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Oxford Financial Group, LTD


Oxford Financial Group, LTD


Expert Perspective

News, research and market insights from our team of experts.


Current Issue | December 20, 2018

Estate Planning Freeze and Squeeze Strategies: The Impact of Potential Interest Rate and Regulatory Changes

By: Julia Weaver, J.D., Director, Family Office Services and The Trust Company of Oxford

In the climate of estate planning, a freezing technique seeks to "freeze" the value of assets so that future appreciation occurs outside of the taxpayer's "taxable" gross estate. For 2016, a "taxable" gross estate is a one in excess of $5.45 million per person, or $10.9 million per married couple. These amounts comprise the Federal Estate Tax (“FET”) exemption for 2016. The value by which an estate exceeds these amounts will be taxed at the rate of 40%.

A freezing strategy is appropriate when there is current or anticipated FET exposure. An ideal scenario is to implement freezing strategies well ahead of rapid growth in asset values. Thus, a freezing strategy is often considered in conjunction with a wealth trajectory analysis in order to identify the timing and degree of future FET exposure.

There are a variety of common freezing strategies, including the popular loans and installment sales to family members, Grantor Retained Annuity Trusts ("GRATs"), sales to Intentionally Defective Grantor Trusts ("IDGTs") and Charitable Lead Annuity Trusts ("CLATs"). These strategies will generally be structured with either annuity or installment payments to the Grantor (or to a charity in the case of a CLAT) for a specified term and each technique has its own nuances that make it appropriate for a specific situation.

There is, however, one common feature with each of these strategies, to wit: all payments on the value of the contributed assets require a certain interest rate be paid over the term of the strategyi. This "rate" is referred to as the "hurdle rate". The spread between the hurdle rate and the appreciation rate of the underlying asset determines the "remainder interest". This is the amount that will be paid outright or in trust to the Grantor's heirs, free of FET.

The more appreciation exceeds the hurdle rate, the greater the remainder interest and the greater the success of the strategy. As such, the "freezing" effect of these types of strategies is amplified when interest rates are low. Unfortunately, the reverse is equally true.

According to Mark Green, Chief Investment Officer for Oxford Financial Group, Ltd., "[t]he Federal Reserve has sent a clear signal to the financial markets that they intend to raise short-term interest rates in the months and quarters ahead. Indeed, their December move to tighten monetary policy – albeit modestly, through a quarter-point increase in the overnight Federal Funds rate – marked a fundamental shift away from the accommodative policy measures that have been in place since the financial crisis of 2008."

For many estate planning strategies, mid-term rates (and the Section 7520 rate) set the hurdle. Mark Green elaborates that "the path for intermediate- and long-term interest rates remains to be seen – depending on factors such as economic growth, inflation and market stability going forward." Any future rise in mid-term rates, however, would have a meaningful impact on many planning strategies. To quantify this impact, we illustrate a hypothetical fact pattern using identical GRAT strategies with the only variable being an increase in the hurdle rateii.

The strategy assumes a 10 year GRAT funded with $10 million, with a zeroed-out gift taxiii. We assumed 5% appreciation and 2% income earned on the underlying assets. These scenarios further assume that the Grantor survives the term of the GRAT (lest all assets would come back into the Grantor's gross estate), and that the GRAT assets are entitled to a 30% valuation discount, discussed further belowiv.

The "Freeze and Squeeze" Combination Strategy
As mentioned in the preceding example, we also assumed a 30% valuation discount in the underlying assetv. By transferring discounted interest through a strategy such as a GRAT, we are able to compress the value of the asset in order to maximize the use of the coveted “one shot” exemption amount.

In other words, assume a GRAT is funded with interest in a closely held business. Rather than passing only 10.9 million worth of actual value with the 10.9 million exemption, it is far better to pass 15.5 million fair market value of business interest, reduced by a 30% valuation discount. This "squeezes” more value through the 10.9 million exemption portal.

The combination of these strategies is often referred to as a "squeeze and freeze" strategy. To add insult to injury, however, we may also lose some of the power of the "squeeze".

A widely publicized statement by the IRS indicated that they may issue regulations that will limit valuation discounts for family-owned businesses. The Service suggested that they may set safe harbor discounts well below what has been historically approved by the Courts. This is mere speculation to date, but if issued, could be made effective immediately.

Taking our original fact pattern, if the hurdle rate increased from 2.2% to 3.2% and the valuation discount on the business interest was reduced from 30% to 15%, the remainder interest to heirs would be reduced from 5.2 million to 3.76 million, a decline of 28%.

It is important to note that each of the rates mentioned are determined on a monthly basis and, as such, could increase on a monthly basis. However, once a strategy is implemented, the hurdle rate will typically be fixed for the term of the strategy. Exceptions would include adjustable rate or demand notes, which should be thoughtfully considered in periods of rising interest rates.

Both rising rates and limits on valuation discounts could have a significant impact on the success of the freeze and squeeze strategy. Taxpayers still have the opportunity to maximize the impact of these popular and effective planning techniques. It is an excellent time to consult with your Oxford advisors as to whether a freeze and squeeze strategy is appropriate for your situation.

iThe amount of the hurdle rate is dictated by the IRS and will either be the IRC Section 7520 rate for any annuity payments, or the Applicable Federal Rate (“AFR”) for any loan or sale strategies. The Section 7520 rate is 120% of the midterm AFR.
ii A GRAT is an irrevocable Trust that provides Grantor with an annuity payment for a predetermined period of time. Appreciation in excess of the §7520 rate passes to beneficiaries at the end of the GRAT term.
iiiThe taxable value of a gift of property to a GRAT is reduced by the present value of the annuity payments back to Grantor, which can be structured to zero out any gift tax. When the trust terms ends, the remaining assets pass to beneficiaries with no additional transfer tax.
ivThe Keys to Success for a GRAT ~ The growth in underlying assets must exceed the hurdle rate and the Grantor must survive the term of the GRAT.
vWhen minority interest is placed in a GRAT, the share value may be discounted for lack of control, lack of marketability or transferability, non-voting status and the like.