Advice regarding testamentary trusts

by Rockliffs Solicitors

The principal differences between the two (2) types of discretionary trusts are:

(a) A deed trust can take effect immediately, a will trust only commences when the will-maker dies; and

(b) A testamentary or will trust qualifies for income tax concessions when net trust income is distributed to minors, i.e. beneficiaries under 18 years.

Some reasons for establishing the two (2) forms of discretionary trusts.

1. Asset Protection

Unless assets have been allocated to a particular beneficiary, the assets of a discretionary trust do not form part of the estate of the person controlling the trust. This attribute is one of the reasons why people in risk occupations (e.g. many company directors and senior executives, medical practitioners, principals of architectural engineering, accounting and other practices or businesses) are and should be have the wills of their parents and spouses establish testamentary trusts for them rather than those relatives leave assets to them personally. The effect of the assets being "non-estate" assets is that if the appointor (or for that matter any other beneficiary of the trust) becomes insolvent, the creditors of the bankrupt appointor or the other beneficiary usually can not access any of the trust assets. The asset protection offered by discretionary trust is not absolute, e.g. it does not apply:

  • If the trust assets were security for the debt (e.g. the trustee had provided a guarantee);
  • To the extent the trustee is indebted or has allocated yet to be claimed income to the appointor;
  • If the bankruptcy "claw-back" provisions apply, eg. in respect of recently made gifts by the now bankrupt person to the trust.

2. Pension eligibility

Under current means Tested Pension Rules, the assets test does not apply to discretionary trusts regardless of whether they have been created by deed or a will. However, the net trust income allocated a beneficiary count as part of the beneficiary's income for income test purposes. In addition, the pension deeming provisions apply for a period of five (5) years after assets are transferred to the trust by a living person (the five (5) year wait does not apply to assets left to a Testamentary Trust rather than to the beneficiary directly).

3. Family law

One of the reasons for establishing a discretionary trust or will is to try to ensure that "in-laws" or family members, particularly if those in-laws are estranged, do not have access to a family's wealth. However, the discretions given to a family or other Court mean that ways are often found by the Court for "in-laws" to access or be compensated for the assets held in a Trust. It should also be remembered that allocations of net trust income which have not been paid or spent on a beneficiary, can be accessed by a Court or creditor.

4. Control and flexibility

A feature of a discretionary trust is that the trustee can retain control of assets but choose which beneficiaries receive the net trust income. The choice can change from year to year. Unlike superannuation funds, dependants need not to be given a priority when payments are made following death. Like family excluded superannuation funds, the trustee's discretion can be absolute but the choice of beneficiaries is usually greater.

5. Access

Unlike assets in superannuation funds, discretionary and testamentary trust assets usually can be removed from the trust, borrowed or used as security, without the prime mover needing to retire or die. Requirements for a spread of investments or audited accounts are not mandatory and a trustee of a discretionary trust can act in a purely self-interested manner. The reasonable benefit limits restrictions effectively limit the amount of assets that can be sheltered in a superannuation fund do not apply to discretionary trusts.

6. Tax considerations

(a)  Income splitting
Like partnership companies and unit trusts, discretionary trusts can provide an opportunity to split income between family members. Spouses, adult children and dependants, adult relatives and related companies and trusts are frequently able to receive income at lower income tax rates. The advantages are enhanced if income can be generated in superannuation funds.

(b) (For trading and exertion geared investment trusts) The lost trust rules restrict the ability to claim deductions for current prior year losses and for bad debts - as a consequence many trusts that are trading on an accrual basis or have losses from previous years need to consider whether to make an election to become a family trust or to issue income or capital units to create at least some fixed entitlements.

Clearly, certain taxation benefits can be obtained from the family of a deceased person by making use of certain provisions in the Income Tax Assessment Act ("the Tax Act"). Division 6AA of the Act applies penal rates of the tax to income derived by minor beneficiaries of Trust estates. The income of those beneficiaries has a tax-free threshold of only $416.00, with the excess over $416.00 being taxed at 66%.

However, the provisions in Division 6AA do not apply to what is termed "accepted trust income". Therefore, income derived by the minor beneficiaries of a Testamentary Trust has a tax-free threshold of $5,400.00 and the excess is taxed at the ordinary marginal rates. Clearly, the more minor beneficiaries that exist in a Testamentary Trust, the greater the tax saving that can be obtained.

It should be noted that accepted trust income includes accessible income derived by the Trustee of a Trust estate from the investment of any property that was transferred to a Trustee by a person upon whom the property was divulged from a deceased estate provided that the transfer to the Trustee took place within three years after the date of death of the deceased.
Therefore, beneficiaries who receive property under the terms of a deceased estate have three years in which to establish a Trust for themselves and their minor beneficiaries to gain the tax advantages.

7. Income streaming

Unlike companies, most trustees of discretionary trusts have been given the power to stream different types of net income to different beneficiaries.

