Wealth Transfer in a Rising Interest Rate Environment. Rates for Establishing Family Loans

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1 Wealth Transfer in a Rising Interest Rate Environment A center of excellence building bridges from thought to action, creating practical, applicable strategies to help benefit you and your family The current low but rising interest rate environment has created challenges and opportunities for both investors and advisors when addressing several financial areas, particularly estate planning and the transfer of assets to subsequent generations. As interest rates have begun to creep up and the possibility of significantly higher interest rates looms, we believe it is important to reexamine the effects of interest rates on wealth transfer. The following is a review of some of the effects of interest rates on estate planning and family wealth transfer in particular, as well as the opportunities offered in both low and high interest rate environments. Hawthorn Institute Resident: Martyn S. Babitz martyn.babitz@hawthorn.pnc.com How Interest Rates Affect Estate Planning Interest rates can affect two essential categories of wealth transfer: n For intra-family loans and intra-family loans related to broader family asset transfers, the interest rate charged is tied to prevailing overall interest rates, likely providing potential wealth transfer opportunities in low interest rate environments. n In a split-interest transfer, the transferor retains an annuity or income interest in specific assets (or possibly provides such an interest to charity) and gifts the remainder interest to family members or charity. With split-interest transfers, the value of the gifted interest is determined actuarially using an interest rate derived from prevailing interest rates. Depending on the interest being gifted, a low interest rate environment could either be beneficial or detrimental to the desired wealth transfer objective. Split-Interest Gifts Many of the wealth transfer tools affected by interest rate fluctuations involve split-interest transfers. The value of the interest that is either retained or transferred to charity is not considered a taxable transfer for federal gift or estate tax purposes. Rather, it is deducted from the overall value of the asset in determining the value of the other transferred interest that is subject to federal gift or estate tax. For a split-interest transfer to qualify for the above treatment, it must fall into a specifically defined type of split-interest transfer sanctioned under the Internal Revenue Code (IRC). Otherwise, the interest that is retained or transferred to charity cannot be deducted, and the entire value of the asset will be subject to gift or estate tax. In order for lifetime charitable split-interest gifts to qualify for an income tax deduction, such interest must qualify under one of the specific statutory provisions under the IRC as well.

2 In addition, loans to family members or other intended beneficiaries of wealth transfer or loans financing sales of assets to such transferees are also affected by interest rate changes. Such loans are also subject to parameters established under the IRC and related federal tax principles. Rates for Establishing Family Loans Family loans and family loans to finance asset sales to family members (or trusts for them) are subject to minimum required interest rates to avoid imputation of interest income for federal tax purposes. These rates, known as the Applicable Federal Rates (AFR), are published monthly by the Internal Revenue Service (IRS). The IRS publishes three AFRs (short-term, mid-term, and long-term) with four different compounding periods: annual, semi-annual, quarterly, and monthly. Typically, intra-family loans will use annual or simple compounding for administrative ease and to help minimize interest accrual, although the annual compounding AFR is adjusted upward to take into account such less frequent compounding. Split-interest transfers authorized by the IRC use a specific interest rate to calculate the value of the respective split interests. The IRS publishes this rate monthly, and it can be used in valuing split interest transfers for that month. Except in the case of charitable split-interest transfers, the most favorable Section 7520 rate for the month of the transfer or preceding two months may be used. The Section 7520 rate equals 120% of the mid-term AFR using annual compounding, rounded to the nearest 0.2%. As can often be the case with interest rates in general, and as the Federal Reserve (Fed) has signaled coming rate increases, the AFR and Section 7520 rates have been increasing from their historic lows. Chart 1 illustrates the most recent 22-year history of the Section 7520 rate for the month of June in each of those years. Chart 2 (page 3) shows the 22-year history of the longterm AFR as published in June in each year. Chart 3 (page 3) demonstrates the trend of the Section 7520 rate as well as the short-term, mid-term, and long-term AFRs over the past 22 years, as published in June of each of those years. Chart 1 History of Section 7520 Rate for June, Rate Percent /93 6/94 6/95 6/96 6/97 6/98 6/99 6/00 6/01 6/02 6/03 6/04 6/05 6/06 6/07 6/08 6/09 6/10 6/11 6/12 6/13 6/14 6/15 2 hawthorn.pnc.com

