By: Linda Galler
On April 18, the IRS issued Rev. Rul. 2020-11, establishing monthly applicable Federal rates (“AFRs”) for May 2020. AFRs are now at historic lows; notably, the short-term AFR is almost zero. Specifically, the May rates will be:
short-term 0.25%
mid-term 0.58%
long-term 1.15%.
AFRs reflect an average of yields on federal borrowings of comparable terms. The short-term AFR applies to debt instruments with a term up to three years, the mid-term AFR applies to instruments with a term over three and up to nine years and the long-term AFR applies to instruments with a term longer than nine years.
AFRs are relevant in a variety of contexts, raising possibilities for planning transactions in which the tax law requires that interest be charged. Loans that fail to charge an adequate interest rate risk recharacterization by the IRS and/or imputation of interest. For example, loans between family members may be recharacterized as gifts, loans between corporations and shareholders may be recharacterized as dividends or contributions to capital, etc. With AFRs below or near 1%, however, only a small amount of interest is now required on such loans.
An example of a planning technique benefitting from low AFRs involves an Intentionally Defective Grantor Trust (“IDGT’) to which an individual sells assets (e.g., a business with substantial value) in exchange for a promissory note that pays interest at a rate at least equal to the AFR. This tool is used to move future appreciation of, and income from, the transferred assets out of the individual’s taxable estate. A low AFR permits the promissory note to pay minimal interest.
Related to AFRs are “7520 rates,” which are used to discount the value of annuities, life estates and remainders. According to Rev. Rul. 2020-1, the 7520 rate for May 2020 is 0.8%. Low 7520 rates coupled with recent market declines suggest that certain types of estate and gift planning may be beneficial at this juncture. For example, grantor retained annuity trusts (“GRATs”) involve placing assets in trust for a term of years during which the grantor receives an annuity based on the value of the property contributed to the trust upon creation and the 7520 rate then in effect. Assets remaining at the end of the trust term are allocated to designated family members or other beneficiaries. Charitable lead annuity trusts are similar to GRATs except that a charity, rather than a grantor, receives the annuity during the term of the trust. The lower the 7520 rate, the lower the annuity that is required. Moreover, the value of trust assets that pass to beneficiaries at the end of the term is a function of investment performance less the amount paid out as an annuity. Thus, the less that is paid out over the term of the trust, the greater the value of the remaining assets.
The combination of an historically high gift tax exemption and low federal interest rates provides optimal estate planning conditions during this equally unprecedented time spent at home to think through these options with a tax planner.