A family trust can form an important part of planning in your will. This can include thinking about protecting the assets you leave behind and also helping your loved ones deal with the financial consequences of inheriting your estate. So, what is a testamentary trust and how are they used?
What is a testamentary trust?
According to the Australian Tax Office (ATO) definition, a testamentary trust is a trust which is established according to a person’s instructions in their will. That is, the trust does not exist until the person who has made the provision in their will passes away.
At this time under the terms of the will, the beneficiaries could be given the option to inherit their assets within a testamentary trust, rather than inheriting them directly.
Establishing a testamentary trust effectively allows you to “ensure that a trust over your assets is created on the day of your death, which means that rather than your assets being distributed directly to your beneficiaries, they are held for their benefit by a trusted individual or organization”.
There are a number of different kinds of testamentary trusts, although in estate planning, commonly a testamentary trust is discretionary, which means the trustee has discretion as to which of the beneficiaries named share in the capital or income of the trust fund.
Why would you leave instructions in your will to set one up?
A discretionary testamentary trust is not for everyone. However, there are some benefits conferred by the structure that make it a good option in some cases.
The benefits most commonly cited are:
- tax effectiveness; and
- protection of the bequeathed assets
Tax effectiveness
Say a couple has two children and either the husband or wife passes away. Under a standard will, the one spouse would leave all of their estate to the other spouse and vice versa. Usually if both spouses pass away then they will provide for the estate to be divided equally among their children.
In the above scenario, where only one of the spouses passes away, then the surviving spouse would inherit all of the estate’s assets.
The surviving spouse will then have to pay tax on any income and capital gains earned from those assets at his or her marginal tax rate, meaning that person’s tax bill could rise significantly and any unearned income distributed to children under the age of 18 would be subject to a penalty tax rate.
Where there are young children or grandchildren under the age of 18, however, then inheriting assets within a testamentary trust can be more tax effective for the family.
This is because Division 6AA of Part III of the Income Tax Assessment Act says that if a child under the age of 18 receives income from a trust established in a will then the adult tax free threshold of $18,200 (for 2012/13 and 2014/15) and marginal rates of tax will apply to the child.
What this means
If the spouse who passed away in our example left an estate of $1m invested and it returned 10%, or $100,000, during the 2014/15 tax year and if the surviving spouse already earned a taxable income of $75,000 that year, then ignoring the Medicare levy, the surviving spouse would have to pay tax on an income of $175,000. This equates to a tax bill of $52,697.
If, however, the will included the provision that the whole of the estate was to be left to the surviving spouse as trustee of a discretionary testamentary trust, with the beneficiaries of the trust being the surviving spouse and the couple’s two children, then the income would be split. If the income was split equally then it would look like the below (rounded to the nearest dollar):
| Beneficiary | Taxable income | Tax liability |
| Surviving spouse | $75,000 + $33,333 | $28,030 |
| Child 1 | $33,333 | $2,430 |
| Child 2 | $33,333 | $2,430 |
This is because each child is entitled to the $18,200 tax free threshold, with the amount over this taxed at 19 cents in the dollar. In addition to this, they would qualify for the low income tax offset of $445.
So, this equates to a family tax bill of $32,890 – a saving of $19,807.
Jonathan Philpot, specialist wealth management adviser at HLB Mann Judd, says that the other big tax advantage is where there is a large amount of unrealized gains with the inheritance – say a large share portfolio.
“This is because the estate is one tax payer so the marginal tax rate for one person applies, whereas if those shares are transferred into a testamentary trust and then all the shares are sold it may be possible to distribute the capital gains, say, between three people, which would reduce the capital gains tax.”
Protection of assets
The other reason commonly cited for establishing a testamentary trust within a will is protection of assets; that is, the desire to ensure that assets remain within the family for the benefit of direct family members.
Philpot says that in his experience, while the benefits of flexibility in terms of distributions covered above is attractive, often more important to his clients is added asset protection in the event of things like future marital breakdowns.
“It’s more about protecting your wealth so it only goes to your lineal descendants and there is no worry about half of your assets going to a child’s ex-spouse, which tends to be what people prefer,” Philpot says.
Protection against a child’s bankruptcy can also be a motivating factor in establishing a testamentary trust as assets are owned by the trust rather than becoming the direct property of the child.
Another instance where a testamentary trust may be used is to provide for a child with a disability, allowing for the assets to be used for the benefit of that child who may not have the capacity to handle financial matters following their parents’ death.
What to watch for
Philpot cites a number of things to consider before establishing a testamentary trust. One consideration is the need to understand at what level of assets it becomes worthwhile to establish a testamentary trust. Generally, testamentary trusts provide the greatest benefit for larger estates with multiple children, Philpot says.
Another is working out who will act as trustee of the trust – of which there can be more than one. For example, a trust may be established where one trustee is independent, such as a lawyer, accountant or other arms-length professional, and one trustee is the primary beneficiary of the trust.
The reason those making a will may want to consider appointing an independent trustee is to ensure all beneficiaries’ best interests are looked after and that distributions are not influenced by things like family politics. For this reason, it can provide an extra degree of protection over assets.
Philpot says that it’s important when considering the structure to speak with an expert – such as a specialist estate planning lawyer.