What is a Testamentary Trust?

A Testamentary Trust is a trust established by a Will.  A Beneficiary Testamentary Trust can be optional (the beneficiary can choose not to use it) discretionary (the beneficiary decides who will benefit) or a fixed trust or a combination of these.

Optional, discretionary Testamentary Trusts are widely recommended for use in modern Wills because of the taxation and asset protection advantages that they offer when compared to a “standard” Will.

A standard Will offers little assistance to a beneficiary of an inheritance in relation to issues of tax efficiency and asset protection.

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Why use a Testamentary Trust?

Establishing Testamentary Trusts in your Will provides your beneficiaries with maximum flexibility in dealing with their inheritance. The usefulness of a Discretionary Will Trust to a beneficiary will depend upon the beneficiary’s specific needs and circumstances at the time of your death so it is important that the terms of the Testamentary Trust are sufficiently wide to offer the beneficiary as many options as possible so as to provide freedom and flexibility.

What if a Testamentary Trust turns out not to be useful to my beneficiaries?

Unless special needs exist, your Will should be drafted so that the primary beneficiary has the power to decide to: 1. use the trust for all, part or none of the beneficiary’s inheritance; 2. wind up the trust at any time; or 3. pass the control of the trust in accordance with the primary beneficiary’s Will. Because a Testamentary Trust can live for up to 80 years from your death it can provide flexibility, asset protection and taxation advantages for many generations of your family.

What Assets can be put into a Testamentary Trust?

Any assets belonging to you can be left to your beneficiaries via a Testamentary Trust on your death. Additionally, payments made to your estate as a result of your death i.e. superannuation death benefits or the proceeds of life insurance can also be directed to be held within a Testamentary Trust. To provide maximum flexibility to your beneficiaries, your Will have should be drafted to allow your beneficiaries to choose what assets belonging to you should be held within a Testamentary Trust.

What does a Testamentary Trust “look like?”

Instead of leaving an inheritance directly to a nominated beneficiary you leave the inheritance to your nominated beneficiary as trustee (or as one trustee) of a discretionary trust with wide discretionary powers.

How will my beneficiaries potentially benefit from a Testamentary Trust?

Significant income Tax savings for beneficiaries
 
Well drafted Testamentary Trusts can give a beneficiary the option to reduce personal income tax by splitting income from the investment of inheritance between a range of family members on low tax rates.
 
The trustee of the Testamentary Trust (normally the primary beneficiary) has complete discretion to determine who receives the income of the trust.  Tax is paid on the income of the trust at the marginal tax rate of the beneficiaries who receive it.  Therefore, by selecting beneficiaries on low marginal tax rates, the trustee can minimise the taxation liability of the trust.  The trustee can choose to distribute income to minor beneficiaries of the trust with each beneficiary being able to receive over $18,000 of income tax-free each year.
 
The trustee can also distribute income from the trust to charitable and religious beneficiaries.  As many such beneficiaries have tax deductibility status or are tax exempt, no tax is paid on allocations to such organisations.
 
Beneficiaries under 18 (minors) attract special tax concessions
 
Normally penalty rates of tax apply to income derived from trusts which is paid to children under age 18.  The Tax Act allows children under age 18 who receive income from a testamentary trust to be treated as adults for tax purposes.  This could mean significant tax savings for beneficiaries who can “split income” with their minor children. 
 
A Testamentary Trust can therefore provide tax free income of over $20,000 per annum to the grandchildren of a Willmaker providing a direct benefit to the parents.
 
Significant capital gains tax savings for beneficiaries.
 
A well drafted Testamentary Trust can also provide the opportunity for your beneficiaries to minimise Capital Gains Tax which arises from the sale of your assets.
 
Capital Gains Tax is not triggered when an asset belonging to you passes via your Will to your executor or the trustee of a Testamentary Trust. Also there is no Capital Gains Tax when your assets are transferred from the trustee of a Testamentary Trust to a beneficiary – see ATO Practice Statement LA 2003/12.
 
As with the income of the trust, the trustee can select which of the beneficiaries of the Testamentary Trust should take the capital gain. By choosing to distribute the capital gain to a beneficiary on a low or nil income, the Capital Gains Tax liability can be significantly reduced.
 
Holding the assets of an estate within a trust offers the beneficiaries an opportunity to defer the need for the sale of assets (and therefore Capital Gains Tax) until later when more numerous beneficiaries come into existence. Tax deferred is tax saved.
 
Beneficiary’s inheritance can be protected from bankruptcy
 
A Testamentary Trust can provide protection to your beneficiaries from the repercussions of bankruptcy.
 
Assets that pass to a Testamentary Trust from an estate are held for the nominated primary beneficiary until the trustee elects to distribute such assets.  At law the assets are not owned personally by the beneficiary and therefore do not form part of the beneficiary’s personal estate.  A creditor or other person claiming against the beneficiary therefore cannot obtain the assets held in the trust.
 
Beneficiary’s inheritance may be protected from family law claims
 
A Testamentary Trust may also provide some protection for a beneficiary who is experiencing family law difficulties.
 
By providing for a beneficiary’s entitlement to be held in a Discretionary Will Trust the primary beneficiary can isolate estate entitlements from personal assets. This may protect his/her estate entitlements from family law property proceedings.
 
The asset protection in relation to a Family Law claim is certainly an improvement on leaving the gift solely to your child. However, there is no guarantee that the asset protection will succeed: firstly, even if the Family Court does not disturb the Trust, it is likely to take it into account and distribute other family assets to your child’s spouse or de facto; secondly, depending on the level of control of your child and on previous distributions, the fund assets could be treated by the Court as property of the marriage.
However greater protection may be possible if:
 
  • your child is never the sole trustee; or
  • your child is excluded from being a potential beneficiary during any Family Law process.
Beneficiary’s inheritance can be kept in the family
 
A modern well drafted Testamentary Trust may also help your beneficiaries keep their inheritance from passing to non-family members for example by providing that on their death the control of the Testamentary Trust passes to their children (rather than to a spouse).
This publication contains general information and does not constitute legal advice.  It is intended to provide a summary of the subject matter and is not intended to be comprehensive. You should seek legal advice on the subject matter.