What are testamentary trusts?
A testamentary trust is a type of discretionary trust established under a Will. The Will sets out what assets are to be gifted into the trust, who the beneficiary of the trust is to be; however, critically, the trust does not start and the assets do not pass into the trust until the Will maker dies.
A testamentary trust is a way in which a Will maker can gift their assets to a beneficiary into a separate entity for the beneficiary instead of directly to the beneficiary. The Will sets out the full terms of the Trust.
The purpose of a testamentary trust, once created, is that the trustee of the trust has the discretion to pay benefits to the eligible beneficiaries that you name under the trust in the Will.
Why consider testamentary trusts?
A testamentary trust can be a great strategy for a succession plan – but there are also some negatives. We are aware that some professionals market testamentary trusts as the golden solution to all succession planning problems. We respectfully disagree. It is only an option and should be carefully considered for that reason. They can be really successful for some people and downright disastrous for others.
Making gifts to a testamentary trust instead of a beneficiary directly is generally favoured for tax planning benefits, succession planning benefits and asset protection benefits.
We set out some of the positives and negatives of a testamentary trust below.
What is the purpose of this explanatory sheet?
We wrote this sheet to:
- explain what a testamentary trust is
- explain why it might be a good strategy to consider for your estate plan and why it might be something for you to avoid
- help you understand what it is and why it might be helpful for your estate planning
Testamentary trusts are designed to provide maximum flexibility, whilst both allowing for the tax-effective distribution of capital and income derived from the assets, and providing a greater degree of asset protection, as compared to if the assets were held by the beneficiaries in their personal capacity.
Advantages of Testamentary Trusts
Protect the legacy for your family
If you leave a gift directly to your child, chances are that they are also in a relationship of some description. If your child dies, their Will or intestacy laws usually provides that the spouse of your child most likely receives whatever your child had at death – including anything that they inherited from you. If your child’s spouse then enters into another relationship then their asset pool will be exposed to the new spouse.
If your gift had been made to a trust for the benefit of your child then, on death of your child, the assets and benefits of those assets could have been dealt with under the trust to bypass the spouse (or only give the spouse a minor benefit) and provide the benefit to the child. The further spouse would have a minimal or no claim to the asset pool you had passed down.
Example (please note that the sums are purely for example purposes and are NOT to be read as what would happen in the below situation – trusts and divorces are very complicated and require specific advices):
- gifting to your son directly:
- you leave $10 million to your son directly
- you die, your son inherits $10 million from you
- your son dies, his Will says his entire estate goes to his wife
- two years later, your son’s wife remarries
- two years later, your son’s wife divorces. The entire $10 million inheritance is treated as part of the property settlement pool.
- your son’s wife loses $2.5 million to the new spouse in divorce proceedings
- gifting to a trust created for your son:
- you leave $10 million to a trust established for your son
- you die, the trust is created and your son is the beneficiary of a trust which holds $10 million
- your son dies – his Will does not affect or change the terms of your trust
- your trust says that if your son dies, his children are the next eligible beneficiaries
- two years later, your son’s wife remarries
- two years later, your son’s wife divorces. The trust is not treated as an asset of the property settlement pool.
- your son’s wife doesnt lose any part of the trust to her new spouse in divorce proceedings.
Please note that if your child is a beneficiary of a trust or receives distributions from a trust then in the event of a divorce between your child and their partner, the trust may be treated as an asset of the property settlement pool and the courts may order a wind up of the trust. Trusts cannot really prevent a breakdown of your child’s relationship affecting the shared property pool but it can protect from your child’s spouses future relationships.
Asset Protection: Solvency and Third-Party Claims
If you gift assets directly to a beneficiary then those assets are exposed to any current or future claims against the beneficiary and might be consumed to pay out any future litigation. Alternately, if you gift assets to a trust then those trust assets may be protected from a third-party’s claim against the individual beneficiary.
- if your child works in a high risk profession and is at risk of being sued personally then any asset you gift them might be consumed to defend or pay out any future litigation. However, if you had a trust in place, the assets could have been held on trust away from the claimant and protected.
- if your child is bankrupt or likely to be bankrupt then the bankruptcy trustee is automatically entitled to the gift that your child would otherwise have received. However, if you had a trust in place, the assets could have been held on trust away from the bankruptcy trustee until your child’s bankruptcy ended.
