What is a Testamentary Trust [TT]?
TT is a trust created under a person’s will which does not come into effect until after their death.
TT has similar characteristics to a discretionary or family trust except the provisions of the trust are set out in the will itself.
It is possible to establish multiple TT in a single will if necessary to ensure your estate is managed in accordance with your wishes
There are a number of potential benefits to incorporating TT into your estate planning arrangements.
These benefits can be generally characterised as Protection Benefits or Taxation Benefits.
Protection Benefits
1. High Risk Beneficiaries: where a beneficiary owns their own business or is engaged in a profession that carries high risk of litigation, the assets of your estate could be exposed to creditors or other third parties.
Where your spouse or an adult child is considered high risk, their intended beneficial distribution could be held under TT. As the beneficiary would not have direct ownership of the assets, they would not be exposed to a third-party claim.
Example: Brian wants to divide his estate equally between his three adult children Ian, Robyn, and Mary. Ian is an entrepreneur and business owner with high exposure to risk. Due to a downturn in the market, Ian’s business collapses and creditors pursue him via directors guarantees given in the ordinary course of business.
• No TT: Brian’s estate is distributed equally between Ian, Robyn and Mary. Ownership of Ian’s share of Brian’s estate has passed to Ian and those assets are available to a claim by the creditors.
• TT: Brian establishes a TT in relation to Ian’s share in which Ian is the trustee and Ian, his wife and children are potential beneficiaries of TT. Ian is able to control his share of Brian’s estate however as his wife and children are potential beneficiaries, the assets are not directly owned by Ian and cannot be claimed by creditors.
2. Family Law Proceedings
2.1. General Principle vs Family Court
General principle is that the entitlement of a beneficiary of a Trust, including a TT, is only to the proper administration of the Trust.
Family Court may infer greater entitlement or value to beneficiary’s interest than general principle.
Family Court will generally categorise Trusts (and the assets held within them) as being one of the following:
• Property of a party – part of pool of assets to be divided.
• A Financial Resource of one a party – not included in the pool of assets for division but will be considered in terms of that party’s ability to support themselves in the future, which may impact on the division of the other assets in the marital pool
• Neither and excluded from consideration in property settlement proceedings.
Factors in categorising TTs:
• extent of control and influence over the decisions made about the operation of the Trust, including distributions made to beneficiaries
• consideration of the historical administration of, and distributions from, the Trust.
2.2. Property of a Party
TT assets are categorised as Property of a party if TT is sham or alter ego of that party i.e. where party is appointor, trustee and beneficiary
Example: based on Lovine & Connor [2011] FamCA 432:
• Brian leaves estate to adult children Ian, Mary and Robyn through TT.
• Ian, Mary and Robyn are all trustees.
• Following death of Brian, Ian separates from wife.
• During divorce proceedings Family Court finds:
• 1/3 has already been distributed to Mary and her children;
• 1/3 already been distributed to Robyn and her children;
• Mary and Robyn no longer have active role in administering trust;
• Remaining 1/3 would ultimately be distributed to Ian and/or his children.
• Court finds TT assets are marital assets however, award Ian higher percentage because TT was an asset to which the wife made no contribution.
2.3. Financial Resource
Factors:
• party is not appointor or sole trustee
• party is one of a number of beneficiaries
• historically has received some but not all of distributions from trust
Example: based on Bernard & Bernard [2019] FamCA 421
• Ian marries Susan in 1998 and they separate in 2015.
• Brian makes will in 2012 and passes away same year.
• Brian’s will creates two TTs:
• TT-No.1: Ian is primary beneficiary, Ian’s sister Mary is sole trustee.
• TT-No.2: Mary is primary beneficiary, Ian is sole trustee.
• Ian and Mary conduct business together through partnership formed from TT-No.1 and TT-No.2
• Finding – assets of TT-No.1 excluded from marital asset pool:
• Ian is not settlor of trust.
• Ian is dependant on Mary to distribute and accumulate income.
• Mary has complete discretion to determine distributions.
• Ian has no direct or indirect control of TT-No.1 despite beneficiary and mirror TT-No.2 where he does have control.
• Although primary beneficiary of TT-No.1, there are many classes of beneficiaries, including wife, children, grandchildren
Example: based on Ward & Ward [2004] FMCAfam 193:
• Brian establishes 4 TTs in his will where Joan (wife), Ian, Mary and Robyn (children) are beneficiaries.
• Trustee of TTs is a company where Joan and children are all directors.
• Joan is sole appointor of TT.
• Following death of Brian, Ian separates from wife
• During divorce proceedings Family Court finds:
• Ian has limited control over trust as needs consent from Joan and siblings before receiving benefit; and
• Trust assets were financial resource of Ian but not marital assets.
2.4. Not Property or Resource
• not appointor or trustee and does not have considerable influence
• historically has not received significant distributions over other beneficiaries
3. Special Needs Beneficiary: if a beneficiary is not capable of managing their own affairs, TT allows another trustee to (either jointly with or independently of the beneficiary) manage that beneficiaries entitlement under your will. For example, if an adult child has addiction problems or a disability, the trustee of TT could ensure the assets of the estate are used appropriately.
