Using Low Interest Rates to Avoid Estate Tax

Tending the money treeWith interest rates at historic lows—for the time being—wealthy families are turbocharging their estate-planning strategies by pairing intra-family loans with trusts. 

In late 2009, a businessman sold his $30 million family limited partnership to a trust he created, all on the advice of Mosaic Advisors in Houston. Because tax rules permit illiquid shares in a family partnership to be transferred to a trust at a discount that’s often around a third, it was a tax-efficient way of transferring ownership in the business to his kids. No gift tax is owed because the transaction is considered a sale. The businessman got a note from the trust in return for the sale, and the note’s interest payments of a few million dollars gave him cash for living expenses.

A recent Barron’s article, titled “How Family Loans and Trusts Can Create Big Wins,” says it gets better. The note has a fixed value, regardless of how much the underlying asset grows, which froze the businessman’s net worth for the IRS, and the asset doesn’t have to appreciate much to make this low-cost loan make sense. His business is now worth $250 million, and has been growing tax-free inside the trust for his children’s benefit. This move saves $40 million to $60 million in estate taxes today, and over $100 million if he lives to his actuarial age.

With low interest rates, families with taxable estates can benefit from structured trusts and intra-family loans. Not that these intra-family loans have their own rates and rules – the rates on intra-family loans allow parents to lend their children cash at rates far lower than a comparable commercial loan. Plus, they can be part of a broader wealth-transfer strategy.

For instance, an aging millionaire can fund a trust for his children’s benefit with a $100,000 gift. He then loans it $900,000 at the allowable 1.82% interest rate for five years, which the trust invests. The trust makes regular payments on the loan and then repays the principal in full at the term’s end. Any investment gains over that extremely low interest rate are tax-free in the trust for the next generation – it’s all legal and great planning.

There are added benefits for using this trust – the oddly named intentionally defective grantor trust. It’s considered an irrevocable complex trust for estate-tax purposes (the assets transferred to it are out of the individual’s estate) and a grantor trust for income-tax purposes. By paying the income taxes on the trust’s income, more is left for the next generation.

Be sure that the loans are just that: they are loans. If they’re determined to be gifts by the IRS, you could owe gift tax at 40% (but the annual gift-tax exclusion is $14,000, and the lifetime gift-tax exemption is $5.43 million). Make sure it’s a loan with the proper documents, terms and interest rate. Payments must be made on time. When you’re planning your wealth transfer, consider a loan and a trust, but do it right with the help of a qualified estate planning attorney.

You can learn more about this topic as well as other strategies on our website under the tab entitled: estate planning in Virginia. Be sure you also sign up for our complimentary e-newsletter so that you may be informed of all the latest issues that could affect you, your loved ones and your estate planning.  However, proper estate planning is not a do-it-yourself project.  Why not call us for a complimentary consultation at 757-259-0707.  

Reference: Barron’s (September 26, 2015) “How Family Loans and Trusts Can Create Big Wins”

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