The low-down on low interest rates
Forget the low returns and focus on the juicy opportunities.

By François M. de Visscher


This past June, the Federal Reserve once again reduced the federal discount rate, this time to its lowest level in 45 years. And judging from Fed Chairman Alan Greenspan's latest comments, low interest rates and low inflation are likely to remain for the foreseeable future. Already, many consumers have re-financed their homes, cars and personal credit lines.

But what do these low rates mean for family businesses? How can you take advantage of this environment?

First, every family business should review its overall capital and financing structure. Bank agreements, loans and other outstanding debts (such as long-term leasing agreements) need to be re-evaluated to reflect today's low interest rates:

Are your bank lines at the lowest possible interest rates? Can you renegotiate them by refinancing at a lower cost?

Can your balance sheet handle some extra debt? If so, this is a great time to borrow, whether for expansion or for acquisitions (see my Autumn 2001 Family Business column, "When takeover targets become takeover artists"). But be wary that banks and financial institutions have become much more prudent in their lending criteria, attaching stricter covenants and conditions to new lending.

Some equally interesting benefits await shareholders:

.  Stock redemptions. This might be a good time to look at buying out restless or less active shareholders who may be itching to squeeze some liquidity from their family business holdings. Benefits abound for both parties.

For the selling shareholders, the recent cut in U.S. dividend tax and capital gains tax makes stock redemptions more attractive without the risk of paying ordinary income taxes. For remaining shareholders, bringing inactives' redeemed shares back inside the company increases your ownership and control. Plus, to the extent the company's return is higher than the interest it pays for the loan to buy out shareholders, the transaction will create new value for remaining shareholders.

.  Estate planning. Low interest rates also could provide some intriguing estate-planning opportunities for family businesses to shift assets to younger generations with minimal tax costs. Some of the most popular asset-transfer techniques that benefit from low interest rates are the grantor retained annuity trust (GRAT), the qualified personal resident trust (QPRT) and the charitable lead trust (CLT).

One of my favorite techniques is the GRAT, which allows you to make a gift of income-producing assets to one or more heirs. A GRAT is a trust set up by an asset owner (called a "grantor"), who contributes assets to the trust and agrees to receive a fixed dollar amount (called the "annuity payment") each year from the trust. In a family business context, a grantor would typically be the patriarch, who would pass on assets or stock to the next generation, who become the beneficiaries of the trust.

A GRAT typically has a ten-year life. When it expires, the annuity stops and whatever is left in the trust passes to the heirs tax-free.

A GRAT is especially attractive in a low-interest-rate environment because the value of the gift, for tax purposes, is reduced by the present value of the donor's annuity payments. If the present value of annuity payments equals the value of the assets gifted to the trust, then zero gift tax will be due.

To calculate the present value of the annuity payments, the IRS makes an assumption about the rate at which trust assets will appreciate. The IRS uses a hurdle rate based on current risk-free interest rates-regardless of how much (or little) the assets in the GRAT actually earn during the life of the trust. The hurdle rate that the IRS uses to discount the grantor's annuity payments, called the "Section 7520 rate," shadows the ten-year Treasury bond's yield.

As of June 2003, the 7520 rate was at a historical low of 3.6%. The average 7520 rate during the last ten years was 7.1%.

Say you create a GRAT today with $10 million of stock or property to be transferred to your heirs-the beneficiaries of the GRAT. The GRAT would pay you a $1.208 million annual annuity for ten years (based on a 3.6% internal rate of return-the 7520 rate), and you would incur no gift taxes. (That 3.6% is not an annual percentage rate, but a discount rate.)

However, it is reasonable to expect that during the next decade any well-balanced portfolio would have a return exceeding today's historically low 7520 rate of 3.6%. So any return on the assets in the GRAT in excess of 3.6% would revert to your heirs tax-free at the end of the life of the GRAT.

Suppose the actual return of the portfolio during the next ten years averages 7%. At that rate, the return on the initial $10 million in assets produces $1.423 million in income per year. After the GRAT pays the grantor the $1.208 million annual annuity, the GRAT retains the excess income of $215,000 per year. Over ten years, that excess income compounds to produce $2.975 million, which would revert to your heirs tax-free.

Caveat: The assets' actual rate of return may not exceed the 7520 rate. If that were to happen, the annuity payments would drain the trust's assets, and nothing would be left to pass on to your beneficiaries. Also, if the grantor dies before the GRAT expires, the assets would revert back into the grantor's estate, where they'd be subject to estate taxes just as if the GRAT had never existed. But in both these cases the grantor loses nothing, other than the legal cost of creating the GRAT.

The qualified personal residence trust and the charitable lead trust can take advantage of low interest rates in much the same way. (Warning: Before you initiate any of these trusts, I advise you to consult your estate-planning professional.)