High Interest Rates Have an Impact on Estate Planning

The Section 7520 rate has been low for the past 15 years and presented many opportunities for good planning. What happens when inflation has returned and rates are moving up, asks a recent article titled “Estate Planning Techniques in a High—Interest—Rate Environment” from Bloomberg Tax.

The Section 7520 rate is the interest rate for a particular month as determined by the IRS. It is 120 percent of the applicable federal midterm rate (compounded annually) for the month in which the valuation date falls and rounded to the nearest two-tenths of a percent. It is used for actuarial planning, to discount the value of annuities, life estates and remainders to present value, and is revised monthly.

In January 2022, the 7520 rate was at 1.6%, but as interest rates increased, it shot up and in December 2022 was 5.2%. This was a 225% increase—unprecedented in the history of the 7520 rate. However, there are four key planning concepts which may make 2023 a little brighter for estate planning attorneys and their clients.

Higher inflation equals higher exemptions. Certain inflation adjusted exemptions and exclusions increased on January 1, 2023. The federal transfer tax exemption rose by $860,000 to $12.92 million, and the annual gift tax exclusion increased to $17,000 from $16,000 in 2022.

These increases give wealthy families the opportunity to make generous new gifts to family members without triggering any transfer taxes. Those who have fully used transfer tax exemptions may wish to consider making additional transfers.

Shift charitable giving to CRTs for higher interest rates. People who might have started Charitable Lead Trusts should instead look at Charitable Remainder Trusts. With both CLTs and CRTs, the value of the income and remainder interests are calculated using the 7520 rate. The key difference, for estate planning purposes, is the impact of a rising rate on the amount of the available charitable deduction.

The return of the QPRT. Qualified Personal Residence Trusts have been hibernating for years because of low interest rates. However, the time has come to return them to use for wealth transfer. A QPRT lets a person transfer a residence at a discounted value, while retaining the right to occupy the residence for a number of years. The 7520 rate is used to determine the value of the owner’s retained interest. The higher the rate, the more value retained by the owner and the smaller the amount of the taxable gift to the remainder beneficiaries, usually the owner’s children.

GRATs still have value. A Grantor Remainder Trust should still be considered in estate planning. A GRAT is more appealing in a low interest environment. However, a GRAT can still be useful when rates are rising. The success or failure of the GRAT usually depends on whether the assets transferred to the GRAT appreciate in value at a rate exceeding the 7520 rate, since the excess appreciation is transferred to the remainder beneficiaries gift tax-free. A GRAT can also be structured as a zeroed-out GRAT. This means that the transfer of assets to the GRAT doesn’t use any of the grantor’s transfer tax exemption or result in any gift tax due. This is still of value to a person who owns assets with significant growth potential, like securities likely to rebound quickly from depressed 2022 values.

Reference: Bloomberg Tax (Dec. 23, 2022) “Estate Planning Techniques in a High—Interest—Rate Environment”

What are the Pitfalls of a Charitable Remainder Trust?

If you have discretionary funds and are philanthropically minded, a charitable trust can serve you well, giving money to an organization you want to support, while passing assets to beneficiaries without burdening them with estate or gift taxes, but is it right for you? Some of the answers can be found in a recent article from U.S. News & World Report titled “Should you Set Up A Charitable Trust?”

Some basics to consider about charitable trusts are:

  • There are a number of different types.
  • Consider all disadvantages and alternatives.
  • Make sure it works with your estate plan and your long-term financial plan.

The most common types of charitable trusts are the Charitable Remainder Trust (CRT) and the Charitable Lead Trust. For the CRT, funding begins with cash or other assets, like stocks. The trust pays an income stream to family members or beneficiaries while they are living or for a set period of time. When they die, or when the time period ends, the remaining assets in the trust go directly to the charity.

For a Charitable Lead Trust (CLT), payments first go to the charity and then the remainder transfers to the beneficiary at the end of the trust term. One of the benefits of the CLT is to reduce the beneficiary’s tax liability, while giving the estate a charitable deduction.