8. Capital Gains Tax ("CGT") and Stamp Duty

In most circumstances, the death of an individual does not cause a Capital Gain or Capital Loss to arise to the estate. Where the individual dies on or after 20th September 1985, any relevant asset which was acquired by the deceased prior to 20th September 1995, the asset that devolves to the legal personal representative or passes to the beneficiary of the estate is taken to be acquired for a consideration equal to market value. Where assets are acquired by the deceased on or after 20th September 1985 that devolve to the legal personal representative or passes to the beneficiary of the estate, are deemed to be acquired by the legal personal representative or beneficiary at the deceased's cost base immediately before his or her death (ie. cost = market value and therefore no capital gain arises). This is referred to as Capital Gains Tax "roll-over".

In certain circumstances, the pre Capital Gains Tax status of an asset held by an individual may be preserved by the individual taking certain steps prior to death. For example, if the individual owns property that property can be transferred to a company using the "roll-over" provision of sub-division pursuant to Section 122A of the Act under which the property retains its pre-Capital Gains Tax status in the company and the shares issued as the consideration have a pre-Capital Gains Tax status. Therefore, on the death of the individual (who owns all the shares in the company) the property retains its pre-Capital Gains Tax status since the death of an individual who holds shares in a private company does not hold the pre-Capital Gains Tax assets of that company to become post-Capital Gains Tax assets.

Further, the transfer of an asset by the legal personal representative pursuant to either a specific legacy or a power to appropriate under a Will is subject to $10.00 stamp duty. Therefore, in certain circumstances, it may be preferable for an asset to be dealt with under a Will rather than a transfer being made during the lifetime of the individual.

The following is an important example:-

Harry and Sally had been happily married and had 2 children. Sally had a professional corporate position and Harry who had been injured in an accident stayed home and looked after the children. Sally subsequently passed away and left her entire estate of approximately $80,000 to Harry however, no consideration had been taken in her will to her major asset being superannuation entitlements of approximately $400,000.

Most superannuation fund deeds give the trustee of the fund a discretion to pay benefits upon the death of a member to either the estate of the member, or to a dependent of a member. Fund trustees are also constrained by the superannuation legislation to pay benefits to dependants. This overriding discretion means there is little a member can do to ensure that the fund trustee will act in the desired way upon his or her death.

Further, the Income Tax Assessment Act 1936("ITAA") taxes payments of death benefits out of a superannuation fund to non-dependants as a taxable death benefit Eligible Termination Payment ("ETP"). The payments of these benefits to non-dependants will attract an additional 15% tax liability.

In Sally's case, the trustee of her super fund has the following options:-

  1. Payment of all of the proceeds into Sally's estate - as Harry is the sole beneficiary of her estate, there will be no death benefit ETP tax liability. However, all of the income earned by the proceeds will be taxed solely in Harry's hands. If Sally's will does not establish a testamentary trust for Harry, Harry will also lose his pension eligibility.
  2. Directly to Harry - resulting in the same problems as outlined in 1 above.
  3. Directly to one or both of the children - the income earned on the investment of the proceeds will be taxed at the adult marginal rates as it is income derived from the property transferred to minors directly as a result of the death. Harry will not be able to access any of the income for his own use.
  4. To a superannuation proceeds trust established in her Will allowing proceeds to be distributed to the children at adult tax rates and allow Harry access to the income and allow the children after they have attained 18 years of age and during the life of the trust, to access the capital by way of loan. Harry's pension will also be preserved.

As can be seen above, a properly established superannuation proceeds trust, gives families with young children a means of preserving superannuation benefits for the next generation whilst accessing income, with accompanying tax benefits immediately. Similar advantages can be achieved by establishing a Testamentary Trust.

9. Superannuation death benefits as part of estate planning

For many, superannuation is a major asset. Accordingly, on death, it will form an integral part of their estate. It is important to be aware that a Will does not bind the trustee of a superannuation fund. The members account in a superannuation fund is not part of their estate unless the trustee of the funds of the fund determines that the death benefit should be paid to the trustee in the estate.

A member of a superannuation fund should ensure that they:

(a) Have completed a Notification of the Dependents with the application and kept it updated in the fund records.
(b) Ensure that their assets are protected in the event of bankruptcy up to the pension reasonable benefits limits.
(c) Consider how best to use the exempt death benefits provisions to allow for assets to pass to the next generation in the most effective manner.
(d) Consider how they wish for their pension to continue to their spouse in the event of their death, most effectively.

10. Tax effective ways of combining superannuation estate planning

A superannuation fund is broadly taxed as follows:

(a) During the accrual phase the income or fund is taxable at 15%, reduced by long term capital gains to 10% and further reduced by dividend imputation contribution credits;
(b) During the benefit payment phase, if the income relates to current pension liabilities and the relevant actuarial certificates have been obtained, the income of the fund is tax-free as the members are paying tax on their pensions.

On death benefits paid, up to the pension, reasonable benefit limits are broadly taxable as:

(a) Death benefits paid to an independent are tax-free.
(b) Benefits paid to the estate are only tax-free to the extent that the Commissioner of Taxation is satisfied that the benefit has been passed on to the dependents.
(c) Pensions are taxable to the pensioner, a 15% rebate may apply in some cases.
(d) Non-dependents are taxable.
(e) The insurance component of a death benefit is taxable at a higher rate.


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