3 Chart 2 History of Long-Term Applicable Federal Rate, Percent Long-Term Rate 6/93 6/94 6/95 6/96 6/97 6/98 6/99 6/00 6/01 6/02 6/03 6/04 6/05 6/06 6/07 6/08 6/09 6/10 6/11 6/12 6/13 6/14 6/ Chart 3 History of Section 7520 Rate and Applicable Federal Rates for June Percent SHORT-TERM AFR MID-TERM AFR LONG-TERM AFR 7520 RATE 6/93 6/94 6/95 6/96 6/97 6/98 6/99 6/00 6/01 6/02 6/03 6/04 6/05 6/06 6/07 6/08 6/09 6/10 6/11 6/12 6/13 6/14 6/15 Favorable Wealth Transfer Strategies In our opinion, the following wealth transfer strategies are more favorable with a lower AFR or Section 7520 rate. Accordingly, as rates increase, the importance of considering and implementing such strategies takes on a sense of urgency. Family Loans With current rates low, a direct loan of cash to family members or a trust for their benefit could provide a straightforward wealth transfer opportunity. For example, if grantor lends $1 million to her son for a three-year term, taking back a three-year promissory note with a 0.27% interest rate (based on the short-term AFR for that month) and the trustee invests the $1 million in a reasonably low-risk investment yielding 6%, the 5.73% spread inures to the benefit of the grantor s son. 3

4 Family Sales An irrevocable trust that is a grantor trust for income tax purposes generally combines the dual aspects of: n excluding the trust assets, and the growth thereon, from the grantor s taxable estate (and if generation skipping tax exemption is used, excluding the assets, and their growth, from the beneficiaries taxable estates for multiple generations); and n having income tax and capital gains tax liability with respect to the trust assets be payable by the grantor rather than the trust, allowing the trust assets to grow unencumbered by income taxation for the grantor s remaining lifetime. This type of trust is often referred to as an intentionally defective grantor trust (IDGT). In addition, transfers of assets between a grantor and a defective grantor trust do not typically create income tax or capital gains tax liability for either the trust or grantor because the grantor is considered the owner of the trust assets for federal income tax purposes. By taking advantage of the income-tax-neutral aspect of transactions between grantors and an IDGT, and by using assets gifted to the trust as collateral, the trust could purchase additional assets from the grantor in exchange for a promissory note. We view this as an enhanced variation of a family loan, as described in the preceding section. As an exchange between a grantor and grantor trust, neither the built-in capital gain on the transferred assets nor interest payments on the note is recognized for federal income tax purposes. For more information on IDGTs and sales of assets to such a grantor trust, see June 2013 Hawthorn, PNC Family Wealth White Paper, The Family Opportunity Trust, Part II: Leveraging the Trust. We believe the primary wealth transfer objective in a grantor s sale of assets to his or her grantor trust is that the assets sold to the trust grow at a greater rate than the payments of principal and interest on the promissory note received by the grantor in exchange for the assets. Thus, the interest rate on the promissory note, based on the short-term, mid-term, or long-term AFRs depending upon the duration of the note, for the month in which the sale occurs, acts as a so-called hurdle rate. To the extent that the growth of the assets transferred to the trust exceeds this rate, wealth is effectively transferred to the family trust without use of tax exemptions or payment of federal gift tax. Grantor Retained Annuity Trusts A Grantor Retained Annuity Trust (GRAT) is a special type of irrevocable trust (treated as a grantor trust for income tax purposes) to which the grantor transfers assets and receives a fixed annuity for a term of at least two years. The annuity amount can increase by as much as 20% annually. The value of the annuity is reduced from the value of the assets transferred to the GRAT to determine the value of the taxable gift. Accordingly, if the value of the annuity equals or exceeds the value of the assets transferred, there is no taxable gift. This type of GRAT is often referred to as a Zeroed Out GRAT. A Zeroed Out GRAT is most comparable to the sale of assets to an IDGT because assets are transferred to a grantor trust in exchange for a note (the required fixed annuity) of equal value, so no gift is involved. 24 hawthorn.pnc.com

