Timing is critical when implementing a freeze strategy

For many family-owned businesses, minimizing your tax exposure when transferring wealth and property to future generations can be a matter of timing. Today’s current economic, tax and political environment has provided a sense of urgency for family offices to wonder if now is the time to implement their lifetime transfer strategy from their succession plan.

To make sure opportunities aren’t missed, reviewing the current external pressures affecting a business’s financial assets is particularly critical now, since there are indications of continued volatility.

An environment of rate increases

“Quantitative easing” brought on by the 2008 credit crisis has kept Treasury yields and the Applicable Federal Rate (AFR) historically low during this extended period. Recent discussion of persistent inflation has caused Treasury to consider tapering the quantitative easing. Tapering, together with contemporaneous announcements of a series of “hikes” in the target federal funds rate, has provided downward pressure on bond pricing, causing an indirect increase in bond yields and AFRs.

The tapering and the current and future increase in the target federal funds rate have already caused a significant increase in the minimum rate required on related party loans. This means that, for example the hurdle rate for mid-term loans (between three- and nine-year maturities) almost doubled, from 1.3% to 2.51%, reflecting an increase of 93% since the beginning of this year.

Coming into 2022, all the major indices of the U.S. stock market were at, or near, all-time highs. Treasury’s announcement of a series of interest rate hikes to ease inflation, together with unease surrounding the war in Ukraine, have steadily caused the major stock indices to reduce close to, if not below, “correction” territory.

The current “volatility” in the U.S. equity markets could have the effect of creating a natural valuation discount on shares in privately held companies, thereby increasing the efficiencies of freeze strategies (i.e. indirectly lowering the hurdle rate). Often, public company comparables and market multiples are used in valuing private company shares.

As these factors are reduced, the value of the private company shares can be correspondingly lowered as well. In addition, the increase in the AFR may also increase the discount rate used to value companies on a discounted cash-flow basis. This should also provide downward pressure on value going forward. We have seen this dynamic play out in the public markets as prices for growth stocks have been hit harder than the balance of the equity markets.

Considerations for a freeze strategy

The current U.S. political landscape and the intense focus on significantly reducing the power of intra-family freeze strategies, as present in the tax portion the unpassed Build Back Better bill, create additional reasons for a sense of urgency for implementation of a freeze transaction. Implementation of a freeze transaction ahead of any new tax bill that remotely resembles what was proposed last year will hold great value to a privately held business with a long-term vision.

Freeze strategies that should be considered in a time-sensitive, low value/low interest rate environment are:

• Installment sale
• Simple intra-family loans and outright gifts
• Grantor Retained Annuity Trusts (GRATs)
• Charitable Lead Annuity Trusts (CLATs)
• Qualified Personal Residence Trusts (QPRTs)
• Charitable Remainder Trusts (CRTs)

To the extent any of these strategies includes a lead property interest and a remainder property interest, the impact of the interest rate on the valuation of the respective property interests must be considered in gauging the overall tax efficiency of the strategy being considered.

For freeze strategies already in place, implemented in a high-value/high-interest rate environment, most likely the assets have under-performed to the point where the possibility of beating the higher hurdle rate is remote. When performing an installment sale, paying-off the old note and re-issuing a new note at the lower rate is possible, assuming the note allows for pre-payment. If not, renegotiation of the existing note to a lower interest rate is an alternative.

In the case of a GRAT, due to the prohibition against commutation, starting over on the entire amount is not possible. However, one permissible strategy includes early payment of the current annuity amount that is due. If the payment is made in-kind, then those assets could be used to start a new GRAT using the lower interest rate. Another permissible strategy would be for the GRAT to sell any under-performing assets to the grantor and to use the sale proceeds to purchase assets expected to produce a better return. No gain or loss would be recognized on the sale because the grantor and the trust would be treated as the same taxpayer for federal income tax purposes.

Natural valuation discounts created by the current volatility in the U.S. equity markets coupled with historically low (but rapidly rising) AFR, the current political/tax climate in the U.S., and inflation adjustments to certain gift, estate and generation-skipping transfer taxes (GSTT) tax provisions, create a time-sensitive environment for a privately held business owner to implement (or modify) a lifetime freeze strategy as part of a long-term strategic plan.