Every month, the Internal Revenue Service (IRS) publishes interest rates that taxpayers use to determine the interest to be charged in income tax and estate planning strategies. Those published rates are called the Applicable Federal Rates and depend on the length of the term of a promissory note, the number of times interest is paid each year (i.e., monthly, quarterly, or annually), and the interest paid by the U.S. Treasury on its obligations. In addition, the IRS publishes a rate under Section 7520 of the Internal Revenue Code that is used for actuarial calculations. The 7520 Rate equals 120% of the federal mid-term rate rounded to the nearest two-tenths of a percent.

Lowered Interest Rates

In response to the unprecedented slowdown of the world economy due to the coronavirus, central banks have lowered interest rates and worldwide markets have experienced a dramatic reduction in bond yields to near historic lows which directly affect the Applicable Federal Rates and the 7520 Rate. For instance, the annual rate for November 2020 (compounded annually) applied to short-term obligations (1-3 years) is 0.13%, the mid-term rate (4-9 years) is 0.39% and the long-term rate (over nine years) is 1.17%. The 7520 Rate which is used to make actuarial calculations for several estate planning techniques is 0.4% for November transactions.

Planning techniques that use installment notes to sell assets to trusts benefit from historically low-interest rates. By using a lower interest rate, less cash flow is returned to the lender, and more cash remains and grows in the trust increasing the assets available for beneficiaries. Assuming a promissory note’s terms permit prepayment, an existing trust could refinance its debt with a lower interest rate.

Estate Planning Strategies

Some estate planning strategies that use the 7520 Rate to value annuities and unitrust interests like Grantor Retained Annuity/Unitrust Trusts and Charitable Lead Trusts benefit from low-interest rates. However, other planning techniques like Qualified Personal Residence Trusts (QPRTs) are not as attractive in a low-interest environment. For example, assume a taxpayer contributes $1,000,000 to a ten-year Grantor Retained Annuity Trust. If the contribution were made in December 2019, the taxpayer would be treated as making a gift of $582,065. On the other hand, if the contribution were made in November 2020, the gift would be $510,825 a $71,240 difference. To demonstrate that a QPRT does not offer the same advantage in times of low-interest rates, assume that a taxpayer transfers a residence to a ten-year QPRT that has a fair market value of $1,000,000. If the transfer were made in November 2020, the gift would be $960,866. However, if the transfer were made in December 2019, the gift would be calculated to be $820,348. The only difference between these two strategies is the reduction in the 7520 Rate from December 2019 to November 2020.

Since low-interest rates will not last forever, now would be a good time to consider estate planning techniques that benefit from low-interest rates. In addition, if you have engaged in estate planning or intrafamily transfers that utilize promissory notes check to see whether refinancing the obligation with a lower interest rate is permitted and advisable.