5 If the net investment return of the GRAT assets exceeds the IRC Section 7520 rate for the month the GRAT is established, there should typically be at least some assets remaining at the close of the charitable lead term to pass without federal transfer tax to the remaindermen. Consequently, the IRC Section 7520 rate is the hurdle rate for GRATs. Any combination of annuity amount high enough and term long enough under the prevailing IRC Section 7520 interest rate to equal 100% of the initial value of the GRAT s assets on a present value basis will typically zero out that GRAT. For example, for a GRAT established in a month in which the Section 7520 rate is 2.0%, a fixed annuity of 12.25% of the initial value of the contributed assets paid annually to the grantor for nine years would likely zero out any gift or estate tax consequences to the transferor. As with other annuities, the lower that applicable interest rate is, the higher the corresponding value of the annuity. Accordingly, in the current historic low interest rate environment, the present value of an annuity received under the GRAT (which provides the deduction for gift tax or estate tax purposes) will be higher than when the same GRAT, with the same annuity terms, is established under a less favorable interest rate setting. If the grantor dies prior to the end of the annuity term, the assets are included in his or her taxable estate. At the end of the GRAT term, the remainder of the trust assets can pass outright to the GRAT remainder beneficiaries or remain in further trust for them. Chart 4 shows the decreasing Zeroed Out GRAT remainder amounts, based on an initial $1 million transfer, nine-year term, and 8% annual rate of return, along a range of increasing IRC Section 7520 rates. Chart 4 Chart 4 Grantor Retained Annuity Trust Zeroed Out GRAT Effect of Section 7520 Rate on Tax-free Remainder Effect of Section 7520 Rate on Gift Tax-Free Remainder 35

6 Charitable Lead Annuity Trusts A Charitable Lead Annuity Trust (CLAT) can be established during the lifetime of the transferor or as a testamentary trust. A CLAT pays a fixed amount, based on a percentage of the initial value of the trust assets, to a qualifying charity or charities for a fixed period of years or for the life or lives of one or more individuals. A qualifying charity could include the transferor s private family foundation.at the close of the term of annuity payments to charity, the remaining balance of the trust assets, if any, either reverts to the transferor or passes to other noncharitable beneficiaries or a trust designated by the transferor in the terms of the CLAT document. The present value of the payments to charity at the time the CLAT is created as determined by the IRC and the applicable interest rate provide a charitable deduction for gift tax purposes (if the CLAT is created during the transferor s lifetime) or estate tax purposes (if the CLAT is created at the transferor s death). Accordingly, if the present value of the charitable annuity equals or exceeds the value of the assets initially transferred to the CLAT, then no gift or estate tax will be incurred as a result of the balance of assets, if any, passing to the noncharitable remainder beneficiaries at the end of the term of required payments to charity. This type of CLAT is often referred to as a Zeroed Out CLAT. For gift tax purposes, a CLAT is essentially the same as a GRAT except that the annuity interest is paid to charity rather than to the grantor. An additional distinction is that a CLAT can be established during the lifetime of the grantor (as with a GRAT) or, unlike a GRAT, at the death of the grantor, in which case the annuity interest provides an estate tax deduction to the grantor s estate. Another difference is that the grantor need not live until the close of the annuity period in order to obtain the full deduction for the annuity interest for gift tax purposes if the CLAT is established during his or her lifetime. Chart 5 demonstrates the differing remainder amounts in a Zeroed Out CLAT with a nineyear term assuming an initial $1 million contribution and 8% annual rate of return based on various IRC Section 7520 rates. Chart 5 Chart 5 Charitable Lead Lead Annuity Annuity Trust Trust Effect of Section 7520 Rate on Charitable Deduction Effect of Section 7520 Rate on Charitable Deduction 26 hawthorn.pnc.com

