What is a Testamentary Trust?
We are often asked about testamentary trusts and their benefits. At a very broad level a testamentary trust is any trust contained in a Will. As almost any Will contains trusts, this is not terribly helpful.
More specifically, a testamentary trust has come to mean a trust arrangement within a person’s Will which allows a beneficiary to have the benefit of an asset given to them under a will without them legally owning it.
The terms of a testamentary trust can be drafted in many ways, but often a beneficiary will be given control of or rights in relation to an asset without actually being the legal owner.
In a ‘standard’ will, the willmaker gives assets to A (their executor) on trust for their beneficiary B. The intention is that, when the estate is finalised B will receive the asset itself or that the asset will be sold and B will receive the net proceeds.
This is different in a testamentary trust arrangement.
Here, the willmaker gives assets to C, who is the trustee of a designated trust within the will. C is often a potential beneficiary of the assets held on trust. C also usually holds the assets for a range of potential beneficiaries (including C). The range of beneficiaries is usually wide, but would usually include C, C’s spouse, C’s children, C’s siblings, C’s parents…the range can be extensive.
This is the most common form of testamentary trust referred to. Effectively it is a discretionary trust structure within a person’s will. Under the terms of the trust the trustee can distribute income, capital or a mixture of both to one, some or all of the range of possible beneficiaries set out in the terms of trust. None of the beneficiaries will have a right to receive anything at all; all they have is a right to be considered by the trustee.
Different lawyers tend to have varying philosophical views on how these documents should be drafted.
We lean towards giving each beneficiary the option of taking their gift under the will either directly (useful, for instance, if a beneficiary has a mortgage they wish to reduce immediately) or having it paid to a discretionary trust created under the will that the beneficiary controls. Alternatively, some can be paid to the beneficiary immediately and some to the discretionary trust. In many cases this flexibility is very useful.
What are the benefits of a testamentary trust?
The benefits available to a beneficiary from having a testamentary trust generally fall into one or both of the following categories:
- taxation advantages
- asset protection advantages.
1. Taxation Advantages
Taxation advantages from a testamentary trust generally relate to beneficiaries who are on a lower tax rates – usually children.
Consider the following example:
James dies leaving an estate valued at $1.8 million. He leaves his entire estate to his widow Tanya who already earns $110,000 per year. They have three children aged between three and 11.
Tanya then invests the $1.8 million and receives investment income of $90,000 from the estate investment portfolio. Tanya already has income of $110,000 per year. When the investment income is added to her regular income she will be taxed on a gross income of $200,000 annually.
If James had provided Tanya with the option of a testamentary trust, Tanya could have distributed the $90,000 investment income equally between the three children. In this case each child would have received income of $30,000 per year. Since each child would be taxed as an adult under the testamentary trust each child would have the benefit of the tax-free income threshold.
On current rates each child would be paying tax of approximately $2,400 from their $30,000 in taxable income. At current rates we estimate that the tax saving would be in the order of $30,000 over one financial year. The benefit arises because the children would be taxed at normal adult tax rates on the trust income distributed to them [refer to section 102 AG of the Income Tax Assessment Act (1936)].
A popular use of this strategy is for the payment of private school fees for children.
2. Asset Protection Advantages
Testamentary trusts can also provide advantages by way of asset protection. As the assets of a testamentary trust are not owned personally by the beneficiary (rather, by the trustee) creditors pursuing a person who is a beneficiary of such a trust will generally not meet with success in seeking to access the assets of the trust.
These vehicles can also be used in an attempt to protect assets from the spouse of a beneficiary in the event of divorce. Over a period of years the Family Court has demonstrated a robust attitude in relation to such trust structures. On some occasions it has found that, although the assets of a trust are not assets of the beneficiary as such, they can be considered as a financial resource available to the beneficiary for the purposes of a family law property settlement.
No One Knows the Future
One of the difficulties with preparing wills for clients is that it is very difficult to peer into the future. No one knows when the willmaker will pass away. No one knows what the circumstances of a will maker’s beneficiaries might be at that time.
If those beneficiaries are on a high income they may benefit from the income tax arrangements available from a testamentary trust. If the beneficiaries are in business and are “at risk”, the testamentary trust arrangements may assist in preventing an inheritance being passed directly to creditors.
And if the beneficiaries are undergoing a property settlement in the Family Court, a testamentary trust may also prove useful.