Abstract: When the economy was booming during much of the 1990s, the goal of most wealth transfer strategies was to minimize federal estate taxes. Given the current bear market and historically low interest rate levels, the focus has shifted to capitalizing on the current economic environment. Several key wealth transfer opportunities are available. Refinancing a mortgage is the most obvious, but two others are viable options — making loans to family members and selling assets to grantor trusts. This article explores the pros and cons of both.
How To Minimize Taxes in a Low Interest Rate Climate
Opportunities Exist in Making Family Loans
When the economy was booming during much of the 1990s, the goal of most wealth transfer strategies was to minimize federal estate taxes. Given the current bear market and historically low interest rate levels, the focus has shifted to capitalizing on the current economic environment. Several key wealth transfer opportunities are available to you. Refinancing your mortgage is the most obvious, so let’s explore two others — making loans to family members and selling assets to grantor trusts.
Family Loans
You may want to consider lending money to a family member (such as a child) because the loan won’t constitute a gift if you charge adequate interest. And if your child in turn invests the money, any excess earned over the interest you charge passes to him or her — estate and gift-tax free. Alternatively, you can sell a valuable asset, such as a business interest, to your child on an installment payment plan, and you can discount the purchase price if it’s a fractional interest. The discount’s leveraging effect and the low interest rate can be significant.
With either route, you’ll have to ask yourself two questions. What interest rate should you charge? Is there a safe-harbor rate so your loan is not treated as a partial gift? To answer both, you’ll have to calculate the applicable federal rate for the loan amount. If you adhere to its guidelines, the difference between the safe-harbor rate and the actual rate charged won’t be treated as a partial gift.
So how is the rate determined? Every month, the IRS computes and publishes the applicable note tables. Essentially, there are three rates:
o Short-term rate, which applies to loans less than three years,
o Mid-term rate, which applies to loans between three and nine years, and
o Long-term rate, which applies to loans longer than nine years.
Each rate varies slightly depending on whether payments are paid annually, semiannually, quarterly or monthly. Generally, the longer the term, the higher the interest rate. For example, in March 2003, the annual short-term rate was 1.58%, the mid-term rate 3.24%, and the long-term rate 4.8%.
For most family loan transactions, the term is between three and nine years, meaning they fall within the mid-term rate. Typically, that term will allow the borrower sufficient time to repay the loan.
In many parent-child loan transactions, the actual loan is structured in a number of ways. For example, the child’s payments may be amortized over the loan’s life. Or, the child may pay interest only during the term with a balloon payment at the end. The loan document, however, should provide no pre-payment penalty.
Sale to a Grantor Trust
Besides making a direct loan to a child, you can sell your closely held business interest to a grantor trust created for your child’s benefit. In this transaction, the trust purchases your business interest in exchange for a promissory note. If the trust language is structured properly, this strategy allows you to fix the stock’s value for estate tax purposes and maintain control over your assets, while allowing the growth to pass to your heirs.
During your lifetime, there is no income tax consequence for the sale because it is disregarded — you and your grantor trust are considered a single taxpayer. No capital gain or loss on the sale is recognized either. Any interest payments made result in no income recognition to you. Nevertheless, there is a downside to this: The asset sold to the trust receives no step-up in basis due to the sale. This means if the trust sells the interest, gain will be calculated based on your basis in the interest, which could be quite low.
By back-end loading installment payments through the use of a balloon payment, the trust may be further leveraged because the assets that would otherwise be used to pay the installment note are retained in trust and leveraged to maximize growth and income within the trust. The trust uses the available cash flow from the business interest to service the note.
No Small Feat
Family-loan transactions are an effective way to transfer wealth with no gift tax. These planning strategies are straightforward; most involve a simple written promissory note. If you think your family will benefit from such loan transactions, please contact us for assistance.
Sidebar: Don’t Put Old Loans Out to Pasture; Refinance
Like homeowners who refinance mortgages to reduce their required monthly payment, many children who borrowed money from their parents at relatively high interest may wish to refinance those loans. But unlike the home mortgage lender, a parent may face adverse gift tax consequences if his or her child refinances the family loan. In short, reducing the child’s rate may appear, to the IRS, as equivalent to making a gift to him or her.
To minimize possible IRS challenges and adverse gift tax consequences, here are three ways to renegotiate the interest rate charge effectively:
1. Default danger. A child who risks going into default on the loan because of the high interest payments may renegotiate the note directly with his or her parent. The default risk should allow the parent sufficient IRS consideration to renegotiate the loan and protect the principal amount owed.
2. “New” loan. Here the child borrows from an institutional lender the amount necessary to pay off his or her parent. He or she does so and then borrows funds from the parent at the reduced rate, which the child uses to pay off the bank loan.
3. Term adjustment. The child prepays a portion of the loan and refinances the balance with his or her parent, using a shorter term than the original note.
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