7 Charitable Donations of Remainder Interests in Farms/Residences A gift of a remainder interest in a farm, residence, or conservation-restricted property generally is eligible for the charitable gift income tax deduction. This deduction is determined by subtracting the value of the landowner s reserved life interest, determined using the IRC Section 7520 rate for the month of the contribution, from the fair market value of the donated property. The more life tenants there are and the younger they are, the lower the value of the remainder interest donated and, hence, the smaller the deduction. Although the property will be included in the transferor s taxable estate, a full deduction for federal estate tax purposes will be allowed for the remainder interest passing to charity upon the transferor s death. Less Favorable Wealth Transfer Strategies The following strategies are less favorable when the IRC Section 7520 rate is low. Accordingly, as the Section 7520 rate continues to increase, these strategies become more worthy of consideration. Charitable Remainder Annuity Trusts A Charitable Remainder Annuity Trust (CRAT) is an irrevocable trust established during the grantor s lifetime or at death. It pays a fixed annuity amount between 5% and 50% of the initial value of the trust assets to a noncharitable beneficiary or beneficiaries, which can include the grantor or the grantor s spouse, or both, for a term of up to 20 years or for the life of the beneficiary. The remaining assets at the close of the noncharitable term pass to a charity or charities (which can include the grantor s private foundation) designated by the grantor. The actuarial value of the projected charitable remainder interest is deductible by the grantor for federal income tax purposes as well as for federal gift or estate tax purposes. Accordingly, if the grantor or grantor and grantor s spouse is the sole noncharitable beneficiary, the assets of the trust will be entirely excluded from his, her, or their taxable estates for federal estate tax purposes. If appreciated assets are transferred to the CRAT, the subsequent sale of those assets would avoid immediate federal capital gains taxation (although all or a portion of that capital gain may be taxed to the noncharitable beneficiaries as distributions are received from the CRAT). Chart 6 (page 8) provides a range of increasing charitable remainder amounts (which create an equivalent deduction for income tax purposes and gift or estate tax purposes) for a $1 million CRAT paying 5% of the initial value annually for a nine-year term, and assuming an 8% annual rate of return on the CRAT assets, in direct relation to increasing IRC Section 7520 rates. 73

8 Chart 6 Chart 6 Charitable Remainder Remainder Annuity Annuity Trust Trust Effect of Section 7520 Rate on Charitable Deduction Effect of Section 7520 Rate on Charitable Deduction Grantor Retained Income Trusts A Grantor Retained Income Trust (GRIT) is an irrevocable trust to which the grantor transfers assets and retains an interest in all the trust s net income annually for a specific term of years. Upon the earlier of the end of the term of years or the death of the grantor, the remaining assets pass to the remainder beneficiaries or in further trust for them. As with a GRAT, the actuarial value of the grantor s retained interest reduces the value of the gift. Because of the potential for manipulating the net income generated by the trust to maximize the remainder interest for the trust s beneficiaries, however, in 1990 the IRC was amended to prohibit a deduction for gift tax purposes for the actuarial value of the grantor s retained interest if the beneficiaries are members of the grantor s family, defined as the grantor s spouse, any lineal descendants of the grantor or the grantor s spouse, or any sibling (or a sibling s spouse) of the grantor or the grantor s spouse. Because permitted remainder beneficiaries do include any individuals not falling under the definition of members of the grantor s family, a GRIT can be a useful wealth transfer tool with respect to nieces, nephews, distant relatives, and nonrelatives including friends or domestic partners not considered a spouse under state law. As with a GRAT, should the transferor die during the transferor s retained term, the property will be included in full in the transferor s taxable estate. Unlike a GRAT, as interest rates and the Section IRC 7520 rate increases, the actuarial value of the remainder interest decreases, thereby reducing the value of the taxable gift and making this strategy more favorable. 28 hawthorn.pnc.com

9 Qualified Personal Residence Trusts A special type of GRIT for a personal residence could provide for any remainder beneficiary, including members of the grantor s family, while obtaining a deduction for federal gift tax purposes as to the actuarial value of the grantor s retained interest. This house GRIT is defined as a Qualified Personal Residence Trust (QPRT) under the IRC. A QPRT involves the transfer of a primary or secondary personal residence to an irrevocable trust with the transferor s retained right to continue to enjoy the home for a period of years. Thereafter, the property passes to the remainder beneficiaries or a continuing trust for them. The transferor could continue to enjoy the property if he or she pays a fair market rental to the remainder beneficiaries. The actuarial value of the transferor s retained interest is deducted from the value of the home in determining the value of the gift for federal gift tax purposes. As with a GRAT, should the transferor die during the transferor s retained term, the property will be included in full in the transferor s taxable estate. Chart 7 illustrates the range of decreasing projected remainder interests (which is the measure of the taxable gift) as IRC Section 7520 rates increase, based on a nine-year QPRT for a married couple, each age 60, for a $1 million residence growing at 8% annually over the QPRT term. Chart 7 Qualified Personal Residence Trust Effect of Section 7520 Rate on Taxable Gift. Chart 7 Qualified Personal Residence Trust Effect of Section 7520 Rate on Taxable Gift 39

