What is a testamentary trust?

What is a testamentary trust?

What is a trust?

In most wills, after a person dies, the executor will hold the assets of your estate “on trust” for your beneficiaries. In other words, the executor acts as the “legal owner” of the assets for a short time until the benefit is transferred to them. During the transition, the beneficiaries are not the legal owners of the estate’s assets. They are known as the “beneficial owners.” This is a trust relationship.

Once an estate is administered (all the bills are paid) the trustee “vests” or transfers legal ownership of the assets to the beneficiaries. At that point, the beneficiary becomes both the legal owner and beneficial owner. Vesting of an asset to a beneficiary makes them the “absolute owner,” of it. Once an absolute owner, the trust relationship is at an end.

An analogy used to explain the difference between legal and beneficial ownership is motor vehicle registration; A car can be registered in A’s name but actually belong to B.

Superannuation funds are another common example. The legal ownership of the fund is held by the trustee appointed by the superannuation company. They hold your investment “on trust,” for you but you are not responsible for making investments.

Discretionary v’s Non-Discretionary

There are two commonly used trusts created in wills. The first being a “discretionary trust” and the second being “Non-discretionary trust”.

A non-discretionary trust is commonly known as a “bare trust.” In a bare trust, a beneficiary can demand that the trustee vest the asset in their name. An example of a bare trust in a Will could be “I give the whole of my estate to my children A and B equally.”

In a discretionary trust, a beneficiary cannot demand anything from the trustee. The distributions of income and capital are made at the discretion of the trustee. The discretionary nature of trusts is the mechanism used to protect assets from marital disputes and creditor claims.

Testamentary trusts are commonly used in estate planning. A separate testamentary discretionary trust can be set up for each beneficiary. For example, for A and B, to be used for the benefit of each of their respective families. In families with adult children A will often be the Trustee for A’s trust and B the trustee for B’s trust. In families with infant children, C (an independent person, friend or relative) may act the Trustee of both A’s and B’s trusts until they attain a specified age defined in the trust (“the preservation age”).

Testamentary discretionary trusts last for a period of eighty (80) years from the date of a person’s death. This means that the trust is capable of distributing income across multiple generations.

Family/Domestic Partner / Asset Protection

According to a report commissioned by the Australian Department of Social Services:

“Divorce continues to be a pervasive feature of Australian social life: 32 per cent of current marriages are expected to end in divorce and it has been predicted that this may increase to 45 per cent over the next few decades if current trends in recent marriage cohorts continue…”[1]

A testamentary discretionary trust may be used (in limited circumstances) to prevent a person’s inheritance forming part of the “asset pool,” for the purposes of matrimonial property disputes. The rules of the trust temporarily excluded your child from acting as the trustee during the dispute. A new trustee would be appointed by them. Whilst an excluded trustee, they cannot demand that the new trustee make distributions to them. Once the property proceedings are resolved, the child can be re-appointed. If the family court treated the trust as “an asset of the marriage,” it would adversely affect the rights of other family members who have an interest in the trust and there is a reluctance on their part to interfere.

Notwithstanding, the Family Court of Australia is an extremely powerful court. If A is no longer a trustee but continues to receive regular distributions from the trust, this will be seen as “de-facto control.” In that scenario the protection may not be effective. If a testamentary trust was set up with the objective of avoiding the jurisdiction of the Family Court (in circumstances where there was suspicion of an impending dispute) the protection may not be afforded. The lesson here is that will-makers ought to create testamentary trusts well in advance of their children’s relationship problems. Doing so strengthens the argument that the trust was set up with a legitimate purpose.

Creditor Protection

Your children may run businesses, or be otherwise exposed to claims by creditors. If you die leaving a “bare trust,” in your Will, your children’s creditors may gain access to the gifts. For example, a trustee in bankruptcy may apply the inheritance to discharge debts. In a discretionary trust that will not happen.

Once again under the rules of the trust your child would “temporarily,” be excluded from acting as the trustee. Once any bankruptcy is discharged they are able to re-appoint themselves as trustee.

Tax Concessions and Savings

Inheritance under a will is treated differently to income received from other sources. Infant children under a testamentary trusts are allowed to claim the tax free threshold of an adult taxpayer ($18,200.00) rather than the nominal threshold normally applicable to children. Marginal tax rates apply to “excepted trust income.” This is compared to the maximum rates charged on distributions made to children from “non-excepted income.” The following examples show the tax effective nature of testamentary wills structures:

Scenario 1 Scenario 2 Scenario 3
Absolute Gift to A who then personally owns $1M

 

Trust owns $1M Trust owns $1M
$1M gift earns 5% income per annum or $50,000.00 $1M gift earns 5% income per annum or $50,000.00 $1M gift earns 5% income per annum or $50,000.00
Income of $50,000.00

Apportioned to A’s annual income

 

Trust distributes $50,000.00 income to A’s 3 infant children Trust distributes $50,000.00 income to A’s 2 infant children
A pays income tax at a rate of 45c in the $1.00

 

Infant children treated as adult taxpayers and claim tax free threshold of $18,200.00 allowed for excepted trust income Infant children treated as adult taxpayers and claim income tax free threshold of $18,200.00 for excepted trust income. Remaining income of $13,600 treated as excepted trust income and taxed at marginal rate of 47%
Tax Payable $22,500.00 Tax Payable $0 Tax Payable $6,392.00
Tax saving $0 Tax Saving $22,500.00 Tax Saving

$16,108.00

Deferred Capital Gains Tax

A trust’s ownership of an asset attracts similar capital gains tax (“CGT”) concessions which apply to individuals (not including the principle residence exemption). Given that a trust can own assets for a period of eighty (80) years, the sale of trust assets in two or three generations time, means the first and second generations may not have to pay CGT during their lifetimes.

Protection for infants, spendthrifts, gamblers, alcoholics and mildly disabled persons

Testamentary discretionary trusts allow you to take the investment and income distribution control out of the hands of vulnerable beneficiaries. People are often concerned that their children will spend their inheritance on a sports car rather than a roof over their head. Testamentary trusts allow vulnerable people to be appointment as their own Trustee in the future should their life circumstances improve.

Non-Retrospective Nature.

A testamentary discretionary trust gives beneficiaries great flexibility. If your beneficiaries do not wish to participate in the trust structure they can easily wind it up, taking their inheritance absolutely. It is important to note that a testamentary discretionary trust cannot be made retrospectively (after death). If the structure is not set up in advance, then none of the asset protection or tax effective structures can be utilised.

[1] Marriage breakdown in Australia: social correlates, gender and initiator status (Australian Department of Social Services)(Social Research Policy Paper No 35) Dr Belinda Hewitt 2008 (Cth).

For more information about testamentary trust’s contact Gregson and Associates today

2020-09-14T08:33:10+00:00 August 17th, 2020|Uncategorized, Wills and Estate Planning|0 Comments