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Estate Planning Techniques in a High-Interest-Rate Environment

Dec. 23, 2022, 9:45 AM

As any estate and trust attorney knows, not all numbers are created equal. Few examples illustrate this better than the Section 7520 rate. Little known outside of the tax planning realm, this inconspicuous figure published monthly by the IRS is used for actuarial calculations and is the sword and shield of many powerful wealth transfer techniques.

When the 7520 rate is low—as it has been for 15 years—opportunities for good planning abound. But what about when the rate is high? Few estate planners have needed to ask themselves that question until very recently.

In January 2022, the 7520 rate stood at a mere 1.6%, not far from its all-time low. But as the Federal Reserve has relentlessly driven up the federal funds rate to combat inflation, the 7520 rate has shot up to 5.2% in December of 2022. This rate of increase—225% in a year—is unprecedented in the history of the 7520 rate. When coupled with erosion in real asset values driven by high inflation, many planners and their clients have been left scrambling for alternatives to the time-tested estate planning techniques that have served them well for a generation.

Fortunately, rising rates do not spell doom for good planning, and there is plenty of silver lining to be found even in inflation. Below are four key planning concepts that may help make 2023 a little brighter both for estate planners and their clients.

Higher Inflation Means Higher Exemptions

The high inflation that has plagued much of 2022 means that certain inflation-adjusted exemptions and exclusions are set for a substantial increase come New Year’s Day. The federal transfer tax exemption amount will rise by $860,000—by far the largest inflation adjustment ever—to $12.92 million, and the annual gift tax exclusion amount will increase to $17,000 just one year after reaching $16,000.

Taken together, these increases give wealthy clients significant wiggle room to make new gifts to family members or others without incurring any transfer tax. Practitioners should encourage clients who previously have fully used their transfer tax exemption to consider making additional transfers and should advise all clients of the increase to the annual gift tax exclusion amount.

Reorient Charitable Gifting for Higher Interest Rates

A rising 7520 rate should cause planners to consider moving away from charitable lead trusts in favor of charitable remainder trusts for charitably inclined clients. Under both strategies, the values of the income and remainder interests are calculated using the 7520 rate. The key difference between the two (at least for tax planning purposes) is the impact of a rising rate on the amount of the available charitable deduction.

For charitable lead trusts, the higher the rate, the lower the present value of the income interest passing to charity, which leads to a smaller available charitable deduction. In contrast, for charitable remainder trusts, a higher 7520 rate will result in a larger remainder interest passing to charity, which in turn means a larger available charitable deduction.

Charitable remainder trusts are also a sensible solution for wealthy clients who are facing a liquidity crunch driven by inflation and tighter markets. These clients may (and frequently do) have highly appreciated assets that are effectively unavailable due to substantial unrealized capital gains. By transferring these assets to a charitable remainder trust, the client can eliminate the capital gains issue and unlock a valuable lifetime income stream, all while providing a long-term benefit to charity.

Bring Back QPRTs

Qualified personal residence trusts have been in effective hibernation for years due to low interest rates. As the 7520 rate jolts back into higher territory, now is the time to wake the QPRT from its slumber and return its status as a viable wealth transfer technique

A QPRT allows a client to transfer a residence at a discounted value while retaining the right to occupy the residence for a number of years. The 7520 rate is used to determine the value of the client’s retained interest—that is, the right to continue to use and occupy the residence. The higher the rate, the more value that is retained by the client and, therefore, the smaller the amount of the taxable gift to the remainder beneficiaries—frequently, the client’s descendants.

QPRTs also provide a valuable tool for clients who struggle to find the right asset to use for a planning strategy—for example, due to asset transfer restrictions—or who have a significant portion of their wealth tied up in residential real estate. By allowing these clients to leverage the value of a primary or secondary residence, a QPRT can be a true game changer from a tax planning perspective.

Don’t Count GRATs Out Just Yet

A grantor retained annuity trust, which has been a mainstay of planning for the past decade, should continue to be included in every estate planner’s toolbox. While it is true that a GRAT is more appealing in a low-interest-rate environment, a GRAT can still be an effective wealth transfer technique when rates are on the rise.

A GRAT’s success or failure usually depends on whether the assets transferred to the GRAT appreciate in value at a rate that exceeds the 7520 rate, as the excess appreciation is transferred to the remainder beneficiaries (such as the client’s children) gift tax-free. In addition, a GRAT can be structured as a zeroed-out GRAT, which means that the transfer of assets to the GRAT does not use any of the client’s transfer tax exemption or result in any gift tax due. Therefore, a client with assets that have significant growth potential—such as securities likely to rebound quickly from depressed 2022 values—should still consider implementing a GRAT strategy. This is especially so if that client has already used their lifetime transfer tax exemption.

In addition, a GRAT is a relatively “risk-free” strategy, which means that if the GRAT fails (i.e., the assets transferred to the GRAT appreciate at a rate less than the 7520 rate), there are no adverse tax or economic consequences other than the loss of the transaction costs. Consequently, a GRAT is an attractive planning strategy for clients who are risk-averse.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Edward Tully is a partner at Lathrop GPM’s trusts, estates, and legacy planning group in Minneapolis. He has extensive experience in estate planning, business succession planning, and asset protection planning and offers clients sophisticated estate planning techniques.

Jim Thomson is a senior associate with Lathrop GPM’s trusts, estates, and legacy planning group in Minneapolis. He represents clients in estate planning, estate and trust administration and litigation, business succession planning, and charitable giving.

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Rising Section 7520 rates do not spell doom for good planning, and there is plenty of silver lining to be found even in inflation. Lathrop GPM's Edward Tully and Jim Thomson offer four key planning concepts that may help make 2023 a little brighter both for estate planners and their clients.