10 Interest Rate Neutral Strategies These strategies are typically unaffected by interest rates as to the valuation of the split interests and corresponding gift or bequest for federal gift or estate tax purposes. Charitable Remainder Unitrusts A Charitable Remainder Unitrust (CRUT) is similar to a CRAT, with the primary difference being that the annual noncharitable distribution during the noncharitable term of the trust is determined based on a fixed percentage of the trust s assets as valued each year. Unlike a CRAT, the noncharitable beneficiaries share in the appreciation or depreciation of the trust assets with the charitable remainderman. The actuarial value of the projected charitable remainder interest is deductible by the grantor for federal income tax purposes as well as for federal gift or estate tax purposes. If the grantor, or grantor and grantor s spouse, is the sole noncharitable beneficiary, the assets of the trust will be entirely excluded from his, her, or their taxable estate for federal estate tax purposes. If appreciated assets are transferred to the CRAT, the subsequent sale of those assets will avoid immediate federal capital gains taxation (although all or a portion of that capital gain may be taxed to the noncharitable beneficiaries as distributions are received from the CRUT) A variation of a CRUT (not available with a CRAT) is a Net Income Makeup CRUT, or NIMCRUT, under which the noncharitable beneficiaries receive the lesser of the net income or otherwise determined percentage distribution amount annually. Any resulting deficit in the normal percentage distribution to the beneficiaries can be made up in future years during the noncharitable term of the NIMCRUT to the extent net income exceeds the percentage distribution amount that would otherwise be paid. Charitable Lead Unitrusts A Charitable Lead Unitrust (CLUT) is similar to a CLAT in that it is an irrevocable trust wherein a charity or charities (including potentially the grantor s private foundation) receives an annual distribution for a fixed period of years or for the life or lives of one or more individuals. Likewise, the remainder interest at the close of the period of charitable distributions passes to individual beneficiaries or in further trust for them. The annual distribution to charity, however, is based on a fixed percentage of the assets as valued annually. Accordingly, the annual charitable distribution will likely fluctuate with the value of the trust assets each year, and the charity would share with the remainder beneficiaries in the appreciation or depreciation of the trust assets. Consequently, if the assets of the trust are growing, the remainder interest will ultimately be lower than with a CLAT. Further, it is not possible to zero out a CLUT, so there will likely always be some taxable amount as to the remainder interest for federal gift tax or estate tax purposes. The need to annually value the assets of the CLUT to determine the amount to be distributed may make administration more costly or impractical if assets other than marketable securities are transferred to the CLUT. 210 hawthorn.pnc.com

