Use of Testamentary Trusts
Testamentary trusts created under a will provide the testator with a significant degree of control over distribution of assets – including income - to beneficiaries as well as tax effective estate planning. They come into existence only upon completion of the administration of an estate and, whereas the estate administration should be completed and assets bequeathed under the will distributed without undue delay, the trust can validly operate for up to 80 years. The trust can be brought to an end and the assets appointed to the beneficiaries by resolution at any time.
As such they provide a very useful means of estate planning.
The most common vehicle relied upon is the discretionary testamentary trust under which the beneficiary may either take all or part of the inheritance, depending upon the discretionary decision of the trustees. If a “primary beneficiary”, he or she may remove and appoint the trustee or even appoint themselves to manage the inheritance.
Operation of the will – triggering the testamentary trust
The trust terms can form part of the testator’s will.
The first part of the will sets out the general testamentary provisions providing for appointment of executors and trustees, granting bequests of specific assets of the testator, either as they existed at the time of death or upon their conversion by the executors to cash.
A separate and distinct part of the will would provide for the formation and administration of the testamentary trust itself - for example, requiring the executors, as trustees of the testamentary trust, to “hold the balance” of the estate -
“…for the benefit of those beneficiaries nominated, and in accordance with the provisions set out, in [that part]…”
Following distribution of specific bequests under the first part of the will the administration of the estate is completed. Thereafter, the “balance” of the estate (which may well be substantial) is transferred to the trust to be administered by the nominated trustees in accordance with its terms. These would typically require investment or other management of the remaining assets of the deceased.
Some specific advantages of testamentary trusts
1. Protective features
(a) Where a beneficiary may not be of the age of legal responsibility or have some other legal impediment (such as due to disability or even, in the view of the testator, at risk of frittering away the inheritance) this form of trust will preserve that interest until a particular date – such as upon reaching the age majority – at which time the beneficiary must take the inheritance through the trust and without any opportunity to appoint or remove trustees.
(b) An ordinary gift under a will can be appropriated by the recipient’s creditors or trustee in bankruptcy. Likewise, the spouse of a beneficiary may claim assets bequeathed to the beneficiary under a will. Given that the beneficiary has no entitlement to assets or income of the testamentary trust unless and until the trustee exercises its discretion to distribute at all, these are protected from creditors and, to a large extent, from claims by the spouse. The effectiveness of the protection will however depend on how the trust terms are drafted.
They can nevertheless be a ‘resource’ available to the marriage while it lasts. Where the trust is a discretionary one, can been proven to be conducted in a truly “discretionary” manner and be independent of a spouse’s effective control, the approach of the Family Court has been not to treat assets of the trust part of the matrimonial pool. However, where on the evidence a party has legal or de facto control of a trust (for example, as trustee or having the ability to appoint or remove trustees, or as a person influencing the trustee’s decisions) then his or her interest forms part of the matrimonial pool of property available to be divided between the parties by the Court.
2. Tax treatment
Concessional tax treatment available by streaming income, capital gains and franking credits through a testamentary trust is also a significant advantage of trusts generally – in particular where beneficiaries who are minors or are otherwise under “legal disability”(for example, bankrupts or mentally incapacitated persons).
Income tax
Trust income is taxed primarily in the hands of the beneficiary receiving or being “presently entitled to” income from the trust. On the other hand, the trustee is assessed as trustee in respect of income of a person under legal disability.
Where a beneficiary who is under a legal disability is presently entitled to a share of the trust income, the trustee is assessed and liable to pay tax in respect of so much of that share of the net income of the trust as is attributable to a period when the beneficiary was resident or, in respect of any period when the beneficiary was not resident, the share of net income of the trust attributable to sources in Australia.
There are clear taxation advantages in distributing the trust income among as many minor beneficiaries as possible. For example, distributions made by the trustee to children under 18 years of age are subject to a substantial tax-free threshold – currently $18,200 per annum.
If trust income can be distributed to a number of minor beneficiaries on a proportionate basis (depending upon the beneficiaries respective interests in the trust) then, taken together with the lower marginal tax rates available, this can allow for a much lower total tax payable than may arise if the trustee is taxed at the higher marginal rates under sections 97 or 99A.
Additionally, income derived by a minor beneficiary from assessable income of a testamentary trust will itself be assessed in the hands of the beneficiary at a lower rate, provided that it qualifies as “excepted trust income”: ITAA section 102AG (2)
Capital gains tax
Assessable income for tax purposes includes net capital gain for an income year: (section 102-5(1) of the Income Tax Assessment Act 1997). Therefore gains made on realized assets of the trust may be significantly reduced where a nominated beneficiary has a low income during the year in which the distribution is made. If a trustee is taxable under section 99A on a capital gain the 50% CGT discount does not apply. But the CGT discount may apply if the trustee is taxed under section 99. Therefore, the question whether section 99 or section 99A applies to the trustee is especially significant if the trustee has undistributed income that includes a taxable capital gain. Finally, if permitted by the trust deed the trust’s capital gains and franked dividends can be effectively streamed to beneficiaries for tax purposes by making the beneficiaries entitled to those amounts, as well as the relevant franking credits.
3. Maintaining entitlement to statutory benefits
While having a contingent entitlement in the trust property, the beneficiary may nevertheless continue to qualify for age, disability or similar pensions and benefits for which they would be otherwise disqualified under a normal inheritance taken under ordinary provisions of a will.
4. Ongoing arrangements for surviving beneficiaries
Understandably a testator may wish to ensure that living and financial arrangements for the surviving spouse are assured following his or her death. This can be achieved by providing for a life tenancy in the testator’s interest in the matrimonial property, or a life interest in the testator’s interest in income producing assets. This is often provided for under the will, being granted to a particular beneficiary (usually the surviving spouse).
If provided in the will the interest would then revert to the estate upon the death of the spouse (or other limitation provided in the will for the spouse’s occupation and use of that property). This will of course unacceptably delay finalization of the administration of the estate, which must be promptly dealt with following the grant of probate.
However if the survivor’s rights to use and occupy premises are provided for under terms of the testamentary trust and set out in suitable terms, the surviving beneficiary’s occupation and use of that asset - for example, the matrimonial residence - can be simply allowed for, with the asset reverting to the trust.
For example, a trust for sale would allow for the occupancy or other use of that asset, or entitlement to income, by that beneficiary for the time being. Upon the surviving beneficiary’s death (or the occurring of any other event allowing for reversion of the asset to the trust) it would revert to the trust for sale and investment by the trustees of the net proceeds of that sale.
In the case of a beneficiary other than the testator’s spouse, an estate can benefit from the main residence exemption. If a beneficiary other than the deceased's spouse or the person to whom the dwelling is bequeathed is likely to occupy the deceased's principal residence, the testator should consider giving that individual a right to occupy the dwelling under a testamentary trust. If the beneficiary subsequently occupies the dwelling, the existence of the right to occupy may allow the executor/trustee to satisfy one of the requirements for the main residence exemption under section 118-195(1) of the ITAA.
With these factors in mind, contact us to arrange for a review of your will or trust and related deeds, and succession arrangements in general.
Trumble Szanto lawyers
Please note: This material is for general educational purposes and is not designed to be advice to any particular person in relation to their own affairs as it does not take into account the circumstances of you as an individual. We do not represent, warrant, undertake or guarantee that the use of guidance in this paper will lead to any particular outcome or result.