Understanding testamentary trusts

Testamentary trusts are fast becoming the preferred vehicle for a will maker who wishes to:

  • protect their estate from their beneficiaries' creditors (typically from a beneficiary's trustee in bankruptcy or a beneficiary involved in a relationship breakdown);
  • benefit from tax advantages; and
  • exercise a level of control over how their assets will be managed by the next generation.

However, it is important that a testamentary trust is appropriate to the will maker's personal circumstances. This article discusses key considerations for any will maker or advisor when determining whether a testamentary trust is an appropriate structure.

 

What is a testamentary trust?

A testamentary trust is a trust established under a valid will. A testamentary trust functions in a similar way to a discretionary family trust, with certain provisions of the will operating like a trust deed.

A will incorporating a testamentary trust will generally address:

  • who is to be the trustee or trustees — a trustee can be an individual or an authorised trustee company;
  • who is to be the appointor — whose role it is to 'hire or fire' the trustee;
  • who is to be a beneficiary of the trust;
  • the powers of trustees to operate the trust — for example, the power to distribute the trust's income or capital at the trustee's discretion;
  • who is to be appointed an umpire — whose role it is to decide on any matter where the executors, trustees or appointors cannot make a decision unanimously; and
  • when the trust is to be wound up — known as the 'vesting day'.

When does the testamentary trust come into existence?

As a testamentary trust is established by a will, it only commences following the will maker's death. This will be at the point when:

  • the residue of the will maker's estate is identified;
  • all specific gifts are distributed; and
  • all debts and liabilities of the estate are paid.

Advantages of a testamentary trust

The main advantages of a testamentary trust are asset protection and access to tax benefits.

Asset protection

If the testamentary trust is well structured, then it can provide significant asset protection advantages for beneficiaries. This is because:

  • the trustee holds legal title to the trust's assets, rather than the beneficiary or beneficiaries;
  • where there is more than one beneficiary, the trustee does not necessarily hold the beneficial interest in the trust's assets for any particular beneficiary or beneficiaries.
Bankruptcy

If a beneficiary is bankrupt, or likely to be made bankrupt, and is not the only person with control of the trust (that is, sole beneficiary, sole trustee and sole appointor), then it is likely that the trust's assets would not be considered part of the bankrupt's estate. This is because the beneficiary's interest in the trust's assets:

  • is not 'vested' — that is, they do not yet have legal and beneficial title; and
  • is dependent on the trustee exercising their discretion to make a distribution to them.
Relationship breakdown

If a beneficiary is:

  • involved in a relationship breakdown;
  • is in sole control of the testamentary trust; and
  • has the sole power to distribute the funds of the trust's income and assets — in its capacity as trustee or appointor including to themselves,

then the trust assets may be exposed as they may be considered part of the marital asset pool which is able to be re-distributed by the Family Court.

If there is a concern regarding the stability of a beneficiary's relationship, the will maker or advisor should carefully consider whether to appoint the beneficiary as a trustee or appointor if the effect of the appointment would be to give them sole control of the testamentary trust.

The Family Court has shown an increased willingness to make orders to alter a party's interests in assets held in discretionary family trusts (which arguably also applies to testamentary trust structures), with the effect that those assets are no longer excluded from the marital asset pool.

Despite this, testamentary trusts for the most part still provide an effective asset protection vehicle as, generally speaking:

  • the trust property is not treated as property originating from the marriage; and
  • the trust may include a broad class of beneficiaries whose interests are dependent on the exercise of the trustee's discretion to distribute to them.

Protection of minor, spend-thrift or disabled beneficiaries

Where a beneficiary may:

  • have special needs due to being a minor (under 18 years of age);
  • have difficulties managing their financial affairs (for example, due to a gambling problem); or
  • suffer from a disability,

it is advisable to establish a testamentary trust with an independent trustee to administer and protect their inheritance. These types of trusts are known as 'protective' or 'protected' trusts. To protect the beneficiary while the trust is in existence, a protected trust may include either a fixed structure for the distribution of income (or capital, at the trustee's discretion) or purely discretionary distributions.

Cleardocs is developing a document package that will allow a will maker to set up a protected trust within the will.

Tax advantages of a testamentary trust

We have explored the tax benefits of testamentary trusts in a separate ClearLaw article here.

In short, when a distribution is made to a minor beneficiary of a testamentary trust:

  • they are not taxed at the penalty rates that would normally apply[1], instead they are taxed as adults under the progressive marginal tax rate regime; and
  • a trustee can stream capital gains or franked dividends to a particular beneficiary in a tax effective manner (assuming the testamentary trust permits it).

Can a testamentary trust be a separate document to the will?

Ideally, a testamentary trust should be integrated into the will.

A testamentary trust can be in a separate document that is prepared at the same time as the will or at a later date. However, a will maker or advisor should be careful to ensure that the terms of the testamentary trust are consistent with the will's terms, as any inconsistency between the two documents may lead to a long and expensive Court application to resolve any dispute.

To avoid this problem, Cleardocs is developing a document package that will allow a will maker to create a single trust for all beneficiaries or separate testamentary trusts for each beneficiary within the will.

Tax compliance and record keeping

A will maker must perform a cost/benefit analysis to determine whether the assets of the will maker's estate will justify the annual operating costs of managing a testamentary trust and the costs of compliance with tax obligations.

If the will maker has a beneficiary who is bankrupt, or is at risk of becoming bankrupt, having a testamentary trust may still be appropriate, despite the estate being of a modest size.

Like any trust, a trustee of a testamentary trust must:

  • file a tax return for every financial year that it is in existence; and
  • maintain proper trust account records (such as trustee's resolutions), especially where a trustee is streaming capital gains or franked dividends.

Depending on who is appointed the trustee and appointor of the testamentary trust, there may need to be a high level of co-operation between family members to ensure the trust is operating effectively.

More information from Maddocks

For more information, contact Maddocks on (03) 9258 3555 and ask to speak to a member of the Private Client Services team.

Essential estate planning resources

Stay on top of issues affecting estate planning with the following resources from Thomson Reuters: Australian Financial Planning Handbook, Death and Taxes and Family Business Succession Guide. Available in book, ebook and online.

More Cleardocs information on related topics

You can read earlier ClearLaw articles on a range of estate planning topics here.

Order Cleardocs Estate Planning document packages



[1] Section 98 of the Income Tax Assessment Act 1936 (Cth).