Use of Testamentary Trusts in Wills
Testamentary trusts created under a will provide the testator, in making her or his Will, with a significant degree of control over distribution of assets – including income – to be bequeathed to beneficiaries. It also offers tax effective estate planning.
The trust takes effect only upon completion of the administration of an estate, after specifically identified bequests have been made to particular beneficiaries. Whereas the estate administration should be completed and assets bequeathed under the will distributed without undue delay following the grant of probate, the trust can validly operate for up to 80 years. The trust can be brought to an end and the assets appointed to the beneficiaries by their resolution at any time.
As such these trusts provide a very useful means of estate planning. Some view them, however, as the testator exercising control from the grave.
The most common vehicle relied upon is the discretionary testamentary trust under which the beneficiary may either take all or part of the inheritance, depending upon the discretionary decision of the trustees. If a “primary beneficiary”, he or she may remove and appoint the trustee or even appoint themselves to manage the inheritance.
Operation of the will – triggering the testamentary trust
The trust terms can form part of the testator’s will with, divided into two discreet parts – for example, “Part A” setting out the general testamentary provisions providing for appointment of executors and trustees, granting bequests of specific assets to particular beneficiaries, either as those assets existed at the time of death or upon their conversion to cash.
A separate and distinct part of the will – say, “Part B”- can provide for the formation and administration of the testamentary trust itself - for example, requiring the executors as trustees of the testamentary trust to “hold the balance” of the estate -
“…for the benefit of those beneficiaries nominated, and in accordance with the provisions set out, in Part B…”
Following distribution of specific bequests under the first part of the will the administration of the estate is completed. Thereafter, the “balance” of the estate (which may well be substantial) is transferred to the trust to be administered by the nominated trustees (usually the executors of the estate under the will) in accordance with its terms.
Some advantages of testamentary trusts
1. Protective features
(a) Where a beneficiary may not be of the age of legal responsibility or have some other legal impediment (such as due to disability), or simply where, in the view of the testator, she or he is at risk of frittering away the inheritance, this form of trust will preserve that interest until a particular date – such as upon reaching the age majority – at which time the beneficiary must take the inheritance through the trust and without any opportunity to appoint or remove trustees. Alternatively, payments of interest or parts of the capital of the trust can be made from time to time at the discretion and under the control of the trustee.
(b) An ordinary gift under a will can be appropriated by the recipient’s creditors or trustee-in-bankruptcy. Likewise, the current or former spouse of a beneficiary may claim assets bequeathed to the beneficiary under a Will. Given that the beneficiary has no entitlement to assets or income of the testamentary trust unless and until the trustee exercises its discretion to distribute at all, these are protected from creditors and, to a large extent, from claims by the former spouse. The effectiveness of the protection will however depend on how the trust terms are drafted, as well how it is treated under Family law.
The beneficiary’s contingent entitlement under the trust can considered a ‘resource’ available to the marriage while it lasts. Where the trust is a discretionary one, can been proven to be conducted in a truly “discretionary” manner and be independent of a spouse’s effective control, the approach of the Family Court has been not to treat assets of the trust part of the matrimonial pool. However, where on the evidence a party has legal or de facto control of a trust (for example, as trustee or having the ability to appoint or remove trustees, or as a person influencing the trustee’s decisions) then his or her interest forms part of the matrimonial pool of property available to be divided between the parties by the Court.
2. Tax treatment
Concessional tax treatment – in particular for beneficiaries who are minors or are otherwise under “legal disability” (for example, bankrupts, mentally incapacitated persons and persons under 18 years of age) provides a significant advantage.
Income tax
Trust income is taxed primarily in the hands of the beneficiary receiving or being “presently entitled to” income from the trust. On the other hand, the trustee is assessed as trustee in respect of income of a person under legal disability.
The Commissioner of Taxation treats a declaration, resolution or other act of the trustee “in effective exercise of his discretion” and made within 2 months of the end of a financial year and resulting in “a specific ascertainable portion” of trust’s annual income immediately and absolutely vesting in the beneficiary as creating a present entitlement: Taxation Ruling IT 329, paras 9 & 11.
