Estate Planning in a Rising Interest Rate Environment

After more than a decade of lowering interest rates in the hopes of improving the US economy, the Federal Reserve has been slowly increasing the “federal funds rate” (the rate banks charge each other). The most recent ¼ point increase was announced on June 14, 2017, after the meeting of the Federal Open Market Committee.[1]  With this increase, the target federal funds rate is between 1 and 1.25%.

The federal funds rate has an indirect effect on other interest rates.  As a result, you may notice a few changes:

  • An increase in the interest banks pay you on your savings;
  • The value of long term bonds you already own will go down as interest rates go up; and
  • The cost of borrowing for business or investing will go up.

Rising interest rates can also have an effect on your estate planning.  Many of Frost PLLC’s clients have a net worth that greatly exceeds the amount that can be transferred to children and grandchildren without paying the federal gift or estate tax. That amount is currently $5.49 million for an individual or $10.98 million for a married couple.  Anything above that amount (and that is not given to charity) is subject to a 40% gift or estate tax.

Rising interest rates can affect your estate planning because many of the techniques that are used to transfer wealth are interest rate sensitive.  Some examples of these techniques include the following:

 

Intra-family loans

One of the simplest wealth transfer techniques is for senior generations to make loans to younger generations.  For tax purposes, as long as the loan carries an adequate interest rate (and the borrower actually pays the interest and principal when due), the loan is not a gift.  Each month, the IRS publishes a table of minimum interest rates for such loans (and other purposes).

Example: Fred and Wilma loan their child Pebbles $1 million at 2.6%[2], with principal and interest due in 10 years. If Pebbles invests the $1 million in assets that earn 10%, she would have $2,593,742 with which to repay her parents at the end of 10 years.  This would leave her $1,301,114 after paying $1 million in principal and $292,628 in interest.  The $1,301,114 “transfer” to Pebbles would have cost her parents $520,445 in gift taxes had they simply given her the same amount in cash.

Intra-family loans provide wealth transfer benefits to the extent that younger generations can invest in assets that earn a higher return than the interest charged on the loan.  Everything else being the same, higher interest rates reduce the effectiveness of this strategy.

 

Intra-family installment sales

In the example above, Pebbles “invested in assets that earn 10%”.  She could have purchased those assets from her parents in exchange for an installment note.  Purchasing the assets from her parents allows the family to (potentially) benefit from two wealth transfer savings.  The first is the rate arbitrage described above.  The second is that it removes high-income and/or high-growth assets from her parents’ taxable estates.

 

Grantor Retained Annuity Trust (GRAT)

GRATs are another technique that work better in lower interest rate environments.  With a GRAT, you (the “grantor”) place assets into a trust that is obligated to pay you an annuity for a fixed period of years.  At the end of the annuity term, the balance of the trust is paid (or held in trust) for the benefit of your children (or someone else you’ve designated).  When creating and funding the GRAT, you are making a taxable gift.  The size of the taxable gift equals the value of the assets put into the trust less the present value of your retained annuity.  Using time value of money concepts, higher interest rates imply lower annuity values.

This explains why GRATs become less effective as rates go up. Nevertheless, GRATs can still be a very effective wealth transfer tool even with rising interest rates.  In the early 1990s, the estate planning community was ecstatic when the rate used to value GRATs fell to an all-time-low of 6%.  The current rate (as of July 2017) of 2.2%[3] was unimaginably low back then.

Example: Barney and Betty want to transfer a 50% interest in Rubble Materials, Inc. (RMI), to their son, Bam Bam.  RMI is an S corporation that earns $2 million a year in taxable income.  The company distributes 43% of its income each year to shareholders  and reinvests the rest to grow the business.  Barney and Betty’s valuation professional believes a 50% interest in RMI, after appropriate discounts, is worth $3,611,110.  The family expects that the business will grow at about 6% (in addition to retained earnings).  Given those assumptions, Barney and Betty could establish a 10 year GRAT for the benefit of Bam Bam and retain an annuity from the GRAT of $406,231.  The present value of this annuity, using the current IRS rate of 2.2%[4], equals $3,611,110, making the size of the couple’s gift to Bam Bam zero.

In 10 years, the value of Bam Bam’s 50% interest in RMI, plus the trust’s reinvested income, is projected to be almost $12 million dollars.  The GRAT would save the family nearly $4.8 million in gift taxes at a 40% rate.

 

Other techniques

Estate planners have a number of other tools in their tool kit, most of which are interest rate sensitive.  These techniques include life insurance, charitable trusts (such as charitable lead trusts and charitable remainder trusts), qualified personal resident trusts, and many others.  Because these techniques all behave differently as interest rates change, it makes sense to review your estate plan to ensure that it continues to meet your needs in this changing environment.  In addition, you may wish to “lock in” what are still historically low rates.

 

[1] https://www.federalreserve.gov/newsevents/pressreleases/monetary20170614a.htm

[2] The annual long-term rate for loans entered into in July 2017.  See https://www.irs.gov/pub/irs-drop/rr-17-14.pdf

[3] This rate, known as the §7520 rate, is set monthly by the IRS.  See https://www.irs.gov/pub/irs-drop/rr-17-14.pdf

[4] Ibid.

Article Written By:

Leader of Frost PLLC’s Private Wealth Services practice, which meets the personal tax and financial needs of the firm’s clients. David began his career in Phoenix, Arizona, working for a “Big 8” accounting firm. David’s clients were mostly entrepreneurial businesses and the business owners and families. As a new manager, David founded the Phoenix office’s family wealth planning practice. Another Big 8 firm recruited David to Dallas to start a similar practice. In working with these clients, David crafted unique solutions that saved the clients hundreds of millions of dollars in taxes. (It helps to have more than a handful of clients who are billionaires.) Many of David’s ideas – unique at the time – have become widely accepted in the industry. Contact David today to see how he can help you!