by Bob Rywick

Whether interest rates are high or low affects various tax and estate planning strategies, e.g., the income, estate and gift tax values of many types of transfers. In some situations, lower rates produce more favorable results for clients, while in others, they result in higher tax costs.

This article discusses key tax and estate planning transactions that are especially useful when interest rates are low. My next article will discuss transactions that benefit from higher interest rates.

In determining what a client should do, keep in mind the tax changes that will take place over several years as a result of the amendments made to the Internal Revenue Code by the Economic Growth and Tax Relief Reconciliation Act of 2001.

These include a significant reduction in the estate tax over several years, followed by its complete repeal for estates of individuals dying in 2010, and the scheduled return of the pre-EGTRRA rules in 2011.

Valuing private annuities, life estates, term interests, remainders and reversions. The value of private annuities, life estates, term interests, remainders and reversions for estate, gift and income tax purposes is determined under tables that the Internal Revenue Service issues under Internal Revenue Code §7520.

The applicable interest rate used is recalculated each month. As a result, the value of private annuities, etc., for a transaction made in one month may be higher or lower than that value would have been if the transaction had been made in an earlier or later month.

Note that for charitable transfers, the interest rate for the month of the transfer or for either of the two preceding months may be used.

The IRC ¤7520 rate, which was as high as 11.6 percent in April and May of 1989, was at an all-time low of 3.0 percent in July 2003, and was 3.2 percent in August 2003. However, for September 2003 it has moved up more sharply to 4.2 percent.

When a taxpayer benefits from lower rates. Lower interest rates produce more favorable results for individuals engaging in the strategies discussed below.

● Private annuities. A private annuity offers a number of income, gift and estate tax advantages. It also can save estate administration expenses and offer other non-tax advantages as well. Private annuities are often used to allow older family members to transfer property to younger members in exchange for the younger member’s unsecured promise to pay the older member a fixed, periodic income for life. If the fair market value of the property transferred equals the present value of the annuity under the IRC ¤7520 valuation tables, there is no taxable gift.

The lower the interest rate is at the time the private annuity transaction is entered into, the lower the annual payment that the younger member will have to make to the older member to prevent a gift from arising on the transfer.

Even though the lower interest rate results in a lower annual payment to the older member, the older member usually will want a lower rate so as to be able to transfer property at the lowest possible cost to the younger member.

Example 1: On Sept. 5, 2003, your client, who is 75, transfers property worth $2 million to her son in exchange for a private annuity. He must make an annual payment of $246,719 to prevent a gift from arising on the transfer. This figure is determined by dividing $2 million by 8.1064, which is the annuity factor from Table S of IRS Publication 1457 for a 75-year-old and an interest rate of 4.2 percent (the IRC ¤7520 rate for September 2003).

Example 2: The same facts apply as in Example 1, except that the transfer was made in August 2003, when the annuity factor was determined using an interest rate of 3.2 percent.

Using the 3.2 percent interest rate, the annuity factor for a 75-year-old was 8.6709, and the annual payment required to prevent a gift from arising was $230,657. This is $16,062 less than the annual payment required if the transfer was made a month later, when the interest rate used was a full percentage point higher.

Observation: If the transfer in Examples 1 and 2 had been made in June or July of 2000, when the IRC ¤7520 interest rate was 8 percent, then the annuity factor would have been 6.4407, and the required annual payment would have been $310,525.

Observation: A private annuity can sometimes be used to transfer substantial amounts of property at a very low cost to the transferee, if the transferee’s actual life expectancy is substantially shorter than what it would be under the tables.

However, the mortality component of the valuation tables cannot be used to determine the present value of an annuity if the measuring life is that of an individual who is terminally ill at the time that the gift is completed.

Reg. ¤25.7520-3(b)(3) provides that an individual who is known to have an incurable illness or other deteriorating physical condition is considered terminally ill if there is at least a 50 percent probability that he will die within one year.

● Grantor retained annuity trust. An individual can save transfer tax by setting up a GRAT. The individual retains an annuity interest for a specified term, at the expiration of which the trust property goes to a child or other individual named at the outset. Gift tax is payable, but only on the present value of the remainder interest, which is the value of the property transferred to the trust less the value of the retained annuity interest.

