United States

October section 7520 rate at 1.6 percent; time for plan to be a loan?

Tax-wise intra-family loans can make sense and transfer dollars


The IRS announced in Rev. Rul. 2016-25 that the section 7520 rate for October will rise to 1.6 percent. Applicable rates for other interest rate-sensitive wealth transfer and charitable planning vehicles rose in essentially lock step.

As we have written in prior months, while applicable interest rates for such popular planning techniques as grantor retained annuity trusts, sales to defective trusts and intra-family loans have been holding steady near historic lows, the same cannot be said for the larger wealth transfer planning environment. For example, the issuance of proposed regulations under section 2704 created a tremor across the tax planning landscape. And, of course, there is the uncertainty created by the polarity in approaches to estate taxes offered by the two major parties seeking control of the government in November.

So, what’s an estate-tax sensitive individual to do in time like these? The answer, of course, is, “It depends.” Some are arguing that he or she who hesitates (doing wealth transfer planning) will have lost, because when the tremors stop, so will have many of today’s opportunities to do tax-efficient wealth transfer planning. But others might argue that, with uncertainty extending well beyond estate taxes to the future of the estates themselves, a more sensible approach might be to just hunker down and do nothing until…whenever. Of such stuff, talk shows are made.

But, one planning technique that can offer a reasonable middle ground between these two points of view, as well as a middle ground between simplicity and complexity, is the intra-family loan. With variations on the theme, an individual establishes a so-called ‘intentionally defective grantor trust (IDGT). An IDGT is an irrevocable trust that is ‘effective’ for transfer tax purposes because transfers to it are completed gifts, excluded from the individual’s taxable estate. But it is ‘defective’ for income tax purposes because the grantor is taxed on the IDGTs income, gains, deductions and credits, i.e., the IDGT is not separate taxpayer from the grantor. The primary benefits of the IDGT are that (1) it eliminates the income tax implications typically associated with transactions between taxpayers, e.g., gain on a sale or interest on a loan, and (2) the grantor’s payment of the IDGT’s income taxes is currently not a gift, thus allowing the grantor to further reduce the taxable estate without gift tax implications.

Once the IDGT is established and before the individual makes the loan to the trust, he or she ‘seeds’ the trust with a gift of enough cash or property to give the trust some ‘equity’ and therefore commercial viability as a borrower. Otherwise, the IRS might not respect the loan, deeming it to be a gift instead. While there is no authoritative guidance on how much equity the trust should have for this purpose, the conventional wisdom is that the trust should have equity of at least 10 percent of the amount it will borrow. Then, the individual lends money to the IDGT, taking back a promissory note from the IDGT. Again with variations on the theme, the note would bear interest at the applicable federal rate (AFR) for the month the loan is made and call for payments of interest only until the loan is due. The note has to bear interest at least equal to the AFR so that the transaction won’t be recharacterized in part as a gift. This type of loan is often given a nine-year term because that is the longest the note can run with a mid-term AFR. Of course, even the long-term AFR is still attractive from a historical perspective. In any case, there will be a balloon payment of the outstanding principal at the end of the loan term. If this transaction were completed now, meaning in September, the mid-term interest rate would be 1.22 percent. Next month it will be 1.29 percent. The corresponding long-term AFRs are 1.9 percent for September and 1.95 percent for October.

The benefits of this technique are that any return generated by the IDGT’s investment of the loan proceeds in excess of the interest rate on the note will be excluded from the individual’s estate. What’s more, if the IDGT is designed as a generation-skipping ‘dynastic’ trust and the individual allocates generation-skipping transfer (GST) tax exemption to the seed gift, then the growth above the interest rate will be free of GST tax as well. Meanwhile, the IDGT’s interest payments are not taxable to the individual, and his or her payment of the IDGT’s income tax (on its investment income and capital gains, for example) are not gifts to the IDGT. If the individual should die before the note is repaid, the unpaid balance of the note will be included in his or her estate.

As always, the devil is in the details. The IDGT has to be crafted properly to achieve the right effective vs. defective balance. If the individual wants the IRS to respect the loan as a true loan, then he or she had better enforce the note according to its terms, i.e., as though the borrower is an arm’s-length third-party. Of course, it certainly helps if the IDGT’s investment returns outperform the loan, because even if they don’t, the loan is still due. That might be the most compelling reason why an individual who is interested in this type of technique would be well-advised to implement it sooner, while rates are still low, rather than later.


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