Testamentary Trusts

 If you are making a Will and thinking about providing for your loved ones (and others) after your death, you might consider using a Testamentary Trust.

 Why a testamentary trust? 

Creditor protection

To protect the bequest from creditors of a beneficiary. It can also protect the bequest from the debts that a beneficiary may incur by guarantees given by that beneficiary of their spouse’s business debts.

Divorce of a child

Assets held in the trust are not assets of any individual and the Family Court cannot make an order requiring the distribution of those funds.

Education

If you are a grandparent, leaving bequests via a testamentary trust for payment of boarding school and tuition fees for your grandchildren is a more tax effective method of providing for their education rather than leaving additional bequests to their parents.

High risk beneficiaries

Where one of the beneficiaries is in a high risk profession or business where negligence claims are likely.

Remarriage of spouse

Where you want to provide for your spouse but are concerned that they may remarry and divert the family assets to the new family or use the family assets in risky or unprofitable ventures at the suggestion of the new spouse.

Children with issues

In the case of spendthrift children/gambling difficulties/drug addiction for example, you can provide for such a child through a trust ensuring his/her share is kept intact.

Tax benefits

Income splitting through trust; distribution tax free to children under 18 up to marginal rate.

Will challenges

If your beneficiaries receive your estate in a trust, and it remains in the trust, as it is not in their estate it cannot be subject to a Will challenge when they die.

Disabled children

Where you need to ensure that any disabled or intellectually impaired children are looked after.

 How do I create and fund a testamentary Trust

A testamentary trust is a trust created by your Will and does not come into effect until after your death. There are various types of testamentary trusts but it is usually a trust where the trustee has full discretion about distributions to the beneficiaries. For a trustee to properly exercise their duties, they must be able to clearly identify the beneficiaries. If there is uncertainty as to who the beneficiaries of the trust are, then the courts can resort to the default position as if you died without a Will. You can create multiple testamentary trusts in your Will if you want and you can give the executor of your Will the discretion to avoid the setting up of a trust with the consent of the beneficiary should circumstances warrant.

There is a second chance for your family to establish a testamentary trust after you die but this second chance must be taken advantage of within three years of your death. This enables a trust to be established from your assets and for the income to enjoy the same tax advantages as income derived through a testamentary trust. However, the assets used to establish the trust cannot exceed the amount which the beneficiary would have received under the law, if you died without a Will.

The trust can be funded by your some or all of your assets and by payments in consequence of your death such as superannuation death benefits or insurance proceeds paid to your estate rather than directly to your dependants or beneficiaries in your Will.

A testamentary trust can continue for a period of 80 years if so required but it is also possible for the testamentary trust to vest at any earlier date if the trustee so decides.

A testamentary discretionary trust has a trustee (or trustees), a range of discretionary beneficiaries (for example, spouse, children, grandchildren) and in some cases an appointor (for instance, the spouse) who controls the trustee/s. It is the trustee who determines which of the beneficiaries, if any, receive any income or capital from the testamentary trust and also the amount of any income or capital they are to receive. Be aware that assets left to children through a testamentary trust must eventually pass to them.

You set the terms of the testamentary trust in your will. These terms can restrict the ability of any of the beneficiaries to control the activities and investments of the trust or give them complete control. You might choose to 'rule from the grave' to ensure that the inherited assets are protected and used sensibly for the benefit of the primary beneficiary. If you do this then you should probably have an independent person in control of the testamentary trust and you should consider all of the implications of this very carefully.

Unlike assets in superannuation funds, testamentary trust assets can be removed from the trust, borrowed or used as security. There are no requirements for a spread of investments or audited accounts and a trustee of a discretionary trust can act in a purely self-interested manner.

Anyone you wish can be the trustee, including the executors of your will, your spouse or partner, or your children. The trustee has effective control of the trust, so the trustee should be a person whom you know and trust to act in the best interests of those who are to receive the benefit. If you establish a number of testamentary trusts, you can have different trustees for each of them.

You should really think through the risks in giving responsibility for the assets to a trustee. People in control of other people’s money may be dishonest, whether they are your much trusted brother, friend or advisor. The assets will only be protected (from creditors, ex spouses etc) if the beneficiary does not have control so the trustee must have full control. Much careful thought must be given to protecting the beneficiaries from dishonesty or even incompetence. In some cases, you might prefer to give the property absolutely and let the beneficiary deal with it, whatever that means.

