Is It Now Time for the Rich to Refinance Their Family Balance Sheets?


October 1, 2019

Written by Bruce Paulson, Senior Client Advisor, CPA, JD, CFP®

By his actions, Mr. Buffett would seem to say yes….

While cash across Berkshire has swelled to over $122 billion, its first yen-denominated bond will soon add roughly $3.9 billion to the balance sheet. The bond maturities will range from five to 30 years and carry interest rates of .17% to 1.1%. Echoing action early this year (January 2019), when Berkshire Hathaway Finance Corporation issued 30-year bonds to refinance $950 million of floating rate debt, it appears Buffett, like others[1], feels the steep, global decline in interest rates is in the ninth inning. CFOs across corporate America have imbibed on easy money, which we see on the chart below:

Nonfinancial Corporate Business Debt (01/2009 to 01/2019)

Source: Federal Reserve Bank of St. Louis

Should families facing estate tax exposure follow suit – refinance their family balance sheets using debt, or create an attractively priced “payable” to reduce their federal (and state) estate tax liabilities?

Why Keep Reading?

While low interest rates can be your estate planning friend, their impact on asset prices and future returns can be your foe. We discuss:

  • Different ways families can refinance their balance sheets (or create payment streams) to take advantage of interest rates, as they are.
  • How rising inflation impacts different wealth transfer transactions.
  • Why today, the optimal “interest rate beating” portfolio should include more than bonds and equities.

Tax Questions

What is refinancing the family balance sheet?

It means creating a debtor-creditor relationship to reduce current or future exposure to estate tax. The transaction can include a legal obligation to borrow from a bank in the future[2], an asset sale from a senior family member to a trust established for children or grandchildren, or, while different, a split-interest trust where its creation benefits from low interest rates (and higher inflation).

What is an intra-family sale?

A senior generation family member (“Senior”) sells an asset to a so-called grantor [3] trust created for children or grandchildren. Senior then holds a note receivable, and the trust owns a new asset, offset by a note payable. The interest rate depends on the term of the loan and is published each month by the IRS. The long-term annual rate (for debt maturities more than nine years) for September 2019 is 2.21%. The note can be interest only with a balloon payment due at the end of the note term.

Why might families consider a sale now?

Wall Street’s consensus view of no inflation and low interest rates may prove incorrect. If the net pre-tax investment return from the asset financed by the note compounds at a rate that exceeds the applicable federal rates (AFR) (2.21% in our example), the excess return can escape estate (and generation skipping) tax.

What if the asset sold is a minority interest in a business or non-voting right in an LLC?

The true investment or transaction hurdle rate decreases if a valuation discount on the asset sold is appropriate. For example, a 30% discount means the effective note rate will be 1.55% (70% x 2.21%).

Does the note sale involve tax risks?

Yes. The trust liability is real; forgiveness of the loan would cause adverse gift tax consequences. The grantor’s death while a note is outstanding raises a tax issue that gives many attorneys cause for concern. These and other issues should be discussed in detail with your legal and tax advisers.

Aren’t there more tax-certain wealth transfer strategies that benefit from low-interest rates?

Two come to mind: grantor retained annuity trust (GRAT) and charitable lead annuity trust (CLAT). Each transaction has an annuity portion and a remainder portion. When created, the annuity portion is the discounted present value of a stream of fixed payments. With the GRAT, these come back to the grantor; with the CLAT, the payments go to charity. The interest rate for each is 120% times the applicable (short, medium, or long-term) rate, or 2.5% to 3%.

Investment Questions

What happens if the asset sold suffers a steep decline in market price?

Future returns must recover both the loss and interest rate to “break even”. An interest-only note reduces this risk, as does using assets that are eligible for a valuation discount.

How would higher inflation impact the seller, buyer, and IRS?

Higher inflation means Senior’s fixed rate receivable declines in real value; conversely, inflation helps the borrower or trustee, as the liability is paid off in dollars where real value is falling in value. (Deflation, of course, increases the cost of repaying a fixed-rate debt.)

Is now a good time to bet that equities will compound at a rate greater 2.21%?

Yes, they should; but it depends on the time horizon, timing, and severity of any decline in equity prices. An equity-only portfolio, to us, is not ideal.

If equities are the dominant asset class in a sale (GRAT or CLAT), what asset classes might reduce the risk falling way behind an interest rate benchmark?

Assets like private debt, farmland, direct real estate, life settlements, and reinsurance seem to be better equity diversifiers than bonds, at least how bonds are priced today. Please see the charts below.

What about hedge funds?

Some might work, but net-after all costs (e.g., fees, incentives, pass through expenses, and taxes) many will fall short, even in a bear market[4].

What about using private (illiquid) assets?

As mentioned, their eligibility for a gift tax valuation discount may reduce the interest rate hurdle for success. Illiquid assets often mean cash to meet required interest or annuity payments is lacking. Balloon notes can push back payment on a note liability, but future returns from private equity may be less than you think, especially now[5].

What about assets already levered?

Be careful. Selling an already-levered asset doubles your debt exposure.

What about S corporation stock?

C or S corporation stock will work. Each raises different cash flow, tax, and structural issues.

Should income tax generating assets reside in a grantor trust?

When they are attractive pre-tax (net-of-fees), yes. But if the grantor, after the transaction, is not exposed to estate taxes, doing this is less attractive.

What about these and other (investment) questions relating to GRATs or CLATs?

Different investment, fiduciary, and tax issues exist with each. A rising rate of inflation reduces the cost of paying down a fixed stream of annuity payments, which exist in both the GRAT and CLAT. In the GRAT, inflation would harm Senior, as the value of his or her retained annuity decreases in real terms. With the CLAT, the real value of dollars going each year to charity may be less than expected.

MRA Associates Note

MRA Associates welcomes clients, fiduciaries, and advisors who desire and need transaction-specific, transparent investment portfolios. Fit-for-most, off-the-shelf solutions to implement important, complex wealth transfer transactions will not be proposed. Retainer pricing is common, as is working with clients who wish to retain investment control.

We welcome any comments, questions, or concerns.

Supporting Charts






[2]Interested readers might read the case Estate of Graegin v. Comm’r, 56 T.C.M. (CCH) 387 (1988) and consider IRC Section 2053 (a) (2) and Treasury Regulations. The discussion may be of interest to families (business owners) who are relying upon installment payment of estate taxes (IRC Section 6166) to pay federal estate tax.

[3] A grantor trust, while a separate legal entity, is ignored for income tax purposes: the grantor, while living, remains responsible for all income taxes. No taxable gain occurs when the asset is sold to the trust. Importantly, the grantor’s annual payment of income taxes for the trust are not gifts, even though they benefit trust beneficiaries.




Written By

Mark Feldman

Bruce Paulson

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