A testamentary trust is a trust created by a Will. It is generally a discretionary trust, i.e. the trustee of the trust will have full discretion about who benefits, and to what extent, under the trust.
This outline is to give you an overview of the common features and advantages of testamentary trusts. There are different forms of testamentary trusts to suit particular circumstances, but this overview is only about the general type of testamentary trust, not all the possible varieties of them.
A testamentary trust has two significant advantages for a Will maker and the nominated beneficiaries:
- Significant taxation advantages in terms of income splitting; and
- Protection of the assets of your estate against the risk of claims arising from financial or other difficulties that can affect the estate beneficiaries.
The following significant tax advantages for testamentary trusts are available under current Australian tax laws:
- Section 102AG of the Income Tax Assessment Act 1936 (incorporated in the 1997 Tax Act) removes the punitive tax rates on unearned income (interest, investment dividends, etc) for children and allows ordinary tax rates to apply where the income is distributed from a trust estate created under a person’s Will. See the worked example in the attachment for an explanation of how this works in practice.
- By using a discretionary testamentary trust, any income gains, capital gains and franked dividends earned from the estate assets after you die can be distributed among family beneficiaries each year in the most tax-efficient way.
The tax concessions do not only apply to income and capital gains earned by the trust from inherited assets. They also apply to any income and capital gains earned from assets or wealth acquired from the reinvestment of moneys received from the original inherited assets.
A Will can establish more than one testamentary trust. If there is more than one beneficiary, your Will can (and indeed should) establish a separate testamentary trust for each beneficiary.
Generally, people should be concerned about protecting their assets and taking measures to ensure that the assets remain within the family and are used to benefit family members (particularly beneficiaries in higher risk categories, such as company directors or professionals).
In particular, people should be concerned about:
- their beneficiaries becoming bankrupt, especially those that are involved in highly leveraged businesses;
- their beneficiaries becoming divorced and their assets being split in the divorce or de facto relationship breakdown;
- their children mismanaging or wasting their inheritance;
- ensuring that the surviving spouse will pass on their assets to their children upon that person's death; or
- looking after handicapped children.
The significant advantage of a testamentary trust is that the assets are owned by one person(s) (the trustee) and the benefit of the income and capital of the trust passes to other persons (the beneficiaries).
By separating the aspects of control and benefit in this way, testamentary trusts can protect assets from legal action involving the beneficiaries and/or the misuse of those assets.
The terms of the testamentary trust are contained within and set out in the Will. These terms can restrict the ability of any of the beneficiaries to control the activities and investments of the trust or give them complete control.
As noted at the outset, testamentary trusts are generally fully discretionary trusts, so that the trustee has the discretion to decide which beneficiaries to distribute to in any given year and what to be distributed. This permits flexibility and maximizes tax planning opportunities for managing the inherited wealth, with the help of appropriate professional tax advice.
The only way that you can ensure that the assets are fully protected is to have at least two trustees, an independent trustee together with the primary beneficiary.
You therefore need to decide whether you want to sacrifice the independence of the beneficiary to ensure that the inherited assets are protected and used sensibly for the benefit of the primary beneficiary and their family. If beneficiaries have full control of their testamentary trusts, this allows the beneficiaries to use the trusts for income splitting and asset protection.
However, if you want to ensure that your assets are invested and managed for the benefit of their beneficiaries then it is appropriate to have an independent person in control of the testamentary trust. This should only be done after careful consideration of the implications. It is also appropriate to have an independent trustee for testamentary trusts established for vulnerable beneficiaries (e.g. those with a significant disability, illness or addiction problems).
To see an example of how this works in practice, see Comparison Between a Simple Will & Testamentary Trust.
For further information, please contact Craddock Murray Neumann Lawyers on 02 8268 4000.