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Testamentary Trusts

What is a Testamentary Trust?

A testamentary trust is simply a trust created in a will.

What then is a trust? A trust is where one party – the trustee, holds property for others – the beneficiaries.

Even the simplest will is likely to have trusts.

For example Brian’s will appoints Penny as a trustee and Penny in that capacity holds a sum of money on trust until Brian’s children reach the age of 18.

In common usage today a testamentary trust is the name given to a long term arrangement created in a will where property is held by a trustee for a wide group of beneficiaries.

The trustee has extraordinary powers at his or her discretion to pick and choose between those beneficiaries from time to time to determine who will get benefits being the distribution of either income or capital or both.

If an arrangement of that nature is created in a deed (and not a will) it is called a discretionary trust deed.

Many businesses in Australia are operated by discretionary trusts.

Types of Testamentary Trusts

The types of trusts that can be put in a will are endless and varied. The only limit is your (and more likely my) imagination!

For example:

  • Protective trusts to protect spendthrifts, bankrupts etc
  • Trusts for the disabled
  • Capital protected trusts
  • Charitable trusts
  • Fully discretionary trusts
  • Trusts creating life interests
  • Trusts permitting only staggered release of a bequest to beneficiaries

This paper addresses fully discretionary trusts in wills where it is intended that a major beneficiary, typically a spouse or a grown up child, will control that trust following the death of the will maker.

Most discussions about testamentary trusts are referring to this type of arrangement.

Why would you set up a Testamentary Trust?

  • There are certain tax advantages which are not otherwise available.
  • It may assist if there is a matrimonial or de facto breakdown now or in the future affecting a close relative typically a spouse or children
  • It may protect inheritances if a that close relative becomes bankrupt
  • It may assist to avoid disputes over wills that may affect those close relatives in the future
  • It provides a long term structure for holding assets following the death of the Testator.
  • It provides a mechanism for distributing financial benefits in the future to chosen family members.

 The Tax Advantages of Death!!

Income earned by children under the age of 18 is taxable at the highest marginal tax rate apart from some very limited exceptions.

One of those exceptions is income earned from a testamentary trust by children under the age of 18 which is taxed as if they were adults and the normal tax free thresholds and marginal rates apply.

Example

  • Brian is married to Penny they have 4 children all aged under 18.
  • Brian has died conveniently on 1 July 2013 leaving an estate of $2 million.
  • That estate generates an income of $91,000 per annum.
  • Penny has her own small income from a part time teaching position of $18,200 per annum.
  • None of the children has any income of their own.

1. Without a Testamentary Trust Will.

If Brian leaves his entire estate to Penny then she would pay tax in the 2013/4 tax year as follows:

Income from estate assets $91,000.00
Other income of Penny $18,200.00
Taxable Income of Penny $109,200.00
Tax payable $28,351.00

2. With a Testamentary Trust Will.

Assuming Brian has a properly constructed Testamentary Trust will and that it provides for a testamentary trust of which the discretionary beneficiaries are Penny and Brian’s 4 children among others. Penny is the trustee of that trust and has the power to make decisions about distributions of income in her capacity as trustee.

Distribution from the testamentary trust to Penny $18,200.00
Distribution from the testamentary trust to each of the 4 children ($18,200.00 each) $72,800.00
Total for distribution $91,000.00
Total tax payable by Penny $3458.00
Total tax payable by children (x4) $nil
Total tax payable by Penny and the children $3,458.00
*Total taxable income of $36,400.00 (i.e. being income of $18,200 from her part time job plus the distribution of $18,200 from the estate)

Tax rates used in the example are those applying as at 2013/2014, with the Medicare Levy and the Medicare Surcharge among other things ignored for simplicity.

 Asset Protection

Whilst the tax advantages are attractive, for many a far more important consideration is the asset protection that a testamentary trust will offer to the beneficiaries typically family members who benefit under the will.

A Testamentary Trust Will separates out ownership of trust assets which is held by a trustee from the benefit of those assets which is or may be enjoyed by beneficiaries.

The beneficiaries usually have only the right to require proper administration of the trust assets and do not have the right to demand distributions of capital or income in their favour (or in favour of anyone else).

