Estate planning transactions can benefit from higher rates

by Bob Rywick

My last article discussed key tax and estate planning transactions that are especially useful when interest rates are low. This article discusses a couple of transactions that benefit from higher interest rates.

● Grantor retained income trusts. A GRIT is like a grantor retained annuity trust, except that the grantor retains the right to all of the income from the trust instead of an annuity interest. Under Internal Revenue Code ¤2702, the grantor is treated as making a gift of the full value of the property if the remainder person is a member of the grantor’s family.

However, the value of the gift of the remainder interest is determined under the valuation tables if the remainder person is not a member of the grantor’s family as defined in IRC §2704(c)(2). (Under that code section, a nephew or niece of the grantor is not treated as a member of the grantor’s family, even though a brother or sister of the grantor is treated as a member of his family.)

Also, if the GRIT is funded with a personal residence of the grantor, the valuation tables are used to determine the value of the remainder interest, even if the remainder person is a member of the grantor’s family.

The higher the interest rate, the higher the value of the retained income interest and the lower the value for the gift of the remainder interest in a residence GRIT or other GRIT excepted from the IRC ¤2702 rules.

Example 1: Your client establishes a personal residence GRIT in September 2003, and retains a 10-year term interest. At the end of the 10-year period, the residence is to go to his son. The value of the residence at the time of the initial transfer to the trust is $600,000. The applicable interest rate for September 2003 is 4.2 percent. Thus, the remainder factor from Table B of IRS Publication 1457 is .662709, making the value of the gift $397,625.

Example 2: The same facts apply as in Example 1, except that your client established the personal residence GRIT in August 2003, when the applicable interest rate was 3.2 percent. In that case, the remainder factor would have been .729799, and the value of the gift of the remainder interest would have been $437,879, or $40,254 more than the value if the gift were made in September 2003.

Observation: One advantage a GRIT has over a GRAT or a grantor retained unitrust is that the value of a contingent principal interest in a GRIT retained by the grantor is subtracted in determining the amount of the gift. Thus, the GRIT could provide that the remainder interest would go to the grantor if the named remainder person died before the termination of the grantor’s income interest.

Observation: Unlike transfers involving GRITS, an individual using a GRAT is usually better off if the transfer is made when interest rates are low. In the case of a GRUT, however, it makes no difference whether the interest rates are high or low. This is because the retained unitrust interest is the right to receive a fixed percentage of the GRUT’s assets, and changes in interest rates do not affect that percentage.

● Charitable remainder annuity trusts. A CRAT must provide for an annual distribution to the estate owner (or other person) of an amount equal to a specified sum. This sum may be expressed as a stated dollar amount (e.g., $10,000) or a fraction or percentage of the initial net fair market value of assets put into the trust (e.g., 10 percent of that value).

However, the specified sum may not be less than 5 percent of the initial net fair market value of the property put into the trust, nor greater than 50 percent.

In addition, a trust does not qualify as a CRAT unless the value of the charitable remainder is at least 10 percent of the initial net fair market value of all property transferred to the trust. A CRAT that fails the 10 percent test may be treated as void from its inception, and no estate, gift or income tax charitable deduction is allowed for a transfer to that CRAT.

Thus, a CRAT allows the donor to retain an annuity interest for himself or someone else, such as a family member, and name a charity to receive the remainder interest at the end of the annuity term. The donor gets a current income tax deduction for the present value of the charity’s remainder interest. A higher interest rate produces higher income, gift and estate tax charitable deductions and decreases the value of the gift of the annuity interest where the annuity is not retained by the donor but is given to someone else.

Example 3: Your client transfers $500,000 to a CRAT in September 2003, when she is 65 years old. She retains an annuity interest of $30,000 a year for as long as she lives with the remainder to go to charity when she dies. The value of her annuity interest is $339,201 ($30,000 times 11.3067, the annuity factor for an individual aged 65 where the applicable interest rate is 4.2 percent). The value of the charitable remainder interest is $160,799 ($500,000 less $339,201).

Example 4: The same facts apply as in Example 3, except that your client made the transfer to the CRAT in August 2003, when the applicable interest rate was 3.2 percent. However, since a gift of a remainder interest to a charity is involved, the interest rate in either of the two months before the transfer can be used to determine values, instead of the interest rate in the month of the transfer.

Since the rate for June (3.6 percent) is higher than the rate for July (3 percent) or August, that rate would be used. The annuity factor is 11.9364, and the value of her annuity would have been $358,092, and the value of the remainder interest going to charity would have been $141,908.

Observation: In Example 3, the interest rate for the month of the transfer (4.2 percent) was used since that rate was higher than the rate for either of the previous two months (3.2 percent in August, and 3 percent in July).