Asset Protection: Children and Other Beneficiaries
A testamentary trust is particularly beneficial for intellectually disabled beneficiaries, as well as beneficiaries with illnesses, addiction problems or other weaknesses which could result in the loss or dissipation of an inheritance. If a child or other beneficiary is temporarily incapacitated, testamentary trusts will enable the assets to be managed by the family for the benefit of that beneficiary, rather than having their assets controlled by a government agency like the Queensland Public Trustee.
In the case of a grandparent leaving bequests for the payment of boarding school and tuition fees for their grandchildren, the use of testamentary trusts allows a degree of control over the application of such assets, which is more effective than leaving additional bequests to parents in a Will. This is also a more tax effective method of providing for the grandchildren’s education.
Income and Capital Gains Tax
Under an ‘ordinary’ trust, if a beneficiary takes their inheritance in their personal name, they are required to pay tax on the income generated from the inheritance at the top marginal tax rate. This means that if a child under eighteen years of age receives over $1,000, they must pay the associated tax at the top marginal rate.
However, under a testamentary trust, children under eighteen are taxed as ordinary taxpayers, commencing at the lower tax rates. When compared to distributions made either directly, or under family law trusts, this results in considerable reductions in the total tax payable when distributions are made to children and grandchildren (until they reach the age of eighteen).
Capital gains realised on assets held by a testamentary trust can also be streamed to one or more beneficiaries in a tax effective manner. Where one or more of the beneficiaries has a low income in the year of distribution, distribution to this beneficiary allows them to take better advantage of the five year averaging rate of capital gains tax losses. In turn, tax payable on capital gains on realised assets can be considerably reduced.
Preservation of Government Benefits
At present, Centrelink does not take assets held by testamentary trusts into account when calculating the pension eligibility of a beneficiary – although the income distributed by the testamentary trust is taxable in the hands of the beneficiary.
Superannuation and Insurance Proceeds
Generally, superannuation proceeds fall outside of the assets in a deceased estate, and the distribution of the proceeds are determined by the rules of the fund. However, a Willmaker may elect to direct the trustee of the superannuation fund to pay the proceeds of the deceased’s superannuation or death proceeds to the deceased’s Legal Personal Representative (i.e. the executor(s) of the deceased’s estate).
In this regard, the proceeds will be paid to the executor(s) and distributed in accordance with the Willmaker’s Will. If the Will includes testamentary trusts, then the proceeds may be directed by the executor(s) to the trustee of a testamentary trust established in the Will, rather than being distributed directly to the nominated beneficiary, which assets would then be held in the beneficiaries personal capacity.
The proceeds will then be distributed to the executor of the deceased’s estate, who will have the discretion to distribute the proceeds and make use of the testamentary trusts established in the Will.
Disadvantages of Testamentary Trusts
The trustee essentially controls the trust and has discretion to determine the future of the trust and its assets. The trustee can distribute all or any part of the income to one or more of the beneficiaries, at such times and in such amounts as they see fit. As such, the succession of the role of trustee must be specifically spelt out in the Will, if the individual wishes to determine who will control the trust upon their death.
If the trust restricts access to capital or income, a beneficiary may become upset and challenge the terms of the Will. The possibility of a challenge may be reduced by the Willmaker communicating their intentions to their beneficiaries at the time that they prepare their Will.
Administration of the trust may require a level of cooperation between family members who may share the role of trustee of the trust. This could lead to potential disharmony.
Assets held by a testamentary trust must be sufficient to justify the expense of administering the trust. For example, accounts will need to be prepared and maintained, and a tax return will need to be lodged each year.
Capital Gains Tax
If the trust has capital assets that are sold at a loss, those capital losses cannot be distributed to the beneficiaries, and must be carried forward in the trust and set off against future capital gains (if any).
If either the primary or another beneficiary is a pensioner, care must be taken to ensure that the beneficiary’s pension eligibility is not jeopardised by their inheritance in the testamentary trust, as any inheritance may affect their income test.
Time capped at 80 years
Queensland testamentary trusts are limited to 80 years from the date of establishment. The effect of this is that the trust is created on your death but must be wound up 80 years later. This is enforced by law. When the trust is wound up, this creates a capital gains tax event and can also incur stamp duty on any property held in the trust. You will no doubt appreciate that this can be a very significant and costly event.
Therefore, our view is that testamentary trusts are not particularly useful for gifts created to hold long term hold assets – for example rural properties. In most rural families, property is intended to be held for generations. So, we therefore recommend other options to anyone looking to gift long term hold assets.