In last month’s update, I shared how our family has documented our memories of the 2020 pandemic. One of my lasting memories will be of the virtual learning assignments for our children. As the self-appointed physical education teacher, I took it upon myself a few weeks ago to create an obstacle course in our front yard. I used a few of our unending supply of cardboard boxes–itself another pandemic memory–to create a hurdle course, a sight that I am sure drew the attention of the board members of our homeowners association. My youngest son initially experienced difficulty in clearing the cardboard box hurdles, by reason of both his diminutive stature (blame his mother’s genes) and his poor flexibility (blame his father’s genes). As a result, I took it upon myself to improve his confidence by cutting down the height of the hurdles, and his performance improved significantly at the new and lower hurdle height.
Similar to how my son’s performance improved by reason of the lower hurdle height, the tax and financial impediments that impact the degree of success for an intra-family wealth transfer have never been lower. Between the current minimum interest rate and assumed rates of return set by the IRS, and current federal and state estate and gift tax rules, from a tax planning perspective there has never been a better time than now for our wealthy clients to consider making significant lifetime transfers to children or grandchildren.
- Lower Interest Rates
First, as I noted last month, the interest rate required by the IRS for intra-family loans is at an all-time low. The following interest rates are applicable for loans provided by parents or grandparents to children or grandchildren in the month of June:
Short-Term Mid-Term Long-Term
Length of Loan: 0 to 3 years 3 to 9 years Longer than 9 years
Interest Rate: 0.18% 0.43% 1.01%
If a child receives a long-term loan and invests the money in the stock market, the child’s investment returns need only exceed 1.01% in order for the child to “net” any overall gain.
- Lower AFR Rates
Second, certain types of irrevocable trusts are structured to transfer assets to family members following the end of an initial annuity term. For example, one type of irrevocable trust, called a “Grantor Retainer Annuity Trust,” (“GRAT”) can be established in such a manner so that the parent or grandparent utilizes no federal gift tax exemption in gifting assets to a trust that, following the end of an initial annuity term, directs that all remaining assets in the irrevocable trust can pass to subsequent generations. The likelihood of success in transferring assets to subsequent generations will depend upon whether the actual investment return experienced by the assets contributed to the trust exceed the “hurdle” of an assumed rate of return set by the IRS. While the historical rate of return (called the “7520 rate”) is historically around 5.0%, the assumed rate of return set by the IRS for a GRAT that is created in June, 2020 is only 0.6%! Therefore, if assets contributed to a GRAT appreciate at anything close to historical returns, a sizable sum of assets can be transferred to the next generation free of any gift or estate tax consequences.
- Current Federal Gift Tax Exemptions
Third, the federal unified credit (which ties together both the federal gift tax exemption and federal estate tax exemption) is at $11,580,000, which is, of course, at an all-time high. If wealthy clients don’t want to bother with a low-interest rate loan, or bother with a sophisticated irrevocable trust such as a GRAT, they could simply gift assets to children or grandchildren. This federal estate tax exemption is not likely to last forever, however. The Democratic Party proposes to reduce the federal estate tax exemption to $3,500,000 per person, and increase the top federal estate tax marginal rate from 40% to 77%. Even if future legislation does not reduce the federal exemption, the current law is due to automatically “sunset” by 2025, such that the federal exemption will be rolled back to $6.2 million per person without any legislative action. Therefore, since it is not likely that the lower hurdle height is going to last indefinitely, wealthier clients should strongly consider using some of their lifetime exemptions now, under current federal estate and gift tax rules.
- Current Minnesota Gift Rules
Fourth, Minnesota residents should be aware of the additional state-level tax benefit of making significant lifetime gifts. Minnesota imposes a state-level estate tax on all assets (i) owned by the Minnesota resident as of his or her death plus (ii) significant gifts made to family members within three years of his or her death. However, since there is no Minnesota state-level gift tax, any significant gifts made more than three years before death will not trigger any state-level tax. Therefore, there is currently no “hurdle” whatsoever for Minnesota residents who wish to make lifetime gifts.
As I summarized in last month’s update, many of our clients have adult children who are, by reason of the broader economic downturn, currently experiencing difficult personal financial hurdles. Making significant gifts now, when these adult children are in most need, certainly makes sense independent of the tax implications of the gifts.