With interest rates at historic lows–for the time being–wealthy families are turbocharging their estate-planning strategies by pairing intrafamily 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.
It gets better. The note has a fixed value, regardless of how much the underlying asset grows, which froze the businessman’s net worth in the eyes of the taxman. The asset doesn’t have to appreciate much to make the low-cost loan worthwhile. His business is now worth $250 million, and has been growing tax-free inside the trust for his kids’ benefit. “This sale was a huge win,” says Brandon Henry, Mosaic’s director of estate planning. “We’ll end up saving on the order of $40 million to $60 million in estate taxes today, and over $100 million if he lives to his actuarial age.”
As long as interest rates stay low, many families with taxable estates can similarly benefit from cleverly structured trusts and intrafamily loans. But beware: Intrafamily loans have their own rates and rules. Set them up wrong or lose the paper trail, and you could end up undermining the play.
In August, the rates on intrafamily loans–set by the Treasury Department and called the applicable federal rate, or AFR–were just 0.48% for short-term loans (up to three years), 1.82% for mid-term loans (three to nine years), and 2.82% for long-term loans (more than nine years). That’s a terrific deal. Parents can lend their kids cash for everything from buying a house to starting a business at rates far lower than a comparable commercial loan.
They’re also great as part of a broader wealth-transfer strategy. Let’s assume an aging millionaire funds a trust for his children’s benefit. He seeds the trust with a $100,000 gift, and then loans it $900,000 at the allowable 1.82% interest rate for five years, which, we’ll assume, the trust invests wisely. The trust makes regular payments on the loan, and then repays Daddy Warbucks his principal in full at the term’s end. Any investment gains over that extremely low interest rate stays tax-free in the trust for the next generation. “It’s all legal, and all great planning for the client,” says Mela Garber, chair of the trust and estates group at accounting firm Anchin, Block amp; Anchin.
There are added benefits for using the oddly named intentionally defective grantor trust, which is considered an irrevocable complex trust for estate-tax purposes (the assets transferred to it are out of the individual’s estate) but a grantor trust for income-tax purposes. By paying the income taxes on the trust’s income, the patriarch leaves more for the next generation.
Anchin’s Garber points to a New York family that lent money to an intentionally defective grantor trust at the short-term rate below 1%. The trust–which benefits the family’s four children–then bought part of the family’s real estate business, while making small payments on the loan. As real estate soared, the business returned 15%, giving the trust substantial funds, at least for three years, to reinvest above its low cost of funds. “The parents,” Garber says, “pay all the income taxes on the rental income, so the children end up with a 15% return, tax-free.”
THE BIG CATCH is making sure that the loans are, well, loans. If they’re gifts in the eyes of the IRS, you could owe gift tax at 40%. (The annual gift-tax exclusion is currently $14,000; the lifetime gift-tax exemption is $5.43 million.) To ensure it’s a loan, you’ll need documents detailing the terms and interest rate, and payments must be made on time. Terms are ironclad; payments still have to be paid, even if a trust’s investments sour. “The fuzzy line is when you are so casual about it that it starts looking like a gift,” says Doug Rothermich, a managing director of wealth planning strategies at TIAA-CREF.
A new Mosaic Advisors client, a business owner with a net worth of $100 million, set up a trust for his children’s benefit in 2010, and made a loan to it, while cutting his real estate deals inside the trust.
A closer look, however, revealed that the man hadn’t properly documented the loan or paid interest on it; thus it could be considered a gift for tax purposes. To fix the problem before it blew up, his advisors documented the loan arrangements and the accrued interest, then prepared tax filings of more than 500 pages. “Lending to the children’s trust was the best thing he could have done,” Mosaic’s Henry says, “but it was complex.”
So when you’re planning your wealth transfer, think about pairing a loan and a trust–but do it right from day one.