• Example: Brian wants to divide his estate equal between his three adult children Ian, Robyn and Mary however Robyn has a history of drug abuse and gambling addiction. Brian establishes TT where Mary and Robyn are joint trustees of Robyn’s share. Mary is able to ensure Robyn’s beneficial interest is directed towards proper purposes.
• Example: Brian wants to ensure part of his estate is available for his daughter Robyn who suffers from an intellectual disability. Brian establishes TT where his other daughter Mary is sole trustee and Robyn is the beneficiary.
4. Protection of Blood Relatives: TT can also be used to preserve the assets of the estate for adult children. If there is a concern that a surviving spouse may remarry and cause the estate to be diverted to new family members, TT could be used to protect adult children.
Example: Brian has three adult children from a previous marriage and his current wife, Joan, also has three adult children from a previous marriage.
• TT: Brian wants to provide for his wife in the event of his passing however wants to ensure the assets of his estate are preserved for his children. Brian establishes TT so that the income of his estate is distributed to his wife for her use during her lifetime. The assets of the estate are preserved and distributed to his children once his wife passes away.
Taxation Benefits
5. Income Splitting: TT gives your trustee/trustees much greater flexibility in managing your assets and in particular, allows them to take advantage of tax splitting so that income earned on trust assets can be distributed in a way that takes advantage of each beneficiary’s marginal tax rate.
Example: Brian passes away leaving an investment portfolio worth $1 million. The investment portfolio has annual income of $60,000. Brian is survived by his wife, Joan who has a salary of $120,000 per annum, and their three children, Ian (19 years), Mary (14 years) and Robyn (12 years).
• No TT: Brian leaves his entire estate to his wife Joan. The annual income from the investment portfolio raises Joan’s annual income with her salary to $180,000. This causes Joan’s income tax liability to increase from $29,467 to $51,667 which means the income tax on the investment portfolio income of $60,000 is approximately $22,200.
• TT: Brian establishes TT under his will which Joan, Ian, Mary, and Robyn are beneficiaries and Joan is the trustee. Joan distributes the investment portfolio income equally between Ian, Mary, and Robyn ($20,000 each). The combined income tax assessment on the distributions to the children are approximately $1,026 ($342 each).
By establishing TT, Brian’s estate has a tax saving of approximately $21,174 per year.
Note figures are estimates only based on current tax rates and brackets.
6. Tax Treatment for Minors: In a simple will where estate assets are left to minor beneficiaries until they reach a certain age, income earned on those assets is taxed as follows:
• First $416 – tax free.
• $416-$1,307 – taxed at 66%.
• Over $1,307 – taxed at 45%.
Where there is TT, all beneficiaries benefit from the income tax free threshold and income over this threshold is subject to normal adult rates.
Example: Brian and Joan pass away leaving an investment portfolio worth $1 million to their three children, Ian (19 years), Mary (14 years) and Robyn (12 years). Joan’s brother Peter is the executor/trustee.
• No TT: Ian, Mary, and Robyn each receive one third of the estate each (Peter holds Mary and Robyn’s interest in trust).
• Each one third of the estate generates approximately $20,000 annual income for each child.
• Ian has a part time job and makes $20,000 for the year. With the income from the estate assets his total taxable income is $40,000 and Ian pays approximately $4,142 in income tax.
• As minors Mary and Robyn are taxed at the higher rate and the $20,000 income from their share of the estate attracts approximately $9,000 each ($18,000 on $40,000 income).
• TT: Brian and Joan establish TT under which Ian, Mary, and Robyn are beneficiaries.
• Peter distributes the total income from the estate equally between the children.
• Ian still pays approximately $4,142 in income tax with his part-time job, while the income distributed to Mary and Robyn only attracts $342 for each child ($684).
By establishing TT, Brian’s estate has a tax saving of approximately $17,316 per year. Note figures are estimates only based on current tax rates and brackets.
7. Pensions: if a beneficiary is eligible for a pension, TT can be used so the assets are not counted towards any means tested pension rules even though they will be entitled to distributions from TT.
Example: Brian wants to make allowance for his brother Peter in his will by gifting him $500,000 of his investment portfolio.
• No TT: The investment portfolio passes to Peter on Brian’s death and these assets are counted in relation to means testing pension rules.
• TT: Brian establishes TT in relation to the investment portfolio and Peter is a beneficiary. Income can be distributed to Peter as a beneficiary however the investment portfolio does not come into consideration when Peter is means tested for the pension.
Potential Trustees
8. Anyone over 18 can be a trustee and although the trustees are usually the executors of your will, this does not have to be the case. A will can establish multiple TTs with a different trustee or multiple trustees appointed under each TT.
9. In appointing a trustee, consideration needs to be given to the intended purpose of TT and any risks being mitigated. For example:
• where a beneficiary is high risk because of their profession, it may be appropriate for them to be trustee of TT.
• where there is risk of family law proceedings or a beneficiary has special needs or cannot be trusted to manage their affairs, they should be joint trustees with another person or not trustees at all.
Important Considerations
10. Are the assets of your estate, including life insurance and superannuation, significant?
11. Will your estate generate significant annual income justifying the taxation benefits of TT?
12. Do your circumstances and the circumstances of your beneficiaries warrant extra protection measures?
