What is a testamentary trust?
Testamentary trusts have been used in estate planning for many years, but what is a testamentary trust? I like to think of it as a ball of play dough that can be moulded to suit any person’s circumstances. At its simplest, it is a gift in a Will to a beneficiary who is under the age of 18 when the Will maker dies. At its most useful, it is a tailor made trust with specific provisions included in a Will. The common theme is that it is a trust created via a Will. In this article and when most lawyers, accountants and financial planners refer to testamentary trusts they are referring to the latter.
Under a Will without testamentary trusts, a beneficiary over the age of 18 receives their inheritance directly in their own hands. The beneficiary must include any income earned on the investment of the inheritance in their taxable income and pay tax on the income at their marginal tax rate. The inheritance also forms part of the beneficiary’s pool of personal assets which are available for distribution in the event of relationship breakdown or bankruptcy.
By contrast, the creation of a testamentary trust involves a gift to a trust, with the trustee holding the inheritance on trust for a number of potential beneficiaries, usually family members or related entities, who are identified in the Will. The trustee can be the principal beneficiary or a trusted independent person or an independent organisation or any combination of those.
Sound complicated? Probably, so why do so many advisors recommend them? The main reasons are flexibility, taxation benefits, asset protection and beneficiary protection.
Flexibility
Most Wills containing testamentary trusts include a provision allowing the primary beneficiary to elect, usually subject to appropriate conditions, not to take their inheritance via the trust. The benefit of such an approach is that it allows the beneficiary to have his or her cake and eat it too. There is usually (hopefully!) a time lag between the deceased signing their will and their death. The beneficiary is empowered to make the decision on whether or not to take their inheritance via a trust after the deceased’s death, rather than when the Will was made. It is important that the Will is structured to allow the beneficiary to “opt out” rather than “opt in”.
The trustee of a testamentary trust has the discretion to distribute the income and capital of the trust between the potential beneficiaries. So, it is the trustee who has the ability to decide how the inheritance is dealt with. This decision can be made based on the individual circumstances of the potential beneficiaries after the Will maker’s death.
Tax benefits
As stated above, the trustee of a testamentary trust has the discretion to distribute the income of the trust between the potential beneficiaries. So, the trustee can minimise tax by splitting the income earned on an inheritance between a number of beneficiaries, just like a family trust. However, the tax laws provide a significant concession on income paid from testamentary trusts to beneficiaries under the age of 18 that is not available in relation to family trusts. When a
“It’s play dough, you can decide how it is moulded! The terms of the testamentary trust can be tailored to suit your goals and the needs of your intended beneficiaries.”
beneficiary under the age of 18 receives income from a testamentary trust, they are taxed on that income as if they were an adult and enjoy the adult tax free threshold (currently $18,200) and adult marginal tax rates. The potential tax savings can be significant.
Asset Protection
If a beneficiary separates from their spouse and is involved in family law property proceedings, a properly structured testamentary trust can help keep the beneficiary’s inheritance separate from the relationship property pool. As a result, the inheritance could be quarantined from a claim by the separated spouse and preserved for the intended beneficiary.
A number of professions and business activities expose people to potential personal liability. An appropriately structured testamentary trust can provide important protection for your intended beneficiaries. The assets within the testamentary trust are segregated from a beneficiary’s personal assets and can be protected if a beneficiary gets into financial difficulties or becomes bankrupt.
Beneficiary Protection
Sometimes, even with the best guidance, some children can go “off the rails”. Others suffer sickness or disabilities that prevent them from managing their own affairs. In either case, testamentary trusts are a great way of managing these risks and ensuring that the beneficiary is protected from adverse outcomes caused by them or others. A testamentary trust can set out directions about how income or capital is to be managed and applied e.g. the provision of accommodation for the primary beneficiary or controls on income distributions.
What are the options?
It’s play dough, you can decide how it is moulded! The terms of the testamentary trust can be tailored to suit your goals and the needs of your intended beneficiaries. They work best when the Will maker is willing to discuss their proposed Will with their intended beneficiaries. If a potential beneficiary has spent their working life structuring their affairs for asset protection, the last thing they want is for an inheritance to fall outside their structuring and be exposed to risk.
How can DDCS Lawyers help?
DDCS Lawyers has dedicated estate planning lawyers who are experienced in tailoring testamentary trusts to suit the specific needs of the Will maker and their beneficiaries.
Brendan Cockerill is a Senior Associate of the firm.
18 Kendall Lane, New Acton, Canberra
phone (02) 6212 7600 [email protected], www.ddcslawyers.com.au