Many estate tax planning strategies rely on loans to family members or to trusts. In the simplest form, one family member would loan cash to a child or a trust for the benefit of a child. In order to not be treated as a gift for transfer tax purposes, the loan must bear interest of at least the minimum "applicable federal rate" mandated by the IRS. The borrower (e.g., the child or the child's trust) would then invest the borrowed funds. If the investments appreciate at a faster rate than the rate of interest on the loan, the excess appreciation would pass free of gift or estate tax.
In a more involved transaction, a family member would sell assets to a trust for a child or other family member in exchange for a promissory note bearing interest at the applicable federal rate. If the trust is structured as an "intentionally defective grantor trust" or "IDGT," no capital gains would result from the sale. If closely held business interests are transferred, the transferor may even be able to claim "valuation discounts" on the transferred assets for lack of marketability and lack of control, reducing the amount that would otherwise be owed on the loan. But, just as with a basic intra-family loan, if the assets transferred appreciate at a faster rate than the rate of interest on the loan, the excess appreciation would pass free of gift or estate tax.
Because of their broad utility, many clients hold outstanding intra-family loans that were instituted years earlier and then left on "autopilot." However, an intra-family loan is an obligation like any other and may be refinanced if prevailing interest rates change. And, all else being equal, it is desirable from an estate tax planning perspective to have a lower rather than a higher interest rate on intra-family loans. A promissory note is considered an asset of the gross estate of the lender, meaning that it is potentially subject to federal estate tax (at a rate of 40 percent) and/or Illinois estate tax (at a rate of 16 percent). Additionally, there can sometimes be negative income tax consequences if a promissory note remains outstanding at the lender's death. Reducing the interest rate on the notes allows them to be repaid sooner, resulting in more favorable transfer tax treatment.
There is some uncertainty around the tax treatment of refinancing intra-family loans, but with proper planning the risk can be reduced. If the borrower on the loan is a grantor trust, there should be no income tax consequences from the refinancing (as the grantor and the grantor trust are treated as the same person for income tax purposes). With respect to gift taxes, it is possible that the IRS could assert that the fair market value of a new, refinanced loan is different from the fair market value of the original loan, resulting in a taxable event for gift tax purposes – although a taxpayer could argue that because of the drop in prevailing interest rates, the values of the two loans are identical and no gift should result. In any case, it is generally advisable for the borrower (e.g., the child's trust) to provide some additional consideration to the lender to support the commercial substance of the transaction. For example, the borrower could make a down payment of principal, reduce the term of the loan (i.e., move up the maturity date), or provide additional security for the loan. While there is still uncertainty around the gift tax treatment of refinancing, taking these steps would help to reduce the risk.
This issue is highly relevant in the current environment because of the rapid drop in interest rates in recent months. The following are the "mid-term" applicable federal rates (for obligations with maturities of more than three years but not more than nine years) for September of the following selected years:
September 2000: 6.22%
September 2005: 4.19%
September 2010: 1.94%
September 2015: 1.77%
September 2020: 0.35%
The current historically low interest rates mean that the interest savings (and potentially the estate tax savings) from refinancing are considerable. For example, suppose that an individual's estate will be subject to both federal and Illinois estate tax, at a combined effective rate of 48 percent, and that the individual made a $1 million, nine-year loan to an intentionally defective grantor trust for the benefit of a child in September 2019, at the then effective mid-term applicable federal rate of 1.78 percent. If left untouched, the total interest payments made over the life of the loan would be $160,200 and the estate tax attributable to the interest payments received would be $76,896.
If the individual refinances the note in September 2020, the AFR would be 0.35 percent. In order to induce the lender to refinance, and to reduce the risk of the strategy, the borrower (i.e., the trust for the child) could prepay $100,000 of principal. The total interest payments made over the life of the loan would then be reduced to $43,000. The estate tax attributable to these interest payments would be $20,640 – representing a tax savings of $56,256. For larger loans, or for older loans bearing a higher rate of interest, the estate tax savings would be even more substantial.
In summary, any clients with existing intra-family notes should consider refinancing. Although there is some uncertainty regarding the gift tax treatment of refinancing, the risk can be reduced with proper planning – and refinancing can in some cases significantly improve a client's estate tax situation.