Testamentary trusts are discretionary trusts established in Wills, that allow the trustees of each trust to decide, from time to time, which of the nominated beneficiaries (if any) may receive the benefit of the distributions from that trust for any given period. There are significant advantages in incorporating testamentary trusts in Wills.
Upon the death of a Will-maker, the assets of the deceased are distributed to the trustee(s) of the testamentary trust that hold(s) the assets for and on behalf of the nominated beneficiaries. In this manner, the assets are not transferred to the individual beneficiaries directly, but rather to a trustee of the established testamentary trust that holds the assets in the trust fund, for and on behalf of the beneficiaries.
Testamentary trusts are designed to provide maximum flexibility, whilst both allowing for the tax-effective distribution of capital and income derived from the assets, and providing a greater degree of asset protection, as compared to if the assets were held by the beneficiaries in their personal capacity.
Advantages of Testamentary Trusts
A testamentary trust can be validly established for up to 80 years, and as such can benefit two to three generations, with the distribution of the trust’s income and assets being completely flexible. Testamentary trusts can also be dissolved at any time, and distributions made to the desired beneficiaries.
The assets held in the testamentary trust are controlled by the trustee(s) (rather than the individual beneficiaries). The trustee(s) may, at their discretion, distribute all or part of the assets to the nominated beneficiaries.
Asset Protection: Re-Marriage and De-Facto Relationships
If a Will is not correctly structured with the incorporation of testamentary trusts, and the deceased’s assets are distributed directly to his or her spouse, those assets may be at risk if one widowed spouse remarries or enters into a de facto relationship.
Assets from the first marriage could be diverted to the benefit of the new spouse (and by extension, their family) if something were to happen to your spouse ahead of their new partner. In a testamentary trust, if one spouse dies, and the other remarries, assets held in the trust can be protected for the benefit of the nominated beneficiaries (i.e. the deceased’s children and grandchildren).
In the scenario where one spouse dies and the surviving spouse either re-marries or enters into a de-facto relationship, the assets held in the testamentary trust may again be insulated and protected for the benefit of the nominated beneficiaries under the testamentary trust, rather than the assets being held directly by the deceased’s ex-spouse’s children born of the first marriage.
Assets held in a testamentary trust may also be protected against Family Law litigation brought by spouses who look to make a claim for family assets within the context of a marriage breakdown. An inheritance held in a testamentary trust is unlikely to be the subject of a Family Court Order, although it may be regarded as a financial resource and thus impact upon the actual terms of a property settlement.
If a beneficiary receives their share of a deceased’s estate in a trust, and it remains in the trust, it cannot be subject to a Will change on the death of the beneficiary, as it would not be considered part of their estate.
Asset Protection: Solvency and Third-Party Claims
Assets held by the trustee of a testamentary trust may be insulated from potential third-party claims made against individual beneficiaries. If a beneficiary is experiencing solvency issues, it is possible that the inherited assets may be susceptible to claims made by creditors.
If the estate assets are distributed to and held by the trustee of a testamentary trust, those trust assets may be insulated from a third-party’s claim against the individual beneficiary, as the assets are held by the trustee for and on behalf of the beneficiaries rather than the assets being held by the individual beneficiary, and therefore being susceptible to third-party claims.
The assets are not held by the beneficiary, but rather by the trustee for an on behalf of the beneficiary, with a discretion to distribute to any of the nominated beneficiaries.
Asset Protection: Children and Other Beneficiaries
A testamentary trust is particularly beneficial for intellectually disabled beneficiaries, as well as beneficiaries with illnesses, addiction problems or other weaknesses which could result in the loss or dissipation of an inheritance. If a child or other beneficiary is temporarily incapacitated, testamentary trusts will enable the assets to be managed by the family for the benefit of that beneficiary, rather than having a portion of the estate controlled by a government agency.
In the case of a grandparent leaving bequests for the payment of boarding school and tuition fees for their grandchildren, the use of testamentary trusts allows a degree of control over the application of such assets, which is more effective than leaving additional bequests to parents in a Will. This is also a more tax effective method of providing for the grandchildren’s education.