The post-transfer appreciation in the value of the trust assets will escape transfer tax, but only if the grantor survives the trust term.

If the grantor dies during the trust term, the trust property will be included in her gross estate under IRC ¤2036(a). IRC ¤2036(a) provides that property transferred by an individual during her lifetime is includible in her estate if she retains an interest for any period that does not, in fact, end before her death.

Observation: Even if an individual who sets up a GRAT dies before the end of the term, her estate would be no worse off than if she had not done the transaction, except to the extent of the costs in setting up and administering the trust.

The lower the interest rate used to determine the value of the annuity retained by the grantor, the higher the value of that annuity, and the lower the value of the gift of the remainder in a GRAT.

Example 3: In September 2003, your client, a widower, transfers $1,000,000 to a trust, which is to pay him an annual annuity of $70,000 for 10 years. At the end of the 10 years, the trust property is to go to his daughter. The value of your client’s retained annuity is $562,149.

This figure is determined by multiplying $70,000 by 8.0307, which is the annuity factor from Table B of IRS Publication 1457 for a 10-year term and an interest rate of 4.2 percent. The value of the gift of the remainder to your client’s daughter is $437,851 ($1,000,000 less $562,149).

Observation: A GRAT will not be of as much use to an individual with a short life expectancy who wants to hedge against failing to survive until greater estate tax relief is phased in. However, such an individual may be able to realize some estate tax savings by establishing a GRAT with a relatively short term that he can be expected to survive.

Example 4: The same facts apply as in Example 3, except that your client has a serious illness. While the illness is not an immediate threat to his life, it is serious enough to make it unlikely that he will live for more than five years. He establishes a GRAT for a four-year term. The value of your client’s retained annuity is $252,903. This figure is determined by multiplying $70,000 by 3.6129, which is the annuity factor from Table B of IRS Publication 1457 for a four-year term and an interest rate of 4.2 percent. The value of the gift of the remainder to your client’s daughter is $747,097 ($1,000,000 less $252,903).

● Charitable lead annuity trust. A charitable lead annuity trust is a trust that provides that an annuity is to be paid at least annually for a term of years or for the life of a named individual to a named charity.

If the annuity is for the life of a named individual, that individual must be the donor, the donor’s spouse, or an individual (or the spouse of an individual) who is a lineal ancestor of all the remainder beneficiaries. The value of the annuity will not qualify for a charitable deduction unless there is a less than 15 percent chance that the remainder interest will not pass to lineal descendants.

While declining estate tax rates and the increasing estate tax unified credit exemption amounts reduce the tax benefits of making charitable transfers, for many estates, transfers to charities will continue to offer tax saving potential for a number of years and will offer intangible benefits other than tax savings.

For an individual who may not survive until significant estate tax relief is phased in, because she has a short life expectancy, but who is still eligible to use the mortality component under the tables, a charitable lead annuity trust offers an opportunity to transfer assets to family members at a low transfer tax cost.

Such an individual can set the charity’s interest to last for her life. If she lives fewer years than the life expectancy used in the tables, she will have succeeded in transferring assets to family members at a low transfer tax cost and with only a relatively small amount going to charity.

The lower the interest rate, the higher the charitable deduction for the annuity interest going to the charity and the smaller the value for any gift of the remainder interest going to a private beneficiary.

Example 5: Your client, a 70-year-old man, makes a gift of $1 million to a charitable lead annuity trust in September 2003. The trust agreement provides that an annuity of $40,000 a year will be paid to his favorite charity for the balance of his life, and on his death, the remainder interest in the trust will be paid equally to his three grandchildren.

The interest rate used to determine the value of the annuity and remainder interests is 3 percent, the rate in effect for July 2003. (Since there is a substantial gift to a charity, you may use the rate in effect for the month of the gift or the rate in effect in either of the two months before the gift to determine the value of the annuity and remainder interests. You would choose the 3 percent rate in effect in July 2003 since this is lower than the rates in effect in August (3.2 percent) and September (4.2 percent), and provides a higher value for the charity’s annuity interest.)

Using the 3 percent rate, the value of the annuity is $427,092, and the value for the remainder interest is $572,908.

Observation: If a 4.2 percent interest rate had been used in Example 5, the value of the annuity interest would have been only $388,172, and the value of the remainder interest would have been $611,828.

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