Last week, former Massachusetts Governor Mitt Romney released his 2010 tax returns after pressure from his opponents in the race for the Republican presidential nomination. In addition to his and his wife’s joint tax return, Romney released the tax returns for three trusts created for the benefit of his family. On each tax return, it was noted that the trusts were structured as “grantor trusts” and any income earned by the trusts was reported on the Romneys’ joint return.
Grantor trusts differ from typical trusts in the way they are structured and how their income is taxed. In a traditional trust, the creator of trust (the Grantor) does not retain any power or control over the transferred property. Conversely, a grantor trust is structured to allow the Grantor to retain certain powers over the trust property. These powers include the ability of the Grantor receive a loan from the trust without adequate consideration or interest; the ability to substitute the trust property for property of equal value; and the Grantor retaining a power of appointment over the trust property without the consent of any adverse party.
The decision to structure a trust as a grantor trust comes with certain clear benefits. First, by having the income of the trust taxed to an individual rather than a trust, the tax rate on the income is typically lower. Second, by paying the income on trust property, the Grantor can reduce the size of his taxable estate while not diminishing the value of the transferred property. Finally, by transferring assets into a grantor trust, a Grantor can utilize a portion of his or her lifetime gift tax exemption and freeze the value of the gifted property for gift and estate tax purposes. This is an especially valuable tool when the transferred property is expected to appreciate greatly in the future.
Grantor trusts are often used to transfer assets without paying any gift tax through the sale of the property to the trust. The property is transferred to the trust in exchange for a promissory note. Over the course of the note term, the trust uses the income of the property to pay the interest on the note. At the end of the note term, the trust makes a balloon payment of the original principal back to the Grantor. This type of transaction is especially effective when the transferred property can be discounted for valuation purposes and when interest rates are low.
Despite the release of his tax returns, much of Governor Romney’s financial background and planning remains a mystery. His use of grantor trusts indicates that he has likely done a significant amount of estate planning and has positioned his family to retain larges amounts of his family wealth for generations to come.
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