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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 | April 04, 2019

The Melting Effect of Rising Rates on Estate Planning

By: Julia Weaver, J.D., LL.M., Director, Family Office Services & The Trust Company of Oxford and
Scott Simmons, J.D., LL.M., Senior Wealth Strategist

As Sir Winston Churchill observed, after every period of delay and procrastination comes a period of consequences.i While we are in this era of historically low interest rates, it is wise to consider the potential cost of delaying certain estate planning strategies.

The Freeze Before the Melt
An estate freezing strategy seeks to “freeze” the taxable value of a family’s estate, or certain assets, so that future appreciation avoids the 40% estate tax. Through freezing strategies, this appreciation grows outside of the taxable gross estate, allowing the family to retain 100% of their future wealth appreciation, rather than only 60% after netting out the estate tax.

The Tax Reform Act of 2017 essentially doubled the federal gift and estate tax exemption from $5.59 million per person to $11.18 million per person for 2018 (with future inflation adjustments). The estate value in excess of these amounts will be taxed at the rate of 40% if gifted during life or when passed to heirs at death.

Notably, the taxable ‘gross estate’ is a value defined by the Internal Revenue Code and it may be much greater than what is included on a family’s Financial Statement. For example, items such as Life Insurance proceeds and certain phantom wealth such as general powers of appointment over trust assets will be included in the taxable gross estate. Your team of wealth advisors should be engaged for an analysis of your family’s estate tax exposure.

A freezing strategy is appropriate when there is a current or potential estate tax liability. Rarely is a family’s wealth static, either in value or in asset composition. As assets appreciate or are monetized, reinvested, spent down or used for lifestyle purchases, the future value of the family’s estate will be impacted. Ideally, a freezing strategy should be implemented well ahead of rapid growth in asset values. Financial modeling of a family’s net worth and an estate tax projection can remove the guesswork from this analysis and provide the answers to ‘if and when’ a freezing strategy should be considered.

The Melting Effect of Rising Rates
Rising interest rates reduce the impact of freezing techniques, causing more wealth to flood back in to the taxable estate. The planner’s ability to hold back the flow of wealth from being taxed at the 40% estate tax rate becomes remarkably limited with each uptick in certain key interest rates.

Common freezing strategies include loans and installment sales to family members, Grantor Retained Annuity Trusts (GRATs), Sales to Intentionally Defective Grantor Trusts (SIDGTs), and Charitable Lead Annuity Trusts (CLATs). Each of these strategies must be structured with either annuity or installment payments back to the Grantor (or to a charity in the case of a CLAT) for a specified term. The nuances of a client’s situation or the underlying asset will determine which strategy is most appropriate at any given time.

The interest rate that determines the required payments back to the Grantor is referred to as the “hurdle rate”.ii The spread between the hurdle rate and the growth in asset values determines the “remainder interest”, which is the amount that will be paid outright or in trust to the Grantor’s heirs, free of estate tax. The higher the hurdle rate the greater the required payments back to the Grantor and the lower the estate tax free remainder interest for heirs. In other words, these strategies are at their maximum impact in a low interest rate environment. Unfortunately, the reverse is equally true.

To quantify the impact of rising rates on these estate planning strategies, we illustrate three hypothetical fact patterns using a GRAT strategy with identical terms, the only variable being an increase in the hurdle rate.iii

Specifically, we assume a 10 year GRAT funded with $10 million, with a zeroed-out gift tax.iv We assume 7% appreciation in the underlying assets and that the Grantor survives the term of the GRAT.v We also assume other prudent planning measures have been taken so that the GRAT assets are entitled to a 30% valuation

The Impact of Rising Rates
An increase in the hurdle rate from 3.2% to 4.2% results in the value of the remainder interest to beneficiaries declining from $7.87 million to $7.09 million, a drop of approximately 10%.

A increase in the hurdle rate to 5.2% would reduce the remainder interest to $6.27 million, which is a total reduction of approximately 20.5%.

The hurdle rates are determined by the IRS on a monthly basis and will follow general interest rate trends. Notably, the rising trend for these hurdle rates since 2017 has been fairly significant. The hurdle rate required for a GRAT strategy has risen from 2.2% in October, 2017, to 3.4% in June, 2018.

However, once a strategy is implemented, the hurdle rate will typically be fixed for the term of the strategy. For this reason, early implementation of a freezing strategy locks in the maximum freezing potential. While these rates remain low from a historical perspective, families 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 freezing strategy is appropriate for your situation.

i“The era of procrastination, of half-measures, of soothing and baffling expedients, of delays is coming to its close. In its place we are entering a period of consequences.” ― Sir Winston S. Churchill
iiThe 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 loan or sale strategies. The Section 7520 rate is 120% of the midterm AFR.
iiiA 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 remainder beneficiaries or in trust at the end of the GRAT term.
ivThe 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, outright or in trust, with no additional estate tax.
vThe 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.
viOften times, a portion of an entity interest may be structured as non-controlling, non-marketable and/or non-transferable. Provided the primary purpose of the entity is for a valid business purposes (a subject of extensive case law beyond the scope of this article), these restrictions may reduce the valuation of the interest, thereby utilizing less of the taxpayer’s lifetime federal estate tax exemption.