Estate Planning – Testamentary Trust
Testamentary Trust – What are they and how do they work?
Short Answer
Testamentary Trust is a Trust that becomes “active” (or legally termed as established) AFTER you pass away and it exists to distribute your assets in a specific format to specific beneficiaries within specific time lines.
Long (and technical) Answer
A testamentary trust allows you to make provisions for certain assets to be controlled and managed by the trustees on behalf of the Trust beneficiaries and by doing this the Trust controls the asset protection and tax planning.
Asset protection
A testamentary trust holds assets that are generally protected from legal action such as claims by the creditor of a beneficiary or the former spouse of a beneficiary.
A testamentary trust can also protect the interests of vulnerable beneficiaries such as young children, the intellectually disabled, spendthrifts, or those who have gambling, drug or alcohol addictions.
A recent case study we observed was a person went through his second divorce and he had young children under the age of 5 years old that he wanted to pass on his assets to in case of his death.
He knew that if he died then the children would be cared for by his ex-wife and she would become the “trustee” of the funds on behalf of the young children.
This would give the ex-wife 13+ years to spend the funds “in the interests” of the children, who were the beneficiaries, with little to no accountability or recourse.
The ex-wife could even buy a property for herself and claim that it’s to provide housing for the children but in reality, the ex-wife is the real beneficiary of that transaction.
To prevent a scenario like this from happening, you would provide for a Testamentary Trust to be established in your Will upon your death. By doing that you would give the trustees full discretion to decide which beneficiaries receive income or capital and when they receive it and you can make specific provisions in your Will restricting access to income or assets until certain conditions are met such as when your children reach certain ages.
Planning Opportunities
If suitable provisions are included in the trust deed:
- The trustees may have the flexibility to decide which beneficiaries receive income from the trust, and
- Income may be directed to different beneficiaries each year, without having to transfer ownership of
the assets.
As a result, the trustees can split investment income amongst different beneficiaries.
Normally, when a minor child receives income from an investment, amounts over $1,300 pa are taxed as high as 45%. However when investment income is distributed to a minor child from estate assets held in a testamentary trust, tax should be payable at normal marginal rates which are around 32%.
The Trust can be used to hold and protect assets such as investments, property, cash, collectible cars and other valuables such as paintings, furniture or jewellery.
The assets held in the trust are called ‘Trust Capital’ and this capital can produce income such as dividends or interest and create capital gains.
Under trust law, the trustee is the legal owner of the assets in a testamentary trust. Trust law requires a trustee to manage the assets held within a trust in the best interests of the beneficiaries.
When you include an instruction in your Will to create a testamentary trust, you name a trustee who is responsible for distributing the trust assets to your beneficiaries in accordance with the instructions in your Will.
You can give your trustee the power to decide when and how to use and distribute your assets to meet the needs and best interests of your beneficiaries.
The trustee you select for your testamentary trust can be a family member or friend aged over 18 who is an Australian resident, or you can choose a trustee company or legal or accounting organization to take on the responsibility.
The two main types of a Testamentary Trust
Discretionary Testamentary Trusts
These give a beneficiary the option to take part or all of their inheritance through a testamentary trust. The principal beneficiary can remove and appoint the trustee. They also have the power to appoint themselves to manage their inheritance inside the trust.
Protective Testamentary Trusts
These require a beneficiary to take their inheritance through the trust and do not provide the option to appoint or remove the trustee. This can be useful if a beneficiary does not have appropriate skills to manage their inheritance such as the young or vulnerable types listed above.
Always Seek Advice.
While your financial adviser can help you assess the merits of a testamentary trust, you will need to seek professional legal and taxation advice when making suitable arrangements and the trust will need to be nominated in your Will which means it gets executed by a lawyer.
A testamentary trust may be worth considering for the following situations:
Bankrupts
Many families include someone who has been forced to declare bankruptcy such as a spouse who guarantees their partner’s business venture, or someone with a failed business.
