06 Nov The benefits of a testamentary trust
A Testamentary Trust is a trust that has been created by a Will.
It is, in essence, a discretionary trust that gives the Trustee full discretion about who benefits, and to what extent, under the trust. It adds two significant advantages to a simple Will and to its nominated beneficiaries:
1. Significant taxation advantages in terms of income splitting and asset distribution; and
2. Protection of the bequeathed assets from any financial or other difficulties that the beneficiaries themselves may suffer.
Any person who wishes directly or indirectly to benefit children or grandchildren (in particular those that are under 18 years of age) should strongly consider establishing a Testamentary Trust under their Will.
Ordinarily, trusts established to benefit children, grandchildren or others under the age of 18 are subject to penalty rates of tax. In short, where trust income is distributed to a minor beneficiary of a trust, under current tax law that minor receives a tax free threshold of only $416. Any amount in excess of $416 is taxed at penalty rates which can be as high as 66%. With the low income tax rebate of $750, this means that a minor beneficiary can receive a distribution of only $1,667 without being subject to any tax.
These penalty provisions specifically do not apply to trusts established under a person’s Will (i.e. a testamentary trust).
As a result, each Australian resident individual who is a beneficiary of a testamentary trust will receive the full tax free threshold, currently $6,000, and the ordinary marginal rates of tax on distributions of taxable income above that.
Here’s an example of how this may be beneficial: A deceased person leaves a spouse, and four children under the age of eighteen, and provides for them through a testamentary trust. The deceased person’s family has an annual tax free threshold of $30,000 (being $6,000 x 5). In addition, the family will not pay tax at the highest rate until their aggregate taxable income exceeds $900,000.
This position contrasts sharply with where a testamentary trust is not used.
In so many Wills, the entire deceased estate is left to the spouse. The spouse then provides income for the children. In these circumstances, the tax free threshold for the family is only $7,664 (being the $6,000 tax free threshold for the adult spouse plus $416 for each of the four minor beneficiaries). In addition, the deceased family will commence paying tax at the top marginal rates (48.5% for the adult spouse and 66% for the minor beneficiaries) once the aggregate taxable income of the family exceeds $181,664.
Financial benefits of a testamentary trust can be enjoyed in a variety of circumstances. Obviously a testamentary trust is appropriate in circumstances where a deceased person has children under the age of eighteen. However, it is equally appropriate where the person has grandchildren, brothers, sisters, aunts, uncles, nephews, nieces, cousins or long term friends who are under the age of 18 or whose extended families include members under that age.
The testamentary trust is an extremely beneficial tool for parents or grandparents wishing to establish ‘education trusts’ for children or grandchildren.
Under the terms of a properly drafted testamentary trust, the trustee can have discretion to distribute different classes of income (e.g. franked dividends, unfranked dividends, interest income, taxable capital gains, non-taxable capital gains) to different beneficiaries to ensure maximum tax-effectiveness of income distributions.
An example of this benefit is where a trustee allocates the net capital gain component of the trust’s net income to beneficiaries with realised capital losses since it is these beneficiaries who can then use the capital losses to offset their capital gains.
Discretionary streaming of trust distributions can also be useful, for example, to distribute unfranked dividends and franked dividends to different beneficiaries.
Asset Protection From Creditors
This is a key benefit of testamentary trusts.
The testamentary trust can be drafted to give beneficiaries the benefit of a discretionary entitlement to income from trust assets, but no fixed entitlement to trust assets or income. As such, if a legal claim was made against estate beneficiaries, assets held in a testamentary trust would be protected.
Testamentary trusts can provide invaluable protection to a beneficiary of assets of a deceased estate in circumstances where that beneficiary is likely to be subject to claims by business creditors or plaintiffs in legal actions.
Family Law and Protection
One in three first marriages, and one in two other marriages, end in divorce. These statistics are not only alarming, but also support experience that a significant objective of estate planning for many is to protect families from concerns that assets left to a spouse, or to children, may be at risk in circumstances of divorce, subsequent marriage or breakdown in a de facto relationship.
In such circumstances, the testamentary trust can be specifically tailored to ensure that a testator’s asset stays within their family or direct lineal descendants for a period of up to 80 years following death.
The level of family law protection can be tailored to meet the specific circumstances of each client.
Income Protection and Social Security
Leaving valuable assets of an estate to a beneficiary in receipt of social security benefits can immediately push that person over social security thresholds.
A testamentary trust can be drafted to secure continuity of social security benefits for such beneficiaries by ensuring they have no entitlement to the assets of the trust.
Establishment of a properly drafted testamentary trust in a Will can have several advantages, including:
- considerable financial advantages accrue to the family of the deceased (or to other persons who the deceased wishes to benefit) by virtue of tax benefits available
- there is broad scope for application of tax benefits of a testamentary trust to circumstances where an estate beneficiary is under the age of eighteen
- the testamentary trust concept is a simple application of a readily available tax concession is provided by the Government under section 102AG(2)(a) of the Income Tax Assessment Act – it is simply up to the individual to make use of that concession
- income (including capital gains) from the testamentary trust can be streamed to beneficiaries to maximise their tax benefits
- the testamentary trust protects a family’s assets for up to 80 years – this may be particularly beneficial for persons concerned about exposure to business creditors (e.g. professionals, or those in business) or those subject to potential legal actions
- properly structured, protection of family assets via a testamentary trust can also extend to the area of family law meaning that assets can be excluded from property settlements on divorce or breakdown in a de facto relationship
- properly structured, a testamentary trust may enable a beneficiary to retain any social security benefits to which they are entitled.