Under a Will, if a child or other beneficiary is experiencing solvency issues or is bankrupt at the time of distribution, the beneficiaries may not receive the gift as creditors are able to claim it. Assets held in a testamentary trust are protected from a beneficiary’s creditors and claimants because the beneficiary has no actual entitlement to a distribution until the trustee so determines, thus avoiding loss of an inheritance due to the bankruptcy or adverse financial circumstances of a beneficiary.
If a beneficiary is considered to be working within a high risk business or profession where negligence (or other) claims are a risk, a testamentary trust also protects the inheritance from these types of claims.
Income and Capital Gains Tax
Under an ‘ordinary’ trust, if a beneficiary takes their inheritance in their personal name, they are required to pay tax on the income generated from the inheritance at the top marginal tax rate. This means that if a child under eighteen years of age receives over $1,000, they must pay the associated tax at the top marginal rate.
However, under a testamentary trust, children under eighteen are taxed as ordinary taxpayers, commencing at the lower tax rates. When compared to distributions made either directly, or under family law trusts, this results in considerable reductions in the total tax payable when distributions are made to children and grandchildren (until they reach the age of eighteen).
Capital gains realised on assets held by a testamentary trust can also be streamed to one or more beneficiaries in a tax effective manner. Where one or more of the beneficiaries has a low income in the year of distribution, distribution to this beneficiary allows them to take better advantage of the five year averaging rate of capital gains tax losses. In turn, tax payable on capital gains on realised assets can be considerably reduced.
Preservation of Government Benefits
At present, Centrelink does not take assets held by testamentary trusts into account when calculating the pension eligibility of a beneficiary - although the income distributed by the testamentary trust is taxable in the hands of the beneficiary.
Superannuation and Insurance Proceeds
Generally, Superannuation proceeds fall outside of the assets in a deceased estate, and the distribution of the proceeds are determined by the rules of the fund. However, a Willmaker may elect to direct the trustee of the superannuation fund to pay the proceeds of the deceased’s superannuation or death proceeds to the deceased’s Legal Personal Representative (i.e. the executor(s) of the deceased’s estate).
In this regard, the proceeds will be paid to the executor(s) and distributed in accordance with the Willmaker’s Will. If the Will includes testamentary trusts, then the proceeds may be directed by the executor(s) to the trustee of a testamentary trust established in the Will, rather than being distributed directly to the nominated beneficiary, which assets would then be held in the beneficiaries personal capacity.
The proceeds will then be distributed to the executor of the deceased’s estate, who will have the discretion to distribute the proceeds and make use of the testamentary trusts established in the Will.
Disadvantages of Testamentary Trusts
The trustee essentially controls the trust and has discretion to determine the future of the trust and its assets. The trustee can distribute all or any part of the income to one or more of the beneficiaries, at such times and in such amounts as they see fit. As such, the succession of the role of trustee must be specifically spelt out in the Will, if the individual wishes to determine who will control the trust upon their death.
If the trust restricts access to capital or income, a beneficiary may become upset and challenge the terms of the Will. The possibility of a challenge may be reduced by the Willmaker communicating their intentions to their beneficiaries at the time that they prepare their Will.
Administration of the trust may require a level of cooperation between family members who may share the role of trustee of the trust. This could lead to potential disharmony.
Assets held by a testamentary trust must be sufficient to justify the expense of administering the trust. For example, accounts will need to be prepared and maintained, and a tax return will need to be lodged each year.
Capital Gains Tax
If the trust has capital assets that are sold at a loss, those capital losses cannot be distributed to the beneficiaries, and must be carried forward in the trust and set off against future capital gains (if any).
If either the primary or another beneficiary is a pensioner, care must be taken to ensure that the beneficiary’s pension eligibility is not jeopardised by their inheritance in the testamentary trust, as any inheritance may affect their income test.
Asset and Estate Planning
Generally, a Will incorporating testamentary trusts will only form part of a total asset and estate plan.
The following should also be considered:
- The control of family companies and trusts following death;
- Superannuation arrangements - binding death benefit nominations;
- Business succession arrangements;
- Enduring Powers of Attorney (financial decisions);
- Appointment of Enduring Guardians (health directives and lifestyle decisions); and
- Family law considerations.
If you have a query relating to any of the information in this guide, or you would like to speak with someone with respect to the effectiveness of Testamentary Trusts in your individual circumstances, please don't hesitate to get in touch with Danny Adno, Partner within Holman Webb's Wills and Estate Planning team today.