April 27, 2020
Commerce Family Office Managing Director Richard English collaborates closely with clients on strategies for addressing complex personal and family financial challenges that can accompany significant wealth. Many of these issues impact current and future generations. Richard has more than 30 years of experience providing comprehensive and sophisticated estate planning services to high-net-worth families. He holds a law degree from the University of Kansas and an undergraduate degree from Washington University. Richard shares his thoughts in this Commerce Trust commentary on a few opportunities for tax-advantaged wealth planning techniques that may be appropriate during the recent economic volatility.
The first falls in the category of intra-family loans. While you cannot typically make an interest-free loan to a family member without adverse tax consequences, you can make a loan at a very low interest rate, if you follow certain guidelines.
Each month, the IRS publishes the Applicable Federal Rate (AFR) – the minimum interest rate that can be charged on private loans of various lengths. For the month of May 2020, these AFRs will be at or near historic lows. For loans initiated in the month of May, these rates will be as follows:
Short-Term AFR (loans of up to 3 years): 0.25%
Mid-Term AFR (loans of more than 3 years up to 9 years): 0.58%
Long-Term AFR (loans of more than 9 years): 1.15%
These rates are significantly lower than they were as recently as March.
A private loan based on a rate of interest at least as high as the AFR will avoid certain adverse tax consequences, such as imputed interest. Structured as an intra-family loan, this can allow a parent or other lender to significantly reduce the borrowing costs for a child or other family member by lending at a low rate.
A second unique opportunity concerns the sale of assets, which can take advantage of temporarily lower stock values. Some estate planning techniques involve a sale of assets in exchange for a promissory note. A common technique is the sale of an asset considered to have strong potential for appreciation. If the seller takes back a note as part of that sale, the ability to charge a lower interest rate increases the potential success of this transaction.
If the asset that is being sold has a low current value, there may be more potential for appreciation. For example, if a parent were to sell a portfolio of stocks to a trust for the benefit of his or her children, the appreciation of that portfolio after the sale would occur outside of the parent’s estate.
The purchaser in these transactions is often a “Grantor” trust for income tax purposes. When structured properly, a sale to such a trust will usually avoid triggering capital gains tax.
A third opportunity is the use of a Grantor Retained Annuity Trust, or GRAT, which is different from a loan but also benefits from low interest rates. With a GRAT, the person creating the trust transfers assets that the person believes have the potential to appreciate. For a set number of years, the person receives an “annuity” payment each year from the GRAT. That payment can be made in cash or in shares of stock (which may have appreciated in value). At the end of that term of years, any assets remaining in the GRAT (after making the annuity payments) pass to the person’s beneficiaries with little or no gift and estate tax consequences.
As an example, assume that Parent transfers a stock portfolio currently worth $5 million to a GRAT in May 2020. As part of the governing trust document, Parent reserves the right to receive five annuity payments, each in an amount slightly more than $1 million. Those payments are made annually, in May of each year, beginning in 2021 and ending in 2025. The annuity payments can be funded with cash, but will likely consist in large part of shares of stock from the portfolio. If the stocks remaining in the GRAT appreciate at the rate of 5% per year during the 5-year term, the assets remaining in the GRAT after the 5-year term will be worth almost $1.4 million (more appreciation yields more value, while less appreciation yields less). At that time, those assets can be distributed to Parent’s children without estate or gift tax cost. This technique has the following advantages:
■ It works well with assets that appreciate in value after being transferred to the GRAT. Stocks with currently depressed values may have more potential growth.
■ It also works well when interest rates are low because a variation of the AFR is used to calculate the amount of the annuity payment. In order to be successful, a GRAT needs to grow at a rate greater than the rate set by the IRS. For May, that rate is 0.8% annually. The lower the interest rate, the lower the annuity amount that is required, leaving more wealth inside the GRAT for future beneficiaries.
■ The risk with a GRAT, other than the costs of establishing it, is the potential for the assets to decrease in value during the term. If this were to happen in the above example, the assets would be depleted before Parent receives 100% of the annuity payments. In other words, Parent gets the stocks back (in the form of annuity payments) and is no worse off for having created the GRAT.
For clients interested in exploring these options, please contact your Commerce Trust relationship manager.
* Always consult with your CPA and professional advisor on matters involving taxes. This material references private lending arrangements at specified rates governed by the IRS, and are not offered by Commerce Bank.
The practice of lending, including lending involving marketable securities which are subject to changes in value, involves risk, including the risk of value decline or loss, and the risk of non-payment of lending obligations. Commerce does not provide tax advice or legal advice to customers. While we may provide information or express general opinions from time to time, such information or opinions are subject to change, and are not offered as professional tax or legal advice. Consult a tax specialist regarding tax implications related to any product and specific financial situation. Consult a legal professional regarding specialized estate planning advice and the applications related to specific estate planning strategies or asset transfers.
Past performance is no guarantee of future results, and the opinions and other information in the commentary are as of April 28, 2020. This summary is intended to provide general information only, and may be of value to the reader and audience.
This material is not a recommendation of any particular security or investment strategy, is not based on any particular financial situation or need, and is not intended to replace the advice of a qualified attorney, tax advisor or investment professional. Diversification does not guarantee a profit or protect against all risk.
Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed, and is subject to change rapidly as additional information regarding regulations, rules and interest rates may change.
Commerce Trust is a division of Commerce Bank.
