Testamentary trusts can be a very effective estate planning tool to assist in providing for spouses, children and grandchildren, and are becoming increasingly popular as more people become aware of the advantages they offer.
A Testamentary Trust is any trust established under a Will, but the term is usually used in the context of a discretionary family trust established under a will.
Why are they becoming so popular?
The increasing popularity arises from the very considerable benefits that can flow from their establishment and use, including the fact that although assets of the trust may be controlled by the intended beneficiary, they do not form part of that beneficiary’s estate.
Other advantages of a testamentary trust include the ability to protect assets and reduce tax paid by the beneficiaries from income earned from their inheritance – providing a greater level of flexibility and control over the distribution of assets to beneficiaries.
Reasons why you should consider a testamentary trust include:
Income Tax advantages
Utilising a trust provides the ability to take advantage of the excepted trust income provisions of the Income Tax Assessment Act 1936.Â For example, income paid to a minor from a minor’s trust is taxed at adult rates with the benefit of the adult tax-free threshold. If there are a number of minor beneficiaries to whom income can be paid from a discretionary testamentary trust, then it is possible to take advantage of multiple adult tax-free thresholds, reducing the overall tax payable considerably.
A testamentary trust can provide a primary beneficiary with the power to distribute income and/or capital among a wide range of potential beneficiaries, and this discretionary power to allocate income can result in considerable, and continuing, annual tax savings following your death.
Testamentary trusts provide a level of protection to the assets held in the trust, including against creditors of the beneficiaries who may want to recover from the trust assets an amount owing to them by a beneficiary, and in the Family Law Court in the case of the divorce of a trust beneficiary.
The Family Court has broad powers, including the power to make orders that are binding on a trustee. However, to date, the Court has taken the approach that trust assets should be treated as a financial resource of one of the parties rather than part of the asset pool available for division, particularly if the trust is not controlled by that party.
If nothing else, holding an inheritance in a trust structure prevents it from being absorbed into a couple’s combined finances, and makes it easier to identify. Notwithstanding this, you need to be aware that it will not be ignored in family law proceedings. For this reason, it is recommended that beneficiaries are placed in control of their own trusts, as it reduces the effectiveness of the trust structure as an asset protection vehicle.
In terms of protection against claims by creditors of an insolvent beneficiary, a testamentary trust is undoubtedly better than an absolute gift to a beneficiary, which can pass directly to a trustee in bankruptcy. There is increased risk if the trust is controlled by the insolvent beneficiary.
Assets owned by the deceased that would have been subject to capital gains tax (CGT) had the deceased sold them before their death, can pass through their estate to a testamentary trust without a CGT event occurring.
If an asset was a pre-CGT asset, the trust will receive a cost base equivalent to the market value of the asset at the date of death. If the asset is a post CGT asset, then the trust will inherit the deceased’s cost base. This is particularly important where the assets have significant unrealised capital gains. This also provides a good opportunity to “reset” the ownership of assets subject to CGT.
If for example, mum and dad own the shares in a company that is the corporate beneficiary of their family trust. The shares may have a nominal cost base but because of trust distributions made over a number of years (and often not paid in cash) the company may have become very valuable. All of that increased value is potentially subject to CGT if mum or dad changed the ownership of these shares during their lifetime. However, after their death the shares can be moved to a testamentary trust and dividends from the company can then be distributed by the trust to a range of beneficiaries, tax effectively.
In addition, trust assets may be transferred to beneficiaries without incurring CGT (but only in respect of assets of the trust that were owned by the deceased when they died).
Protecting ‘at risk’ beneficiaries
It is not uncommon for people suffering a variety of disabilities to be unable to properly manage their financial affairs. At the same time, families may wish to ensure that an adequate fund is set up to meet the beneficiary’s reasonable needs, and so as not to affect any pension rights they may have.
These people can be described as being ‘at risk’, a description that may for example include people who are drug or gambling addicted, mentally or physically disabled or simply spendthrifts who are not capable of looking after any wealth that is left to them. For these people, a testamentary trust can be managed by a trustee (who should be) a responsible and capable person (or people) who take action for the benefit of the ‘at risk’ person.
It is becoming much more common to steer away from the traditional husband and wife Will, which provides for a husband and wife to give everything to each other and then to their children, and to replace this with one or more testamentary trusts controlled by the surviving spouse and/or children under which the spouse and children are potential beneficiaries.
If the funds in the estate justify it (and remember this may include the proceeds of life insurance policies, or superannuation), Wills providing for testamentary trusts can provide that on the death of the spouse, sub-trusts come into existence for the benefit of each child and that child’s family.
Testamentary trusts are a very powerful and useful estate planning tool. The flexibility of such trusts, especially if combined with a memorandum of wishes as to how the trust should be administered, can be an appropriate arrangement as well as providing a highly advantageous tax mechanism, for many years into the future.
To find out more about how testamentary trusts can benefit you, contact us on (02) 8014 5885 or email firstname.lastname@example.org.