Trusts have been known to lawyers for centuries, they have been around since before the reign of King Henry VIII.

Trusts are very common in Australia.

According to the Australian Taxation Office website in 2004/05 about 5% of the 13m tax returns filed in Australia were trust returns. Of these about 10% related to deceased estates.



A trust will be created in many different factual situations including being made under a will. A trust made under a will comes into existence as a consequence of the willmaker dying, not when the will is made. Trusts created under a will are known as "testamentary trusts", other trusts are known as "inter vivo trusts". This article deals with testamentary trusts, in particular discretionary testamentary trusts.

Testamentary trusts take many forms including:

  • a life tenancy;
  • a life interest estate;
  • a trust for minors;
  • a trust for protected beneficiaries; or
  • charitable trusts.

However, in some circles the expression "testamentary trust’ has a narrower meaning: it is a discretionary trust created under the will of a deceased person. In the remainder of this article, the term "testamentary trust" will be used in that sense.

Form of a Testamentary Trust

Testamentary trusts are drafted to mimic the operation of an inter vivos discretionary trust: the testamentary trust will have a broad range of discretionary objects, usually the members of an extended family. The trustee of the testamentary trust selects from the class of discretionary objects that person or those persons who will receive a gift of trust income or trust capital.

Until the trustee selects an object to benefit, no person has a vested interest in the assets of the trust.

Careful drafting of the testamentary trust will ensure that the discretionary object selected, who becomes a beneficiary, only has an interest in the trust to the extent that the trustee has determined.

The trustee of the testamentary trust may be the executor of the deceased estate or he may be some other person, who will be appointed by the will or pursuant to a formula contained in the will. Often the trustee will be the person to whom the willmaker, but for the testamentary trust, would bequeath his assets or a good part of them.

Consider a grandfather in making a will. The grandfather is a widower. The grandfather has a son and a daughter, both of whom have children. The grandfather could leave his estate equally to his children, in which case after satisfaction of estate formalities and debts, the son and the daughter will own half their father’s assets each. If, however, the son is a trustee of a testamentary trust which consists of half the

grandfather’s assets, and the daughter a trustee of a similar trust, then instead of owning the grandfather’s assets, the son will be trustee of a trust, in which he is a discretionary object which consists of half his father’s assets. The daughter is in a similar position in relation to an identical second trust. Instead of ownership the son and daughter merely control the assets.

Why use a Testamentary Trust?

A testamentary trust offers three advantages compared with ownership passing directly to a beneficiary.

1. Asset Protection

As with an inter vivos discretionary trust because a discretionary object has no interest in a particular asset until the trustee exercises his discretion in favor of that object, it follows that a creditor of that particular discretionary object can have no recourse to the assets of the trust unless the trustee of the trust specifically gives the discretionary object an interest in the asset of the trust by either distributing the asset to the

discretionary object, or by resolving to distribute that asset to the discretionary object.

Compare this with the position where the discretionary object is given a gift outright under the will: the creditors of the discretionary object can have recourse to that asset.

2. Tax

Distribution to Beneficiaries

A distribution from a testamentary trust to a beneficiary of that trust is "exempt trust income". Unlike most other forms of unearned income, in the hands of a minor beneficiary (i.e. Someone under the age of 18), exempt trust income will be taxed at adult marginal tax rates, not penalty tax rates.

Tax rate for resident minors

 

Normal unearned income tax rates (e.g. Distribution form inter vivos trust)

Exempt trust income (e.g. Distribution from testamentary trust)

0 to 417

Nil

Nil

excess over 417 to 1,307

66%

Nil

excess over 1,307 to 6000

45%

Nil

excess over 6000 to 30,000

45%

15%

excess over 30,000 to 80,000

45%

30%

Thus, compared with the position where the discretionary object is given the gift outright under the will, if the discretionary object is an adult and in receipt of other income (e.g. Employment income), the tax saving may be substantial if the income can be distributed to a minor.

If the discretionary object who is a minor were to receive the gift outright, the discretionary object would be taxed on the income generated by that asset at the unearned income rate.

Undistributed Income

Where an inter vivos trust does not distribute taxable income in the year in which it is earned, the trustee of the trust will usually be required to pay tax on that income at the highest marginal rate - 45% (S99A ITAA36).

However, in a testamentary trust this may not be the case. Where the tax year in which the accumulation occurs ends within three years of the death of the willmaker, the trustee may be taxed at usual adult tax rates, not a flat 45%. Where the tax year is outside this period, the trustee will be taxed at adult marginal rates, but without the benefit of the tax-free threshold.

Capital Gains Tax

Ordinarily, on the passing of assets from one person to another a capital gains tax event will occur, and the disposer may be liable for capital gains tax. This applies whether or not the disposal is as a result of a sale.

In the context of a deceased estates, this outcome is ameliorated by S128-15(3) ITAA97 which defers the taxing point until the beneficiary disposes of the assets, perhaps years after receipt from the willmaker.

In the context of an inter vivos trust, a capital gains tax event occurs when the trustee distributes an asset in species to a beneficiary. It does matter that the beneficiary gives no consideration for the asset, a present capital gains tax liability might arise.

The in species distribution of an asset by the trustee of the testamentary trust to a beneficiary of the trust at any time will be treated as being subject to S128-15(3) with the capital gains taxing point deferred until the beneficiary disposes of the asset provided that the asset was originally the property of the deceased willmaker at his death.

Assets acquired by the testamentary trust after the death of the willmaker will be taxed when transferred by the trustee to the beneficiary (i.e. Same as inter vivos trust).

3. Family Law

As asset passing from a deceased estate to a party to a marriage, who subsequently becomes the subject of a family law property dispute will find the assets from the deceased estate included in the divisible property of the marriage.

Similarly property the subject of an inter vivos trust which was acquired during the marriage will also be included in the divisible property of the marriage.

Where property is the subject of a testamentary trust, and one of the beneficiaries is the subject of a family law property dispute, provided it can be said that the party the subject of the family law property dispute does not control the trust, that property will not form part of the divisible property of the marriage.

Conclusion

Testamentary trusts offer a willmaker advantages which are not available where the willmaker’s assets pass directly to beneficiaries. However, a testamentary trust will usually lead to greater administrative costs to the estate. In making a decision to include a testamentary trust in a Will, these costs must be weighted against the advantages.

Michael Norbury is a Partner at Madgwicks Lawyers and practices in the areas of commercial law and revenue law in many industry sectors. Recently Michael has been appointed to the Australian Tax Institute’s State Taxes Subcommittee.

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.