An estate planning attorney will help refine these choices to the ones best suited for each individual. The CLT and CRT let you support a cause you believe in, while alleviating the tax burden to loved ones.

Charitable trusts are also useful when wishing to sell an asset. If an asset with a large capital gain is to be sold, like real estate, individual stock or a business, the asset may be moved into the charitable trust. The trust becomes the owner of the asset, and then the asset can be sold, avoiding the capital gain. Speak with your estate planning attorney to ensure that this is done correctly.

What about the disadvantages? There are fees to establish and maintain a trust. Charitable trusts are usually irrevocable, so if your financial situation changes, you may not be able to gain access to the funds. There may also be some pushback from heirs or family members who would rather see your money being given directly to them and not a charity.

Make sure that the benefits you and your heirs seek to gain from establishing a charitable trust, whichever type you use, outweigh the management costs. Do not create a trust with money you may need in the future. Charitable trusts are feasible only if you have already paid off all debts and are confident you will not need any of the assets in the future.

The exact amount to put in the trust should be carefully considered, with an eye to future expenses and your overall financial status. Your estate planning attorney may wish to meet with you and senior officers from the charity to ensure a clear understanding of your wishes and make sure that this is the best solution for all.

Reference: U.S. News & World Report (Feb. 23, 2022) “Should you Set Up A Charitable Trust?”

How Does a Charitable Trust Help with Estate Planning?

Simply put, a charitable trust holds assets and distributes assets to charitable organizations. The person who creates the trust, the grantor, decides how the trust will manage and invest assets, as well as how and when donations are made, as described in the article “How a Charitable Trust Works” from yahoo! finance. An experienced estate planning attorney can help you create a charitable trust to achieve your estate planning goals and create tax-savings opportunities.

Any trust is a legal entity, legally separate from you, even if you are the grantor and a trustee. The trust owns its assets, pays taxes and requires management. The charitable trust is created with the specific goal of charitable giving, during and after your lifetime. Many people use charitable trusts to create ongoing gifts, since this type of trust grows and continues to make donations over extended periods of time.

Sometimes charitable trusts are used to manage real estate or other types of property. Let’s say you have a home you’d like to see used as a community resource after you die. A charitable trust would be set up and the home placed in it. Upon your death, the home would transfer to the charitable organization you’ve named in the trust. The terms of the trust will direct how the home is to be used. Bear in mind while this is possible, most charities prefer to receive cash or stock assets, rather than real estate.

The IRS defines a charitable trust as a non-exempt trust, where all of the unexpired interests are dedicated to one or more charitable purposes, and for which a charitable contribution deduction is allowed under a specific section of the Internal Revenue Code. The charitable trust is treated like a private foundation, unless it meets the requirements for one of the exclusions making it a public charity.

There are two main kinds of charitable trusts. One is a Charitable Remainder Trust, used mostly to make distributions to the grantor or other beneficiaries. After distributions are made, any remaining funds are donated to charity. The CRT may distribute its principal, income, or both. You could also set up a CRT to invest and manage money and distribute only earnings from the investments. A CRT can also be set up to distribute all holdings over time, eventually emptying all accounts. The CRT is typically used to distribute proceeds of investments to named beneficiaries, then distribute its principal to charity after a certain number of years.

The Charitable Lead Trust (CLT) distributes assets to charity for a defined amount of time, and at the end of the term, any remaining assets are distributed to beneficiaries. The grantor may be included as one of the trust’s beneficiaries, known as a “Reversionary Trust.”

All Charitable Trusts are irrevocable, so assets may not be taken back by the grantor. To qualify, the trust may only donate to charities recognized by the IRS.

An estate planning attorney will know how to structure the charitable trust to maximize its tax-savings potential. Depending upon how it is structured, a CT can also impact capital gains taxes.

Reference: yahoo! finance (Dec. 16, 2021) “How a Charitable Trust Works”