Protection of a beneficiary from themselves

A will maker will quite often be quite concerned that by virtue of youth or immaturity children, grandchildren and other beneficiaries should only gain control of an inheritance once they achieve a certain minimum age.

Most of my clients think 25 years of age is the age at which children reach maturity but its a matter of much debate.

There are of course other reasons for denying beneficiaries control over their inheritance such as drug addiction or a particular person having a spendthrift nature.

In the case of serious disabilities it may be that a particular beneficiary should never have control of their inheritance.

Asset Protection from Creditors

The inheritance by a beneficiary of assets through a testamentary trust will provide a large measure (but not necessarily absolute protection) from claims by creditors to the assets contained in the trust. It is essential however that the bankrupt beneficiary is not a trustee of the relevant trust or at very least is noty a trustee at the time iof his/her bankruptcy.

Asset Protection from Claims by a former spouse or partner under the Family Law Act

The best starting principle is to assume the Family Court may bust any trust no matter how well crafted.

The Family Court is very robust in the way it exercises powers.

However a well-crafted trust may well still offer considerable advantages for a beneficiary who is at risk of being the subject of a relationship break down.

Very few property disputes go to a formal hearing and it would be wrong to assume that every trust will be dismantled to the disadvantage of your chosen beneficiaries when a relationship breaks down,

I find that lawyers who practise regularly in the family law area are very keen to have their clients potential inheritances protected (so far as that is possible) in a testamentary trust.

Issues arising from Testamentary Trusts

1. Complexity

For many will makers there is an overwhelming desire is to get a “simple will” no matter how large their estate is and no matter how complex their family affairs.

I believe this concern is not to be lightly dismissed and my experience is that the tolerance of the will maker to a long complex will should be carefully tested before time money and energy is expended on the exercise.

In other instances my client (or more commonly his or her financial advisor!) is enthusiastic to set up a testamentary trust but the assets (especially those that will fall into the estate) are not of a sufficient quantum to justify the exercise.

However it is not unusual for the “simple will” to be exceedingly difficult to put into effect or to create a great unhappiness and injustice.

2. Flexibility

The will that is drafted today may be at the “cutting edge” of legal knowledge but the document may be inadequate in the future as laws inevitably change and drafting techniques become more sophisticated.

This issue is exacerbated by the marked reluctance of the bulk of the population to regularly review or update their wills.

For these reasons I include an “opt out clause” in my testamentary trust wills. This clause allows say a surviving spouse to choose to take his/her share of the estate either by:

(a) Taking under the testamentary trust arrangement;

(b) Electing to take the inheritance as an absolute gift; or

(c) Taking some part of the estate under the testamentary trust and the other part of the estate personally

For example, if the principal place of residence is owned solely by the deceased the surviving spouse needs to decide whether to take that property in his/her own capacity or have it as part of the testamentary trust. That decision will have different consequences from a tax and bankruptcy point of view.

The tax and asset protection benefits being promoted today may disappear as relevant legislation changes tomorrow.

A will can only deal with assets that fall within the estate. Significant assets may pass consequent to the will maker’s death but outside the will. This may include among other things superannuation, life insurance proceeds, trusts controlled by the testator and assets owned as joint tenants. A well drafted will can allow the executor to take these matters into account in the distribution of the estate.

Who Needs a Testamentary Trust

There are no set criteria when it is advisable to have a testamentary trust will but in my mind the following would indicate to me it is worth considering.

  • Assets in excess of $500,000 which will form part of the estate
  • Beneficiaries are or maybe children or grandchildren under the age of 18
    (The more children there are under the age of 18 the larger are the potential tax savings for the family as a whole!)
  • Vulnerable beneficiaries
  • Children (or their partners) who are at risk of getting into financial difficulty.
  • Children are at risk of divorcing or separating from their partner
  • Where there are asset protection strategies already in place and the benefit of those strategies is sought to be preserved after the death of the will maker.
  • Children have their own businesses.
  • One or both of the partners to a relationship is in business on their own account.
  • Where a person holds large life insurance policies.
  • Where substantial Superannuation benefits may form part of the estate.
  • A testamentary trust is recommended to you by your financial advisor.

Current as at 1 July 2013