How S&P Downgrade of U.S. Debt Rating May Affect Family Wealth Succession Planning

09 August 2011 Publication

Legal News Alert: Estates & Trusts

On Friday, August 5, 2011, Standard & Poor’s downgraded the long-term credit rating for U.S. treasury debt from AAA to AA+. One of the ripple effects of this action may be to cause an increase in the safe harbor interest rates for intra-family debt transactions (i.e., the Applicable Federal Rates or AFRs), which are currently near historic lows. Low AFRs enhance the effectiveness of many estate tax planning and business succession techniques that involve lifetime transfers to children or grandchildren. Therefore, it would be best to complete family wealth and business succession transfers before the S&P downgrade or other factors cause AFRs to increase.

In December 2010, the federal government enacted the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRA), which increased the federal gift tax exclusion to $5 million dollars. (The federal gift tax exclusion is the maximum amount of taxable gifts that a person can make during his/her lifetime without incurring a gift tax liability.) However, the TRA is scheduled to sunset at the end of 2012, which (under current law) would cause the federal gift tax exclusion to fall back down to $1 million. Many high net worth individuals and business owners have been considering whether to make large gifts to children and grandchildren before the end of next year to take full advantage of the increased gift tax exclusion under the TRA.

In the meantime, the AFRs have been hovering near historic lows since the beginning of the year, which also has led to a better environment for lifetime gifting. The federal gift tax consequences of intra-family transactions (including loans, some gifts, and many sales transactions) are determined, in part, based upon the AFRs. When the AFRs are low, it is possible to transfer more wealth to children and grandchildren within federal gift tax limitations because of the possibility that the transferred wealth will appreciate at a rate that is higher than the corresponding AFR. This month, the AFR for short-term debt obligations (i.e., three years or less) is only 32 basis points (i.e., 0.32 percent), the AFR for mid-term debt (i.e., more than three years but no more than nine years) is only 1.9 percent, and the AFR for long-term debt (i.e., more than nine years) is 3.86 percent. Further, asset values are depressed, due to the recession, which could lead to rates of appreciation, as the U.S. economy recovers, that are much higher than current AFRs. The combination of the increased gift tax exclusion, near record low AFRs, and depressed asset values have combined to create possibly the best tax environment for lifetime wealth transfers in years.

Some of the intra-family transactions that are enhanced by low AFRs include low-interest loans to family members, sales of private company stock to family members in exchange for installment obligations, grantor retained annuity trusts (in which the transferor puts property in trust for family beneficiaries but reserves an annuity for a term of years), and charitable lead annuity trusts (in which the transferor puts property in trust for family beneficiaries but gives to charities an annuity for a term of years). 

Unfortunately, if the yields on U.S. Treasury obligations increase as a result of the downgrade, then AFRs also will likely increase. AFRs are set by the Secretary of the Treasury each month based upon the average market yield for that month on outstanding marketable obligations of the United States with short-term, mid-term, and long-term maturity dates, respectively.

Some commentators believe that the downgrade will not have a significant effect on the yield on U.S. Treasuries. The Obama administration expressed strong disagreement with S&P’s downgrade, and (for now) other rating agencies have affirmed their AAA rating for U.S. Treasury debt. Further, the S&P did not downgrade the U.S. short-term credit rating. However, AFRs generally change each month and, given how low they are now, it is possible that those monthly changes will trend upward after the downgrade.

For these reasons, the prudent course of action would be to review family wealth transfer opportunities before AFRs increase significantly, whether as a result of the recent downgrade of the U.S. credit rating or otherwise.

Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues.

If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or the following individuals:

Gregory F. Monday
Madison, Wisconsin

Wendy S. Rusch
Milwaukee, Wisconsin

Internal Revenue Service regulations generally require that, for purposes of avoiding United States federal tax penalties, a taxpayer may only rely on formal written opinions meeting specific requirements described in those regulations. This newsletter does not meet those requirements. To the extent this newsletter contains written information relating to United States federal tax issues, the written information is not intended or written to be used, and a taxpayer cannot use it, for the purpose of avoiding United States federal tax penalties, and it was not written to support the promotion or marketing of any transaction or matter discussed in the newsletter.

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