income to the lead beneficiary do NOT qualify for a charitable deduction, even if the entire remainder goes to charity. The greater the stream of payments going to the non-charitable lead beneficiary, the smaller the actuarial value of the interest going to the charitable remainder beneficiary. Thus, a higher rate of return will provide more income to pay the retained annuity or unitrust amount, thereby increasing the value of the assets remaining for the charitable remainder interest. The remainder value determines the charitable income, estate, and gift tax deduction available to the grantor.

The other estate planning technique that works better in a high-interest rate environment is the QPRT. The grantor contributes their residence to the QPRT. The terms of the QPRT allow the grantor to use the residence as their own during the initial term of the trust, while the remainder goes either outright or in further trust for named beneficiaries. Upon the expiration of the QPRT, the grantor must pay fair market value rent to the new owners of the home (i.e., the trust or the beneficiaries) for continued use of the home. If the grantor dies during the term of the QPRT, then the date-of-death value of the QPRT will be included in the grantor’s estate and subject to estate taxes. However, the grantor’s estate will receive credit for any tax consequences of the initial gift to the QPRT, putting the grantor in no worse a position than if he or she had never created the QPRT.

QPRTs provide several benefits to the grantor of the trust. Creating a QPRT results in a gift to the remainder beneficiaries of the discounted present value of the remainder interest of the QPRT using the rate under §7520. Any appreciation in the value of the home passes without additional estate or gift tax consequences. Use of the QPRT removes the home from the grantor’s estate as long as the client survives the term of the QPRT. In addition, QPRTs provide an asset protection component because the grantor only has a right to use the residence for a term of years, instead of the full bundle of property rights in the home. Not only does this reduce the value of the property rights for attachment by creditors, but it increases the inconvenience to the creditor because the grantor (or the creditor standing in their shoes) cannot force a sale of the home. Finally, using multiple QPRTs allows for discounting when determining the value of the gift.

As noted above, a QPRT works well if the home appreciates faster than the §7520 rate. A grantor can increase the estate tax savings by splitting the house into two or more fractions and establishing separate QPRTs for each piece. Splitting the house allows the grantor to discount the value of the house. If the grantor has a spouse, then it’s common to have each spouse put one-half of the home into separate QPRTs. This allows the clients to minimize the risk against one of them dying during the term of the QPRT. If the couple desires additional discounting or protection, then each could set up multiple QPRTs with differing terms thereby decreasing the likelihood of death during the term of the QPRTs.

The above techniques work better in high-interest rate environments. Remember that certain strategies like Tenancy in Common Fractionalization and Family Limited Partnerships or Family Limited Liability Companies do not depend upon interest rates at all. Finally, although the techniques discussed in Part 1 of this article work better in low-interest rate environments, it may make sense to utilize them in certain situations even when rates are higher.