Commerce Family Office Managing Director Richard English collaborates closely with clients on strategies for addressing complex personal and family financial challenges that can accompany significant wealth. Many of these issues impact current and future generations. Richard has more than 30 years of experience providing comprehensive and sophisticated estate planning services to high-net-worth families. He holds a law degree from the University of Kansas and an undergraduate degree from Washington University. Richard shares his thoughts in this Commerce Trust commentary on a few opportunities for tax-advantaged wealth planning techniques that may be appropriate during the recent economic volatility.
The first falls in the category of intra-family loans. While you cannot typically make an interest-free loan to a family member without adverse tax consequences, you can make a loan at a very low interest rate, if you follow certain guidelines.
Each month, the IRS publishes the Applicable Federal Rate (AFR) – the minimum interest rate that can be charged on private loans of various lengths. For the month of May 2020, these AFRs will be at or near historic lows. For loans initiated in the month of May, these rates will be as follows:
Short-Term AFR (loans of up to 3 years): 0.25%
Mid-Term AFR (loans of more than 3 years up to 9 years): 0.58%
Long-Term AFR (loans of more than 9 years): 1.15%
These rates are significantly lower than they were as recently as March.
A private loan based on a rate of interest at least as high as the AFR will avoid certain adverse tax consequences, such as imputed interest. Structured as an intra-family loan, this can allow a parent or other lender to significantly reduce the borrowing costs for a child or other family member by lending at a low rate.
A second unique opportunity concerns the sale of assets, which can take advantage of temporarily lower stock values. Some estate planning techniques involve a sale of assets in exchange for a promissory note. A common technique is the sale of an asset considered to have strong potential for appreciation. If the seller takes back a note as part of that sale, the ability to charge a lower interest rate increases the potential success of this transaction.
If the asset that is being sold has a low current value, there may be more potential for appreciation. For example, if a parent were to sell a portfolio of stocks to a trust for the benefit of his or her children, the appreciation of that portfolio after the sale would occur outside of the parent’s estate.
The purchaser in these transactions is often a “Grantor” trust for income tax purposes. When structured properly, a sale to such a trust will usually avoid triggering capital gains tax.
A third opportunity is the use of a Grantor Retained Annuity Trust, or GRAT, which is different from a loan but also benefits from low interest rates. With a GRAT, the person creating the trust transfers assets that the person believes have the potential to appreciate. For a set number of years, the person receives an “annuity” payment each year from the GRAT. That payment can be made in cash or in shares of stock (which may have appreciated in value). At the end of that term of years, any assets remaining in the GRAT (after making the annuity payments) pass to the person’s beneficiaries with little or no gift and estate tax consequences.
As an example, assume that Parent transfers a stock portfolio currently worth $5 million to a GRAT in May 2020. As part of the governing trust document, Parent reserves the right to receive five annuity payments, each in an amount slightly more than $1 million. Those payments are made annually, in May of each year, beginning in 2021 and ending in 2025. The annuity payments can be funded with cash, but will likely consist in large part of shares of stock from the portfolio. If the stocks remaining in the GRAT appreciate at the rate of 5% per year during the 5-year term, the assets remaining in the GRAT after the 5-year term will be worth almost $1.4 million (more appreciation yields more value, while less appreciation yields less). At that time, those assets can be distributed to Parent’s children without estate or gift tax cost. This technique has the following advantages:
■ It works well with assets that appreciate in value after being transferred to the GRAT. Stocks with currently depressed values may have more potential growth.
■ It also works well when interest rates are low because a variation of the AFR is used to calculate the amount of the annuity payment. In order to be successful, a GRAT needs to grow at a rate greater than the rate set by the IRS. For May, that rate is 0.8% annually. The lower the interest rate, the lower the annuity amount that is required, leaving more wealth inside the GRAT for future beneficiaries.
■ The risk with a GRAT, other than the costs of establishing it, is the potential for the assets to decrease in value during the term. If this were to happen in the above example, the assets would be depleted before Parent receives 100% of the annuity payments. In other words, Parent gets the stocks back (in the form of annuity payments) and is no worse off for having created the GRAT.
For clients interested in exploring these options, please contact your Commerce Trust relationship manager.
* Always consult with your CPA and professional advisor on matters involving taxes. This material references private lending arrangements at specified rates governed by the IRS, and are not offered by Commerce Bank.
The practice of lending, including lending involving marketable securities which are subject to changes in value, involves risk, including the risk of value decline or loss, and the risk of non-payment of lending obligations. Commerce does not provide tax advice or legal advice to customers. While we may provide information or express general opinions from time to time, such information or opinions are subject to change, and are not offered as professional tax or legal advice. Consult a tax specialist regarding tax implications related to any product and specific financial situation. Consult a legal professional regarding specialized estate planning advice and the applications related to specific estate planning strategies or asset transfers.
Past performance is no guarantee of future results, and the opinions and other information in the commentary are as of April 28, 2020. This summary is intended to provide general information only, and may be of value to the reader and audience.
This material is not a recommendation of any particular security or investment strategy, is not based on any particular financial situation or need, and is not intended to replace the advice of a qualified attorney, tax advisor or investment professional. Diversification does not guarantee a profit or protect against all risk.
Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed, and is subject to change rapidly as additional information regarding regulations, rules and interest rates may change.
Commerce Trust is a division of Commerce Bank.
