Australia: What is a testamentary trust?

What is a Testamentary Trust?

Introduction

A will is the only way in which you can determine what happens with your assets after you die.

The person you nominate to make these decisions for you after your death is usually called the executor and often the trustee of your estate because their role is to hold and distribute the estate assets as trustee for the beneficiaries of your estate.

A trust set up by a will is known as a "testamentary trust" and therefore does not come into existence until the death of the will-maker (usually called "the testator"). It can be discretionary, non-discretionary ("fixed") or a combination of the two ("hybrid") as in the case of trusts set up during one's lifetime (called "family trusts" or "inter vivos trusts").

Like family trusts, a trustee of a testamentary trust can be given broad discretion to distribute assets and income in the estate among different beneficiaries in a way that provides significant taxation and asset protection benefits.

Income tax advantages

The main advantage with testamentary trusts arises because minor beneficiaries (ie beneficiaries who are under 18) are taxed at normal adult rates on excepted trust income that has been distributed to them, which means that they are not taxed at penalty rates, and therefore receive the benefit of the progressive taxation rates, including the tax-free threshold. Depending on the circumstances of the willmaker (also called "the testator") and the beneficiaries, and the tax rates and the law that applies at the relevant time, the tax benefits derived from testamentary trusts can be quite significant.

Other taxation advantages

As is the case with family trusts, testamentary trusts can provide other tax-related benefits to certain beneficiaries.

For example, testamentary trusts can be used to stream different types of income, such as franked dividends (where a company chooses to pay tax on the dividend received by a shareholder) paid to different beneficiaries, which can help reduce the overall liability of such beneficiaries.

Distributions of income from a testamentary trust to:

  1. adult beneficiaries whose marginal rates are low (eg a stay at home spouse or adult child) helps to split income and reduce the overall liability for tax of the household;
  2. tax-exempt beneficiaries (such as some charities) also will help reduce the overall tax burden.

Asset protection strategies

As with other trust structures, the trustee of a testamentary trust does not own the estate assets but control them on behalf of the beneficiaries of the trust. Similarly, the beneficiaries of the trust neither own, nor do they have control over the assets of a testamentary trust.

Therefore testamentary trusts afford some protection to beneficiaries of estate assets. For example, if a beneficiary becomes bankrupt, and they have a trustee in bankruptcy appointed for them, generally speaking any interest they may have in a testamentary trust is protected, provided it is clear that they do not have any real control over the trust assets and for example the terms of the trust are such as to enable distributions of income and capital that do not get caught by claims from trustees in bankruptcy.

Protection in the event of separation

If you are a beneficiary of a testamentary trust, the Family Courts will generally not treat your interest in that trust as an asset of the relationship or marriage but may well treat it as a financial resource which will have less of an adverse impact on your overall settlement.

The Family Law Courts often treat a person's interest in a family trust as an asset of the relationship or marriage, or at the very least a financial resource, but are less likely to treat an interest in a testamentary trust in the same way, however as recent Family Court cases show, the Family Courts have broad powers to determine what is and what is not an asset or a financial resource of a relationship or marriage, which means that each case is treated differently on its merits and each testamentary trust must therefore be set up carefully to avoid or minimise risk of claims in this regard.

Protecting estate assets for and from beneficiaries

If a beneficiary of a testamentary trust has a problem such as drug or gambling addiction, the trustee of the trust is able to protect assets of the trust from being wasted by that beneficiary, and at the same time help safe-guard the future interests of that beneficiary. Such trusts are often termed "protective trusts".

Possible disadvantages of having a testamentary trust

The first thing to be aware of when considering establishing a testamentary trust is that there is an initial higher cost in terms of drafting a will with testamentary trust provisions in it.

Then when a testamentary trust is in operation, after the death of the testator, there will be operating and administrative costs that would not apply in the case of a normal estate without testamentary trust provisions.

For example, taxation returns must be lodged for each testamentary trust and it is usual for separate accounts to be maintained. In these circumstances, given the extra work involved, it is common for trustees to charge a commission in the administration of testamentary trusts.

In all cases where cost is a factor, the testator and his or her advisers need to look at the size and nature of the estate, the number and personal circumstances of the beneficiaries of the estate, what risks are involved relative to these two factors, before being able to determine what is the right vehicle from a cost-benefit point of view.

Conclusion

One size does not fit all when it comes to wills and especially testamentary trusts. Whether or not a testamentary trust is to be considered will depend on your estate, your beneficiaries and what you want to achieve from the structure you want to set up.

Because you will be gone before the testamentary trust commences operation, you need to have both certainty of outcome and flexibility to deal with different domestic and financial contingencies.

This is where the drafting capabilities and knowledge of legal experts skilled in this area is critically important.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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