I frequently analogize estate planners to mechanics. When you bring your car into a shop to fix an odd sound coming out of the engine, chances are that the repair garage that you chose for repairs is going to have the same tools as the repair garage down the street. Whether or not your car is successfully repaired is dependent on the mechanic’s ability to analyze the problem and use the right tools, the right way, to repair the car.
All estate planners have the same figurative toolbox. Like a good mechanic, a good estate planner will use the right tool under the right circumstances. Just like mechanics, some estate planning tools require significant additional education and understanding to be used properly. Estate plans for individuals that are subject to estate taxes require the use of sophisticated tools and techniques. Choosing the right tools, and using them properly, requires an understanding of all relevant circumstances. One of the many variables that must be considered in estate tax reduction strategies is interest rates.
We are in a period of historically low-interest rates so I’ve decided to write a series of posts that focus on estate tax reduction strategies that are favored in low-interest-rate environments.
Understanding Applicable Federal Rates
Before getting to the strategies, a little background is required. If you have been following treasury yields recently, you already know that a phenomenon with interest rates has been occurring – a flattening (and sometimes inverting) yield curve. Treasury yields are the basis for interest rate benchmarks that are established by the Internal Revenue Service – the Applicable Federal Rates (AFR’s). Each month, the Internal Revenue Service issues a Revenue Ruling that lists AFR’s for that month. The latest ruling as of the date of this post, Revenue Ruling 2019-23, sets the AFR’s for October 2019.
There are three AFR’s, “short term” for debt instruments (e.g., loans) with a term that is three years or less, “mid-term” for debt with a term that is over three years but is not longer than nine years, and “long term” for debt with a term that is over nine years. The October 2019 AFR’s are 1.69%, 1.51% and 1.86% for “short term”, “mid-term” and “long term”, respectively. Note the fact (somewhat rare) that the “mid-term” AFR is less than the “short term” AFR – the rates are inverted which is consistent with (as of October 4th) the inverted spread between the three month and ten-year treasury yields.
Without getting too technical just yet, it is important to understand that the IRS issues AFR’s as interest rates at, or above which, the IRS will allow for private loans between taxpayers without imputing (i.e., creating deemed income) interest to a taxpayer. As I will explain in what follows, the AFR’s have an additional purpose in the context of estate tax reduction strategies.
Why the Rates are Important
Now that we’ve covered the background, I can explain why these AFRs are so important in estate tax reduction strategies.
In the most general sense, the AFR is an economic hurdle. If you are able to secure a rate of return on an investment that is higher than the AFR, then there is an opportunity to shift wealth in a manner that is advantageous for estate and gift tax purposes.
To illustrate, lets assume that an individual has a portfolio of commercial real estate properties that generates a good amount of cash flow and a consistent return of ten percent (10%). This real estate portfolio is likely a good asset to use in an estate tax reduction strategy because, among other things that I will explain in future posts, the rate of return greatly exceeds all of the AFRs.
In general, any asset that can generate a return materially over the AFR is a good asset for estate tax planning – choosing the right tool from the estate planning tool box to maximize tax benefits depends on balancing numerous other factors including the anticipated cash flow from the asset, ages of the individual and beneficiaries/family members, availability of values (e.g., assets being easy to value or hard to value), anticipated appreciation or depreciation of the asset, general economic factors, political changes (e.g., potential changes in the tax laws) and the risk tolerance of the individual.
Some of the Tools that Work
In the posts that follow, I will delve into estate tax reduction strategies that work well in low interest rate environments. These strategies will include Grantor Retained Annuity Trusts (GRATs), sales to Grantor Trusts, Charitable Lead Annuity Trusts, Life Insurance Premium Financing, Split Dollar Life Insurance and Inter Family Loans.Where possible, I will also highlight preferences of certain techniques over others that depend on various circumstances.
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Steve Schermer is a founding partner of Silverman Schermer, LLC, a boutique law firm with convenient offices in Fort Lauderdale and Miami focusing in the areas of business, estate and tax planning. The experienced team at Silverman Schermer, PLLC helps high net-worth individuals, entrepreneurs, and business owners achieve their wealth-preservation goals. Contact us today at 954-314-4000 for a confidential consultation.