11 Grantor Retained Unitrusts A Grantor Retained Unitrust (GRUT) is an irrevocable trust from which the grantor retains annual payments from the assets transferred for a specific term and equal to a fixed percentage of the value of the trust assets as determined annually. At the end of the term, the remaining assets pass to the remainder beneficiaries or to a trust for their benefit. A GRUT is similar to a GRAT except that the annual distribution to the grantor is not a fixed amount but rather a fixed percentage of the annually determined value of the trust assets. Because the value of the trust assets will vary from year to year, the annual distribution amount will typically vary. In addition, because the grantor receives a fixed percentage of the annual value of the trust assets each year, the grantor shares in the benefit or detriment of the appreciation or depreciation of the trust assets. Accordingly, the amount passing to remainder beneficiaries in a GRUT that is appreciating will not be as great as with a GRAT where the annual distribution amount is fixed regardless of increases (or decreases) in the trust assets value. burdensome and often impractical if hard-to-value assets (such as closely-held business assets) It is not possible are transferred to zero to the out trust. a GRUT. Accordingly, there will always be some taxable gift as to the actuarial As with a GRAT, remainder should the value. transferor In addition, die during the transferor s need to revalue retained term, the assets the property annually will be included in full in the transferor s taxable estate. to determine the amount of the GRUT distribution to the grantor makes administration of a GRUT more Conclusion burdensome and often impractical if hard-to-value assets (such as closely held business We believe assets) the current are transferred low-interest rate to the environment, trust. combined with recent significant growth in valuations in certain asset classes such as equities, provides outstanding potential wealth transfer As with a GRAT, opportunities. should As interest the transferor rates continue die to during move higher, the transferor s and as a Fed rate retained increase in term, the near the term seems certain, specific estate planning vehicles such as QPRTs and CRATs will likely property will become included more attractive in full as tools in the such transferor s as GRATs become taxable less optimal. estate. Other tools such as CRUTs Chart 8 Chart Wealth 8 Transfer Techniques Summary Wealth Transfer Techniques Summary Low Interest Rate Environment Code Sanctioned Charity Participant Special Asset Can be "Zeroed Out" Section 7520 Rate Applicable Federal Rate Technique Intra-Family Loan Favorable Family Sale Favorable GRAT Favorable CLAT Favorable CRAT Unfavorable GRIT Unfavorable QPRT Unfavorable CRUT No Effect CLUT No Effect GRUT No Effect will likely be unaffected by a changing interest rate landscape. For a summary of the individual strategies and their features, see Chart 8. Understanding the favorable or unfavorable sensitivity, insensitivity, or neutrality to increasing interest rates with respect to wealth transfer vehicles is, in our view, a critical aspect of evaluating and implementing any such options. This understanding is also important for determining the urgency of utilizing a specific tool that may fit an individual or family situation, or whether waiting may be more appropriate

12 Conclusion We believe the current low-interest rate environment, combined with recent significant growth in valuations in certain asset classes such as equities, provides outstanding potential wealth transfer opportunities. As interest rates continue to move higher, and as a Federal Reserve rate increase in the near term seems certain, specific estate planning vehicles such as QPRTs and CRATs will likely become more attractive as tools such as GRATs become less optimal. Other tools such as CRUTs will likely be unaffected by a changing interest rate landscape. For a summary of the individual strategies and their features, see Chart 8 (page 11). Understanding the favorable or unfavorable sensitivity, insensitivity, or neutrality to increasing interest rates with respect to wealth transfer vehicles is, in our view, a critical aspect of evaluating and implementing any such options. This understanding is also important for determining the urgency of utilizing a specific tool that may fit an individual or family situation, or whether waiting may be more appropriate. Low interest rates have provided benefits and detriments for the economy and investment markets. We believe this interest rate environment similarly offers both opportunities and drawbacks in estate planning for clients and advisors to take into consideration. July 2015 The PNC Financial Services Group, Inc. ( PNC ) uses the marketing name Hawthorn, PNC Family Wealth ( Hawthorn ) to provide investment consulting and wealth management, fiduciary services, FDIC-insured banking products and services, and lending of funds through its subsidiary, PNC Bank, National Association ( PNC Bank ), which is a Member FDIC, and to provide specific fiduciary and agency services through its subsidiary, PNC Delaware Trust Company. PNC does not provide legal, tax, or accounting advice unless, with respect to tax advice, PNC Bank has entered into a written tax services agreement. PNC does not provide services in any jurisdiction in which it is not authorized to conduct business. PNC Bank is not registered as a municipal advisor under the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Act ). Investment management and related products and services provided to a municipal entity or obligated person regarding proceeds of municipal securities (as such terms are defined in the Act) will be provided by PNC Capital Advisors, LLC, a wholly-owned subsidiary of PNC Bank and SEC registered investment adviser. Hawthorn, PNC Family Wealth is a registered trademark of The PNC Financial Services Group, Inc. Investments: Not FDIC Insured. No Bank Guarantee. May Lose Value The PNC Financial Services Group, Inc. All rights reserved. 212 hawthorn.pnc.com