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If you care how your personal and business assets are distributed after your death, it’s essential to do some estate planning, as this can help minimise the impact of tax and ensure your assets end up with your intended beneficiaries.
An important tool in any good estate plan can be a testamentary trust. This type of trust is established as part of your Will and offers more options than simply relying on a standard Will.
A testamentary trust can protect your assets and provide considerable flexibility in how those assets – and the income they generate – are distributed to your chosen beneficiaries.
Your Will: Standard vs testamentary trust Will (TTW)
A standard Will is the very minimum everyone should have in place prior to their death. A standard Will prevents your family and friends being left with the emotional stress and potential hardship of you dying intestate (with no valid Will in place).
If you die intestate, the Supreme Court of your state appoints a suitable administrator to wind up your affairs. This usually involves arranging your funeral, collecting your assets and distributing them to your family after paying tax and any debts you leave behind.
In its simplest form, a standard Will outlines the person or persons you want as executors for your estate, who your chosen beneficiaries are, and your instructions for the distribution of your estate.
Standard Wills do not offer any protection for your assets from former spouses, creditors, business associates or disgruntled beneficiaries, or provide any opportunities to minimise the potential tax payable on your assets. A testamentary trust Will (TTW) on the other hand, is a type of Will that establishes a trust (or trusts) to hold your assets after you die.
How does a testamentary trust Will work?
In simple terms, a testamentary trust Will (TTW) is a Will and discretionary trust deed combined in a single document. The testamentary trust operates on terms specified in your Will and it provides a level of control over what happens to your assets and how they are distributed.
A TTW specifies which assets from your estate are to be transferred into the testamentary trust (or trusts) created by your will. This trust can be used to hold and protect assets such as investments, property, cash and valuables such as paintings, furniture or jewellery. The assets held in the trust are called trust capital and this capital can produce income (such as dividends or interest) and create capital gains.
Who is the trustee?
When you include an instruction in your Will to create a testamentary trust, you name a trustee who is responsible for distributing the trust assets to your beneficiaries in accordance with the instructions in your Will. You can give your trustee the power to decide when and how to use and distribute your assets to meet the needs and best interests of your beneficiaries.
The trustee you select for your testamentary trust can be a family member or friend aged over 18 who is an Australian resident, or you can choose a trustee company or legal or accounting organisation to take on the responsibility.
There are two main types of testamentary trusts:
- Discretionary testamentary trusts – These give a beneficiary the option to take part or all of their inheritance through a testamentary trust. The principal beneficiary can remove and appoint the trustee. They also have the power to appoint themselves to manage their inheritance inside the trust.
- Protective testamentary trusts – These require a beneficiary to take their inheritance through the trust and do not provide the option to appoint or remove the trustee. This can be useful if a beneficiary does not have appropriate skills to manage their inheritance (see below).
What beneficiaries suit a testamentary trust?
Testamentary trusts can suit a number of different family and beneficiary situations. If some or all of your beneficiaries fall into the following categories, a testamentary trust may be worth considering:
- Bankrupts: Many families include someone who has been forced to declare bankruptcy (such as a spouse who guarantees their partner’s business venture, or someone with a failed business). With a testamentary trust, the bankrupt’s inheritance can be protected from creditors.
- Divorcees: Relationship breakups are commonplace and inheritances are usually subject to a Family Court order. If a testamentary trust is in place, the outcome may be more favourable to a beneficiary or leave fewer assets that are subject to a Family Court decision.
- Remarriage: Children living with a divorced partner can be sure to receive their inheritance if they inherit through a testamentary trust.
- Retirees and Age Pensioners: Currently, assets held within a testamentary trust are not counted when determining a beneficiary’s eligibility under the assets test for the Age Pension. Income from a testamentary trust, however, is counted for the income test.
- Spendthrifts or beneficiaries with drug or gambling problems: Beneficiaries who are unlikely to responsibly manage their inheritance can still benefit if their inheritance is provided through a testamentary trust.
- People with disabilities: Families often wish to ensure the financial future of a disabled child by establishing a testamentary trust and appointing an appropriate trustee to take care of their financial affairs.
- High-risk professions: Beneficiaries in a profession where negligence claims are a possibility can be protected by receiving their inheritance via a testamentary trust.
Pros and cons of a testamentary trust
- Provides protection for assets in the event of marriage or relationship breakdowns.
- Protects children and vulnerable beneficiaries.
- Protects beneficiaries in ‘at risk’ professions.
- Protects against creditor and bankruptcy claims.
- Discretion to distribute income to multiple beneficiaries are available to the trustee.
- Income, capital gains and franked dividends can be distributed to beneficiaries in a tax-efficient way.
- Tax is not payable when assets are transferred into the testamentary trust.
- Trust not required to pay tax on income distributed to beneficiaries.
- Creates opportunities for income splitting by adult children and lower income earners.
- Reduced tax rates for children under age 18 compared to outside the trust. Testamentary trust income is taxed at adult – rather than minor – rates, giving a child beneficiary the normal adult tax-free threshold of $18,200, rather than the $416 threshold applying to minor income.
- May allow access to Age Pension payments, as testamentary trust assets are not counted in the assets test.
- Provides flexibility for trustee to manage and invest trust capital.
- Allows trustee to invest according to changing needs of beneficiaries.
- Testamentary trusts can be complex and both the trustee and beneficiaries need to understand the structure and operating rules.
- Potential loss of CGT exemption on your main residence if held in testamentary trust.
- In some states, CGT may apply on assets acquired by the testamentary trust on your death.
- If capital assets are sold at a loss, capital losses cannot be distributed to beneficiaries and must be carried forward to set off against future capital gains.
- Trust is required to pay tax on undistributed income.
- Franking credits from dividend income must be distributed in the same proportions as dividends.
- Ongoing administrative, accountancy and tax preparation fees are payable.
- Fees will reduce assets held in the trust.
Flexibility and succession
- Disputes can occur and a resolution mechanism needs to be established.
- If family members share the trustee role, there is the potential for disagreements over distributions.
- Provisions are needed to cover asset sales if one or more primary beneficiaries dies.
- Succession of the trustee role can cause disputes and should be covered in the Will.