Testamentary trusts are fixed or non-fixed trusts that are:
- established by a Will
- funded by:
- o the assets of a deceased estate; or
- o by payments to the estate in consequence of death, e.g. superannuation death benefits or insurance proceeds paid to a deceased estate rather than directly to dependants or nominated beneficiaries; and
- to be administered by the executor of the estate or a trustee appointed in accordance with the Will and (in both cases) subject to the terms of the Will.
Types of Testamentary Trusts
Testamentary trusts can be divided into several main categories, ranging from the usually executor controlled very restricted trusts designed to protect a vulnerable beneficiary to the beneficiary controlled fully discretionary trusts that offer flexibility, asset protection attributes and income tax advantages.
Probably the greatest advantages associated with testamentary trusts are:
- the ability to provide creditor asset protection for intended beneficiaries (nonfixed and split fixed testamentary trusts only);
- the tendency of the Family Court to view a testamentary trust as a resource available to a party in a domestic relationship, rather than as a divisible asset (non-fixed and split fixed testamentary trusts only);
- the ability to transfer use, enjoyment and benefit (and any resultant income tax or CGT liability) derived from the trust free of transfer costs in a vehicle that usually offers ease of access to funds (non-fixed and split fixed testamentary trusts only); and
- income tax advantages from the splitting of income and taxable capital gains (all fixed and non-fixed testamentary trusts with adult and especially minor [i.e. under 18 years of age] beneficiaries).
Note: to the extent that they are funded by other sources, e.g. gifts or non-arm’s length loans, testamentary trusts are unlikely to qualify for the excepted income tax concessions that usually apply to testamentary trusts – see paragraph 102AG(a) of the Income Tax Assessment Act 1936 (“ITAA 1936”).
These advantages come with accompanying potential pitfalls that need to be avoided if the testamentary trusts are to achieve their purpose. These pitfalls (including tax considerations such as eligibility for the main residence exemption for CGT and land tax purposes, family trust election rules and future tax laws) mean that it is important that the executor is given a menu of defined options as to the form and administration of each testamentary trust.
Asset Protection Advantages
By giving a primary beneficiary of the estate the default option to inherit via a discretionary testamentary trust, the primary beneficiary does not have to inherit assets personally. This will be an attractive attribute for a primary beneficiary who:
- faces the prospect of bankruptcy in a worst case scenario, eg because of personal guarantees in force or because the nature of the person’s occupation or circumstances carries a risk of litigation;
- is faced with difficult family or domestic circumstances, e.g. the breakdown of a marriage or de facto relationship;
- is their own worst enemy and can’t control their spending whether it be through an addiction or other problem; or
- has the prospect of a contested personal estate when the primary beneficiary subsequently dies.
The primary beneficiary can still, however, either have control of the inherited assets as trustee or appointor of the trust or, in the event of insolvency or health or other crisis being in place when the Will maker dies or subsequently occurring, have the assets controlled by a “friendly” party.
It should be noted that a Family Court has the discretion to disregard a trust, company or other ownership structure and to treat assets as part of the joint assets of a domestic relationship, notwithstanding their formal legal ownership. The Court can also make orders that are binding on 3rd parties such as relatives, accountants and lawyers. An indicator of the Family Court’s usual view of a testamentary trust can be seen in the decision in Ward and Ward  FCMA 193. In that case the Court did not view the discretionary and non-capital reserved testamentary trust created by the late parent of the husband as a divisible asset of the relationship, but did view the trust as a financial resource available to the husband. A determining factor in these cases is whether the spouse has effective control of the trust or not.
Income Tax Advantages
The potential for tax savings when income from a fixed or non-fixed testamentary trust (or a child superannuation pension or annuity) is distributed to benefit a child or grandchild under 18 is significant. This is because the income is “excepted” by section 102AG of the ITAA 1936 from the higher income tax rates that otherwise apply to minors under 18 years.
The marginal income tax rates currently applicable to the first $75,000 of testamentary trust income per individual beneficiary (beneficiary not also receiving other forms of income) regardless of age currently are:
- if the parent or grandparent of the minor beneficiaries would face relatively high marginal tax rates on any income from inherited assets, testamentary trusts can be particularly attractive. The potential tax savings from income of a testamentary trust being spent on the child or grandchild instead of forming part of the adult’s income may effectively subsidise the education and maintenance of the child or grandchild.
- on 17 October 2006 the Federal Government announced that new rules are to apply to capital gains in testamentary trusts from 1 July 2005, removing the requirement that still applies to family and unit trusts established by Deed for income beneficiaries to pay tax on capital gains. Presumably these new rules will also apply to an accumulation of a capital gain for the benefit of no particular beneficiary.
Income Tax Streaming
For the time being at least, the trustees of non-fixed testamentary trusts can be given the power to stream different types of income or deemed income (for example taxable capital gains and interest income) to different beneficiaries. Franking credits from dividend income, however, must be distributed in the same proportions as the dividends and will be forfeited when the dividend is distributed from a non-fixed trust to beneficiaries, unless certain conditions are satisfied, e.g. the:
- beneficiaries have a fixed entitlement to the trust capital, ie the trust is a capital reserved trust;
- trust is a deceased estate or an executor managed testamentary trust of less than 5 years duration; or
- trustee has made an election to become a “family trust” for taxation purposes and be subject to the rules that apply to trusts that have made those elections.
Testamentary trusts are a fantastic tool if used properly. If you have any concerns about asset protection for your family then you should seriously consider the use of a properly created testamentary trust to suit your circumstances.