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Volatile economic signals present opportunity for beneficial re-evaluation of estate and business plans

The initial months of 2022 have featured economic news quite different from recent years, and the U.S. economy is facing multifaceted inflation. First, there is money supply related inflation: the growth rate of all dollars in circulation increased 36% over the two-year period from March 2020 to March 2022, in particular as the federal government pumped money into the system as part of various COVID-19 relief programs. Second, inflation is being driven by geopolitical issues related to the crisis in Ukraine as well as ongoing supply chain issues. The Consumer Price Index rose 8.5% for the 12 months ending March 2022, the largest 12-month increase since December 1981. 

On May 4, the Federal Reserve increased the federal funds rate by 0.5 percentage points, the highest increase in 22 years. At the time, Fed Chair Jerome Powell said, “Inflation is much too high and we understand the hardship it is causing, and we’re moving expeditiously to bring it back down.” It is widely expected that the Federal Reserve will increase the federal funds rate several more times this year.  

On the estate and charitable planning side, IRS-provided interest rates are a critical component in calculating the benefits for clients as they review various strategies available to them. While these rates—the Section 7520 rate and the Applicable Federal Rate (AFR)—are still relatively low from a historical perspective, they are rising rapidly. For example, the Section 7520 rate has increased from 1% in October 2021 to 3% in May 2022.  

After more than a decade of record low interest rates, the combination of inflation and increasing interest rates has investors jittery; however, it also presents an opportunity for high-net-worth individuals to review and adjust their existing strategies for estate planning, business planning, financial planning and wealth management.  

Estate planning 

Despite recent interest rate increases and the expectation that rates will continue to rise for the foreseeable future, it is important to keep in mind that interest rates remain historically low. That being said, now is a good time to consider locking in strategies that tend to perform well with low rates. Now is also a good time to evaluate strategies that perform well when rates are high in anticipation of further rate hikes. 

Four strategies to consider while interest rates are low include: 

  • Intrafamily loans. Low interest loans to family members can afford those family members an opportunity to invest the borrowed proceeds and earn returns in excess of the interest they are required to pay you. That excess return can be thought of as a gift-tax-free gift. In a low interest rate environment, such as the current one, intrafamily loans are more likely to succeed as a wealth transfer strategy. 
  • Grantor Retained Annuity Trust (GRAT). A GRAT is a trust to which a donor transfers property and retains an annuity interest for a term of years. The annuity is based on the Section 7520 rate. Appreciation in GRAT assets over that rate pass to the remainder beneficiaries free of gift tax. Thus, the lower the Section 7520 rate, the greater the potential wealth transfer. Given that rates are expected to increase, now is the time to consider locking in the low rates with longer-term GRATs, such as 5 or 10 or more years.
  • Installment Sales to Intentionally Defective Grantor Trusts (IDGTs). Although sales to IDGTs are more complicated than intrafamily loans – and also more effective – the concepts are similar. The idea is to sell appreciating assets to trusts (likely for the benefit of family members) in exchange for a promissory note. Appreciation in excess of the AFR charged on the note is transferred gift-tax free. Like intrafamily loans, sales to IDGTs work best when rates are low, as they are now. 
  • Charitable Lead Annuity Trust (CLAT). CLATs are similar to GRATs except that the annuitant is a charity rather than the donor. Like with GRATs, the lower the Section 7520 rate the higher likelihood more will pass to the remainder beneficiaries (likely family) at the end of the CLAT term.

Not all planning strategies benefit from lower interest rates. As interest rates go higher from their recent historic lows, you should investigate the following:

  • Qualified Personal Residence Trust (QPRT). With a QPRT, a homeowner transfers his or her personal residence into a trust and retains the right to use the residence for a certain number of years. After that time, the residence passes to the remainder beneficiaries of the trust. The initial transfer to the QPRT results in a taxable gift equal to the value of the remainder. As rates increase, the value of the taxable gift decreases as the value of the homeowner’s right to use the residence increases. Thus, QPRTs work best when rates are higher.
  • Charitable Remainder Annuity Trusts (CRAT). With a CRAT, the donor transfers assets to the trust, and the trust pays an annuity to one or more persons, which can include the donor. At the end of the trust term, the remainder goes to charity. The donor is entitled to an income tax charitable deduction for the value of the remainder passing to charity. The remainder is determined by reference to the Section 7520 rate. The higher that rate, the more value that will likely pass to charity, and therefore, the greater the income tax charitable deduction.

Individual/business planning

Succession planning for closely held businesses are evergreen, despite interest rate or inflation volatility. For example, having in place a buy-sell agreement that will protect the business in the event of death, disability or retirement is a necessity in any economy or environment. But in addition to having a solid succession plan, business owners need to protect and strengthen the existing business. One of the most critical aspects to doing so is finding and retaining key talent, particularly in today’s economy. In a time when more and more workers have the option of working remotely, simply increasing compensation and benefits may no longer be sufficient to retain key people or attract the necessary people to your business.

Rising inflation may provide business owners with a new type of employee to target and hire – the recently retired who have discovered that stock market volatility and rising interest rates have affected their retirement portfolios to the extent they may have to get back into the job market. Businesses may tap into these seasoned professionals to fill critical role in their organizations.

If a family business is transitioning ownership from older to younger generations, some of the estate planning strategies above will likely come into play. 

Wealth management

Investors, especially those who believed they were taking a conservative, prudent approach with their portfolios, may be concerned by the drop in their portfolios and surprised to see that bond investments, typically a safe haven, may have fallen even more than equities. Consider the following in the near term:

  • Understand your bond portfolio. Whether you hold individual bonds or have a barbell strategy pairing short-term and long-term bonds, this is the time to get educated on the types of bonds you own and their duration.
  • Refinance your mortgage. Yes, mortgage rates remain historically low. But rates for a 30-year mortgage have gone from around 3.18% in the summer of 2020 to over 5% in the spring of 2022, with higher rates likely later in the year. So, this would be a good time to refinance and lock in a fixed rate.
  • Revisit your asset allocation. In recent years, closely examining your asset allocation has been less important since most equity asset classes were appreciating in value. Now is a good time to better understand the standard deviation of the rate of return on your portfolio, which will help measure the inherent volatility of an individual asset class.

Inflation and interest rates are not the only things to consider. The historically high federal estate tax exemption ($12.06 million per person, $24.12 million for married couples) is scheduled to sunset at the end of 2025. Thus, now is the time to plan. Taking a measured approach to re-examining your estate plan, considering new strategies and adjusting your portfolios will allow you to take advantage of this volatile environment.

Ready to adjust your estate plan or investment strategy? Connect with a Baker Tilly or Baker Tilly Wealth Management professional to learn more.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

Baker Tilly Wealth Management, LLC (BTWM) is a registered investment advisor. BTWM does not provide tax or legal advice. BTWM is not an attorney. Estate planning can involve a complex web of tax rules and regulations. Consider consulting a tax or legal professional about your particular circumstances before implementing any tax or legal strategy. The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Securities, when offered, and transaction advisory services are offered through Baker Tilly Capital, LLC, Member FINRA and SIPC; Office of Supervisory Jurisdiction located at 4807 Innovate Ln., Madison, WI 53718; phone: +1 (800) 362 7301. Baker Tilly Wealth Management, LLC and Baker Tilly Capital, LLC are controlled by Baker Tilly US, LLP. Baker Tilly US, LLP, is an independently owned and managed member of Baker Tilly International. © 2022 Baker Tilly Wealth Management, LLC

Kelly Baumbach
Executive Managing Director
William Grady
Michael Lum
Director, J.D.
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