Where a beneficiary who is under a legal disability is presently entitled to a share of the trust income, the trustee is assessed and liable to pay tax in respect of so much of that share of the net income of the trust as is attributable to a period when the beneficiary was resident or, in respect of any period when the beneficiary was not resident, the share of net income of the trust attributable to sources in Australia “as if it were income of an individual and not subject to any deduction”: section 98(1) Income Tax Assessment Act 1997 (‘ITAA’)
Moreover, distributions to children under 18 years of age are subject to a substantial tax-free threshold.
Undistributed income of a trust is, in general, taxed under s Section 99A of the ITAA at the top marginal rate plus the Medicare levy. However, that does not apply where the trust estate arises under terms of a will.
The marginal rates applicable depend on whether the relevant trust estate is a deceased estate or a testamentary trust and whether the deceased person died less than 3 years before the end of the year of income. If the trust estate is a deceased estate and the deceased died more than 3 years before the end of the year of income, or if the trust estate is a testamentary trust, ordinary marginal tax rates apply, except that the tax-free threshold is not available.
When deciding whether to exercise the discretion to exempt a deceased estate or testamentary trust from the operation of section 99A, the Commissioner of Taxation must take into account a list of specified criteria intended to determine the extent to which the trust has been or could be used primarily as a vehicle for tax minimisation (see sub-sections 99A (3) and (3A)). The Commissioner would normally exercise the discretion to apply a lower marginal rate of tax under section 99 to a deceased estate provided no tax avoidance is involved and the administration of the estate is not unduly delayed.
In determining whether the top marginal rate applies under section 99A, a major consideration of the Commissioner may be whether the trustee has increased the assets of the trust by, for example, granting of special rights or privileges to the trust or by transferring property to it, or the making of loans to it. Given the terms of section 99A, a trustee would have a strong case to argue that the lower marginal tax rate should apply provided the assets of the testamentary trust have not been added to after death.
An estate can benefit from the main residence exemption. If a beneficiary, other than the deceased's spouse or the devisee of the dwelling, is likely to occupy the deceased's principal residence, the testator should consider giving that individual a right to occupy the dwelling under the will, or under the terms of any testamentary trust established under the will. If the beneficiary subsequently occupies the home, the existence of the right to occupy may allow the executor/trustee to satisfy one of the requirements for the main residence exemption under section 118-195(1) of the Income Tax Assessment Act 1997.
Capital gains tax
Assessable income for tax purposes includes net capital gain for an income year: (section 102-5(1) of the Income Tax Assessment Act 1997). Therefore gains made on realised assets of the trust may be significantly reduced where a nominated beneficiary has a low income during the year in which the distribution is made. If a trustee is taxable under section 99A on a capital gain the 50% CGT discount does not apply. But the CGT discount may apply if the trustee is taxed under section 99. Therefore, the question whether section 99 or section 99A applies to the trustee is especially significant if the trustee has undistributed income that includes a taxable capital gain.
3. Maintaining entitlement to statutory benefits
While having a contingent entitlement in the trust property, the beneficiary may nevertheless continue to qualify for age, disability or similar pensions and benefits for which they would be otherwise disqualified under a normal inheritance taken under ordinary provisions of a will.
4. Ongoing arrangements for surviving beneficiaries
Understandably a testator may wish to ensure that living and financial arrangements for the surviving spouse are assured following his or her death. As far as residential arrangements and living expenses are concerned, this can be achieved by providing for a life tenancy in the testator’s interest in the matrimonial property, or a life interest in the testator’s interest in income producing assets. This is often provided for under the will, being granted to a particular beneficiary (usually the surviving spouse).
If provided in the will the interest would then revert to the estate upon the death of the spouse (or other limitation provided in the will for the spouse’s occupation and use of that property). This will of course unacceptably delay finalisation of the administration of the estate, which must be promptly dealt with following the grant of probate. Moreover, there can be the taxation implications already raised above.
However, if the survivor’s rights to use and occupy premises are provided for under terms of the testamentary trust and set out in suitable terms, the surviving beneficiary’s occupation and use of that asset - for example, the matrimonial residence - can be simply allowed for, with the asset reverting to the trust.
For example, a trust for sale would allow for the occupancy or other use of that asset, or entitlement to income, by that beneficiary for the time being. Upon the surviving beneficiary’s death (or the occurring of any other event allowing for reversion of the asset to the trust) it would revert to the trust for sale and investment by the trustees of the net proceeds of that sale.
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With these factors in mind, contact us to arrange for a review of your will or trust and related deeds, and succession arrangements in general.