With skyrocketing unemployment rates, a sagging real estate market and a struggling economy, our nation is facing the worst recession since the Great Depression. But believe it or not, there is a silver lining: this tough economy has driven applicable federal rates (AFRs) to rock bottom levels.
Each month, the IRS provides these prescribed rates for federal income tax purposes. AFRs are used to calculate the value of remainder and annuity interests and ensure that a debt transaction will not have below-market interest.
So, what do these incredibly low AFRs mean for you and your clients? It means that now is the time to tap into the power of grantor trusts for your clients. Read on to learn about a few winning grantor trust strategies.
Delving into the DIGT
An intentionally defective irrevocable grantor trust (DIGT) is a trust in which the income is attributed to the grantor instead of the trust. It’s an irrevocable trust created so the grantor is treated and taxed as the owner of the trust’s assets for income tax purposes.
By shifting the income tax burden to the grantor, the DIGT offers some valuable income-producing and appreciation opportunities without the typical income tax consequences. In other words, these trusts often accumulate a greater amount of income for your client.
Lending funds the smart way
One smart DIGT strategy begins with lending funds to the trust. Since the grantor is responsible for paying the trust income tax, he or she can make additional contributions to the trust without using their gift exemption.
Here’s how it works: Your client, the grantor, lends money to the DIGT in exchange for an interest-only promissory balloon note, based on AFR. (A balloon note is a promissory note with one large payment—a “balloon payment”—due upon maturity.) The trust pays the interest on the loan and the principal at the end of the note’s term. Before the end of the term, the trust invests the funds borrowed loaned, and your client pays any income tax due on the income produced from these investments. The client can then invest the resulting funds into a no-lapse guaranteed life insurance policy.
There’s an added bonus for your client as well. Typically, when a client lends a large amount of funds to a DIGT, the income generated from the loan investments will be enough to pay for the interest due on the note, as well as premiums on the related life insurance policy. Because the majority of the loan is preserved, the client can then use it to repay the note’s principal.
When you use this strategy with your client, the promissory note and life insurance are generally structured to be completed in nine years. This means that by the 10th year, your client will have the funds he loaned back plus interest. On top of that, the intentionally defective irrevocable grantor trust now includes a fully paid guaranteed life insurance policy. It’s a win-win.
Of course, it’s important to realize that this method only works well with clients who are able to make a large loan to their grantor trust. Clients with significant liquid assets are ideal candidates for this technique. For those clients who do not have a large amount of money to loan to their grantor trust, they may want to consider making a smaller loan that will work as a “sinking fund.”
This fund is designed to be consumed over the entire term of the promissory note, and it allows the client to set up a longer premium payment schedule for the life insurance policy. However, the principal on the grantor’s note will still need to be paid off, so work with your client to develop a proper “exit strategy.”
The great GRAT method
With AFRs so low, now is also the perfect time to explore the possibility of using grantor retained annuity trusts (GRAT) with your client. A GRAT is basically an irrevocable trust designed to help your client transfer the appreciation on their assets with very little or no gift taxes. This is a super smart strategy in a low-rate market, like the one we’re experiencing today.
By using a GRAT, a client can transfer income-producing assets into the trust and reserve an annuity for a specified number of years. At the end of this term, the trust terminates. At that time, if the assets appreciate more than the annuity payouts (and odds are good with such low rates), the leftover trust funds are transferred to the client’s beneficiaries tax-free.
On the other hand, if the assets appreciate less than the annuity payments, the trust is considered a “failure” and the funds are returned to the client. If this happens, encourage your client to try this strategy again when rates change. This type of trust is highly recommended because there is no downside. Even if the trust “fails,” your client doesn’t lose anything.
Another great benefit of using a GRAT is to provide a gift-tax method of transferring funds to beneficiaries. It also reduces the value of the client’s taxable estate. For clients in their 50’s who think their estates will be worth more than $3.5 million (the current estate tax threshold) by the end of their lives, this could be a great tool for them.
Anything but defective
As you can see, these handy grantor trusts may be called “defective,” but when used properly they are anything but. If you want to help your clients transfer assets in a smart and financially savvy way, take advantage of today’s record low AFRs, and help them purchase life insurance with a guaranteed rate of return, a DIGT may be the way to go. Work with your client to determine if this is the most appropriate strategy for them.