Testamentary (or Will) Trust

It is important from an income tax and commercial perspective to have an effective estate plan in place and a testamentary (or will) trust is an extremely valuable estate planning tool. An estate planning strategy is particularly important for families with small children, where extra income is needed to support surviving family members should a parent die, or where minimising tax is a concern.

What is a Testamentary trust?

A testamentary trust is created upon death and can be formed only if there is a specific provision in your Will. It may be either a fixed or a non-fixed trust, and can be structured so that income and capital can be distributed in a tax effective manner.

Testamentary trusts can be:

  • Funded by the assets of a deceased estate or payments made to the estate in consequence of death (such as superannuation death benefits); and
  • Administered by an executor of the estate or a trustee appointed in accordance with the Will.

Why would you use a Testamentary trust?

The two most common reasons for creating testamentary trusts in wills are to:

1. To provide flexibility so that the trust can be adapted to meet the changing circumstances of its beneficiaries; or

2. To allow the person who created the Will to “rule from the grave” by imposing restrictions on the trust beneficiaries.

How does a Testamentary trust work?

Testamentary trusts allow the assets of a deceased person to be distributed by an executor or trustee upon his/her death or otherwise remain in trust for the benefit of his/her beneficiaries.

The terms of the trust may give the trustee full discretion as to who will receive the net trust income. The trustee may distribute income to children under 18 without adverse income tax consequences as beneficiaries of a testamentary trust are excluded from the penalty tax rates that normally apply to the unearned income of minors.

Who can be the trustee of a Testamentary trust?

Basically, anyone can be nominated to be the trustee of a testamentary trust. This includes the executors of your will, your spouse or your children. The trustee has effective control of the trust so it should ideally be someone who you believe will act in the best interests of your beneficiaries.

What are the advantages of using a Testamentary trust?

The major advantages of using a testamentary trust are:

  • Flexibility - Testamentary trusts generally provide a lot of flexibility in the distribution of income and assets of the trust. For example, it is possible to distribute the income to one beneficiary (e.g. your spouse) and the assets to other beneficiaries (e.g. your children) only on the death of the income beneficiary.
  • Protection of beneficiaries against creditors and bankruptcy - No discretionary beneficiary has a proprietary interest in the trust so that from the point of view of the Bankruptcy Act the beneficiary will not own any property in the trust.
  • Protection against spendthrift beneficiaries - A testamentary trust can avoid the possibility of your children spending their share of their inheritance irresponsibly.
  • Income tax advantages - This is a major benefit of testamentary trusts. All or some of the net income of the trust can be distributed to minors (i.e. children or grandchildren less than 18 years of age) who receive the benefit of full adult rates of income tax. This can result in substantial tax savings.
  • Capital gains tax savings - he ability to distribute capital gains to minors in a tax effective way. In addition, the 50% CGT discount may apply where a trust asset has been held for at least 12 months.
  • Protection against future spouse of partner or children - This is particularly important considering the increased incidence of divorce proceedings brought before the Family Court.
  • Income tax streaming - The trustees of non-fixed testamentary trusts have the ability to stream income to different beneficiaries.
  • Incapacity - In the event that a beneficiary is temporarily incapacitated, a testamentary trust will enable the assets of the trust to be managed by the family for the benefit of the beneficiaries, rather than having control passed to an external agency.

It is also possible to transfer the accumulated balance of a superannuation fund and the proceeds of a life insurance policy into a testamentary trust and achieve the above benefits.

What are the potential problems of establishing a Testamentary trust?

There are also pitfalls that need to be avoided if testamentary trusts are to achieve their purpose. These include:

  • Main residence exemption - Trusts do not qualify for the main residence exemption from capital gains tax.
  • Unnecessary tax liabilities - Wills are often drafted without advice from a financial planner or accountant which means that tax and other practical issues may be ignored and unnecessary tax liabilities could arise.
  • Family trust and other tax elections - Testamentary trusts may have to make ‘family trust’ or ‘interposed entity’ elections under the tax legislation in the future.
  • Lack of long-term planning - Many testamentary trusts fail to address how control is to be shared so it is recommended that a dispute resolution clause be included in the terms of the trust.
  • Lack of flexibility to deal with future tax and other changes - It is important to ensure that Wills be drafted with as much flexibility as possible to enable the asset protection and income tax advantages to be utilised and the possible capital gains tax and income tax disadvantages to be minimised.

What are other factors that should be considered before establishing a Testamentary trust under my Will?

There are usually no stamp duty implications where an asset (i.e. the family home or an investment property) is transferred into a testamentary trust. However, land tax liabilities may arise in the future as the trustee of the trust will be assessed on such a property for land tax purposes (usually without the benefit of the land tax free threshold).

Where either spouse intends to leave substantial assets to more than one child, there could be future disputes if a single testamentary trust was controlled by all children. It may be best if one testamentary trust is established for each beneficiary, or even for different types of assets. This means that each beneficiary would ultimately have control over their own testamentary trust and therefore confidentiality of their affairs would be preserved.

There will be ongoing administrative issues involved in maintaining a trust, such as accountancy fees incurred to prepare the trust accounts and tax returns. You also need to consider whether the income generated by your estate will be sufficient to warrant setting up a testamentary trust. For example, if all your assets are owned jointly with another person or by a family trust, there may not be enough assets in your own name to make the establishment of a testamentary trust worthwhile.

What advice should be obtained before deciding to set up a Testamentary trust?

You should consult your accountant, solicitor and and/or a financial advisor to ensure that you are fully aware of the potential advantages and disadvantages of setting up a testamentary trust. Keep in mind that you can include a testamentary trust as an option in your will to cater for future changes in your circumstances that may arise, or changes in your beneficiaries’ circumstances.