Common areas which require thought are:-

  • Whether to have one or several Trusts established under the Will
  • The selection of the trustee or trustees
  • The method of appointing replacement trustees
  • Whether the beneficiaries be limited to your descendants only or whether their spouses might be included
  • Whether some classes of beneficiaries are restricted to income and some to capital

 Advantages of a Trust

The significant advantage of a testamentary trust is that the assets are owned by one person(s), the trustee, and the benefit of the income and capital of the trust passes to another person/s, the beneficiaries. This separation of control and benefit allows testamentary trusts to protect assets from any legal action involving the beneficiaries and/or misuse of those assets. Indeed if you yourself are involved in a 'risk' occupation where you might be sued and want to protect your own assets, you might consider having the Wills of your parents and spouse establish testamentary trusts for you rather than inheriting assets personally.

If you have a beneficiary who has an intellectual impairment, you could leave part of your estate for that person's benefit by naming that person as the primary beneficiary of a testamentary trust with a family member, professional adviser or a trustee company as the trustee.

If an intended beneficiary faces bankruptcy, an inheritance for that beneficiary through a testamentary trust will not form part of the beneficiary’s estate for bankruptcy purposes.

Assets held within a testamentary trust are unlikely to be the subject of a court order in the case of beneficiaries experiencing a break-up of their marriage although they may have some effect on the terms of the property settlement.

Tax Advantages

The main tax advantage of using a discretionary, testamentary trust is that any income, capital gains and franked dividends can be distributed among all your family beneficiaries each year in the most tax-efficient way. A trust does not have to pay income tax on income that is distributed to the beneficiaries, but does have to pay tax on undistributed income. The trustee is free to distribute trust income to as many beneficiaries as possible, and in proportions that take best advantage of those beneficiaries' personal marginal tax rates. The beneficiaries then pay the tax on distributions made to them.

Franking credits from dividend income, however, must be distributed in the same proportions as the dividends and can be forfeited when the dividend is distributed from a non-fixed trust to beneficiaries, unless certain conditions are satisfied:

  • The Beneficiaries have a fixed entitlement to the trust capital; or
  • Trust is a testamentary trust of less than 5 years duration; or
  • Trustee has made an election to become a 'family trust' for taxation purposes and be subject to those rules

The tax concessions do not apply solely to income and capital gains derived by the trust the assets you bequeath it, they also apply to any income and capital gains derived from assets acquired from the reinvestment of moneys received from the original inherited assets.

There are penalty tax rates for children under 18 to stop parents splitting their income with their children through a family trust. However, income from inherited assets and from testamentary trusts are taxed at normal adult rates, in particular the child has the normal tax-free threshold. Without going into too much detail, you should consider a pension from superannuation first as a source of tax effective income for your dependent children (under 18 or under 25 if in full time education) - if you are over 60 when you die, it is tax free; if under 60, taxed with a 15% rebate. These concessions do not apply to income from a testamentary trust, so testamentary trusts may only be a preferred income tax option when:

  • Child superannuation pensions or options are not available because of an inflexible superannuation fund
  • Lack of superannuation funding
  • The children are your grandchildren and are not your financial dependants
  • Access to the capital is needed

Pension

There may be advantages for beneficiaries who may be eligible for a pension as the assets of a testamentary trust are not currently taken into account in establishing pension eligibility under the current means tested pension rules. However, income from the trust is taken into account for income test purposes.

Capital Gains Tax and Stamp Duty

There is normally no tax on the transfer of assets on your death from your legal ownership to legal ownership by your executor and then to the trustee of the testamentary trust or on the cash proceeds of a life insurance policy or superannuation death benefit. Similarly, there is no tax when assets that originally belonged to you are transferred from the trustee to a beneficiary, however that may not extend to assets acquired by the executor or the trustee. There may be differences between states in the imposition of stamp duties.

 Disadvantages

You should be careful about the taxation rules for superannuation death benefits if the trust beneficiaries are not confined to dependants.

You should also be aware of any taxation implications for the exemption from capital gains tax on the family home if the residence is held in the trust and for tax concessions for active assets for small businesses in the trust.

You should consider what is to happen if the trust continues past the primary beneficiary’s death and think about dispute resolution formulas for a 'second generation' situation.

One disadvantage is the cost of administering a testamentary trust. If a professional is appointed trustee, there will be fees for this service. There will be ongoing administrative costs involved in maintaining a trust, such as accountancy fees for preparation of trust taxation returns. You should consider whether the income generated by your estate will be sufficient to warrant a testamentary trust. If, for example, all your assets are owned jointly with another person or by a family trust, there may be insufficient assets in your estate to make the establishment of a testamentary trust worthwhile. If you are uncertain about whether you will have sufficient assets in your estate, a testamentary trust can be included as an option in your Will, with the trustee(s) making the decision whether or not to implement the trust at the relevant time.

If you already have a family trust the assets of your family trust do not form part of your estate. If all your assets are presently owned by your family trust, there would be no point in establishing a testamentary trust unless you planned to wind down your family trust and transfer the assets in it to yourself.