Testamentary trusts are an effective tool utilised for greater asset protection and certain tax benefits. This article will provide an insight into what a testamentary trust is, their benefits and the important things to consider when appointing a trustee.
What is a testamentary trust and how do they operate?
A trust is a relationship in which a settlor or a will maker (testator) gives the legal right to property to a trustee to hold for the benefit of a beneficiary or beneficiaries. Testamentary trusts are created by a Will and come into effect after the death of the testator. The testator can chose to include some or all of the assets in the estate in a testamentary trust. Once the administration of an estate is complete either all or just the specified parts of the estate will be transferred to the trustee to manage in accordance with the terms of the trust. The property on trust will pass on to the beneficiaries after the trust is vested at the discretion of the trustee.
Reasons to incorporate a testamentary trust
To protect assets
One reason to implement a testamentary trust into your will is to protect your assets. If property is left to a beneficiary absolutely outside of a testamentary trust, that property is subject to any potential claims against that beneficiary. In cases where a testamentary trust is in place the trustee has the legal right to the trust property, not the beneficiary. This means that if someone attempted to claim against the beneficiary they would not have access to the trust property. If a testator is concerned that their beneficiary may face divorce, bankruptcy or could lose their inheritance through addiction, then it might be worth implementing a testamentary trust and appointing a reliable trustee to control the trust property until it may be safer to distribute the assets to the beneficiaries.
Tax benefits
The flexibility of testamentary trusts often result in certain tax benefits. The trustee of a testamentary trust has the discretion to distribute capital and income from the trust to the beneficiaries, subject to the terms of the trust. A beneficiary’s income tax rate will be determined by aggregating the trust income distribution and any other income that beneficiary receives. Therefore, the trustee can distribute income among the beneficiaries in a manner that utilises the progressive income tax rates by making higher distributions to low income earners.
Additional tax benefits can be accessed with testamentary trusts if one or more beneficiaries is a minor. In an inter vivos trust (a trust created during one’s lifetime) minors are generally required to a pay penalty tax rate of 47% on any income earned over $416. However, under section 102AG of the Income Tax Assessment Act 1936 (Cth) income earned from a testamentary trust is ‘excepted income’. This results in the minors being taxed at the same progressive rates as adults on excepted income. As long as the minor isn’t receiving income from another source, they wouldn’t be required to pay tax on any income under the $18,200 tax free threshold.
Case study – Tax benefits of testamentary trusts
In this case study John passes away leaving his entire estate worth $1 million to his son, Sam. Sam is married to Mary and they have two children, Bill and Lucy. Both children are under 18 years of age. Sam is employed full time earning $250,000 per year and is taxed at the rate of 45%. Mary and the two children are not employed and do not earn any income.
Example one below will illustrate the tax payable if John leaves his estate to Sam absolutely without a testamentary trust. Example two will demonstrate the tax payable if John leaves his estate in a testamentary trust to Sam and allows him to distribute the income to his family.
Example one – Standard Will (without a testamentary)
Example two – Using a testamentary trust
In example two, the use of a testamentary trust allows Sam to distribute the income of the testamentary trust to his family which results in a tax saving of $28,574 in comparison to example one.
*The tax calculations in this case study are based on the 2018/2019 financial year, do not include the Medicare Levy and assume that all tax payers are Australian residents for tax purposes.
Appointing a trustee
A person above the age of 18 or a company legally entitled to hold property can act as a trustee. However, there are a number of important considerations to take into account when deciding who to appoint as the trustee of your testamentary trust. Whoever you decide to appoint as the trustee will have an obligation to invest the trust property for the long term benefit of the beneficiaries and exercise discretion in distributing capital and income, subject to the terms of the trust. Due to the discretionary power of the trustee of a testamentary trust, beneficiaries won’t be able to compel the trustee to distribute trust property to them. Therefore, it is essential that caution be exercised in appointing a trustee who can be relied upon to competently make strategic financial decisions and ensure the beneficiaries receive their entitlements in accordance with the wishes of the testator.
If you would like assistance to implement a testamentary trust in your Will or have any other questions about effective succession planning, please do not hesitate to get in touch.
This article was written by Lindsay Reed, Partner and Ibtassam Zia, Solicitor.
P: +61 7 3169 4948
E: lreed@hwle.com.au