With a testamentary trust, the bankrupt’s inheritance can be protected from creditors.
Divorcees
As listed above (ex-wife example) relationship breakups happen all too often and inheritances are usually subject to a Family Court order. If a testamentary trust is in place, the outcome may be more favorable to a beneficiary especially if they are minors or vulnerable and it prevents the Family Court making the final decision.
Remarriage
Many people think about divorce and separation but what about remarriage? Children living with a divorced partner can have the certainty that they will receive their inheritance if they inherit through a testamentary trust and this completely excludes the new incoming person’s claim on any of the assets.
Retirees and Age Pensioners
Currently, assets held within a testamentary trust are not tested when determining a beneficiary’s eligibility under the Centrelink assets test for the Age Pension but income from a testamentary trust is.
High-risk Professions
Beneficiaries in a profession where negligence claims are a possibility such as Doctors and Lawyers can be protected by receiving their inheritance through a testamentary trust.
Tax benefits
Another benefit of a Testamentary Trust is how income can be distributed to the beneficiaries. For example capital gains and franked dividends can be distributed to beneficiaries in a tax-efficient manner as long as the Trustee has discretion on how the income can be distributed.
Tax is not payable when assets are transferred into the testamentary trust and the Trust is not required to pay tax on income distributed to beneficiaries.
This allows the trust to do “income splitting” to adult children and lower income earners.
Testamentary trust income is taxed at adult tax rates rather than minor tax rates which provides for a child beneficiary the normal adult tax-free threshold of $18,200, rather than the $416 for minors.
Investment Benefits
A Testamentary Trust provides flexibility for the trustee to manage and invest trust capital at their discretion as long as is done with the interests of the beneficiaries in mind. This means the trustee can invest according to the changing needs of beneficiaries such as when they get older or change health or relationship status.
Downfalls of a Testamentary Trust
Complexity
Testamentary Trusts are complex and both the trustee and beneficiaries need to understand the structure and operating rules.
Tax and CGT issues
If you hold your primary place of occupancy (IE the house you live in) inside the Trust then there is the issue of the potential loss of Capital Gains Tax exemption on your house.
In some states, CGT may apply on assets acquired by the testamentary trust on your death. If capital assets are sold at a loss, capital losses cannot be distributed to beneficiaries and must be carried forward to set off against future capital gains, similar to how Company income tax gets treated (EG carry forward tax losses)
The Trust is required to pay tax on undistributed income.
Franking credits from dividend income must be distributed in the same proportions as dividends.
Costs
Because they are so complex (but very useful and necessary) the ongoing administrative, legal, accountancy, financial advise and tax preparation and lodgement fees are payable and these can run into the thousands. The Trust is required to lodge annual tax returns and this can be even more complicated if there is a trustee company managing the trust capital.
This is usually not a problem is there are over $1 Million worth of income and assets being managed by the trust but it can be restrictive when the assets are a couple hundred thousand and as a result the ongoing fees may reduce the income and assets held in the trust.
Succession Planning
If family members share the trustee role, there is the potential for disagreements over distributions. Disputes can occur and a resolution mechanism needs to be in place to manage this.
If one or more primary beneficiaries die then provisions are needed to cover the sale of respective assets.
If this were to happen then it can cause disputes and such scenarios need to be covered in the Will.
So that’s the long answer on how Testamentary Trusts work.
Want to Know More?
If you want help, more information or advice on Estate Planning and talking about how a Testamentary Trust can work for you then fill out the Contact Form below and an estate planning adviser will contact you to discuss your unique situation and answer any questions.
People who wanted advice on establishing a testamentary trust also considered their Will and Superannuation Beneficiaries.
Every State and Territory in Australia has it’s own laws regarding Probate Law. Below are the State Trustees for VIC, NSW and QLD.
Victoria – State Trustees
NSW – NSW Trustee & Guardian
QLD – Public Guardian