Undistributed net income of a Trust will be taxed at the highest marginal tax rate (currently 45%), but it is the way in which the income is taxed in the hands of the Beneficiary that demonstrates the tax effectiveness of the Trust structure.
Through the Trust structure, the Trustee is able to distribute net income of the Trust to minor Beneficiaries and Beneficiaries who have lower taxable incomes.
For a distribution to a minor Beneficiary from a Testamentary Trust, the first $18,200 will be tax-free (2015/2016 tax-free threshold). If the low income tax offset applies, this tax-free amount increases to $20,452.
Claudette leaves her estate worth approximately $1,200,000 to her two sons Paul and Phillip. Paul receives his share of the estate outright, whereas Phillip’s share is placed into a Trust of which he is the Primary Beneficiary.
In the first year, each 50% share of the estate generates $40,000 income.
- Paul’s income is $145,000 per year. The added income puts him at the highest marginal tax rate and he will pay tax of about $18,800.
- Phillip decides to distribute the Trust income of $40,000 equally between his two children. The low income tax offset in available which results in no tax being payable.
A Testamentary Trust can also offer tax effectiveness in relation to capital gains tax, including the flexibility to determine who real estate is transferred to and receives the CGT rollover, and distributing the assessable gain between Beneficiaries following the sale of property.
Testamentary Trusts can prevent loss of estate assets due to:
- Mismanagement by the Beneficiary, possibly owing to youth, immaturity, disability, or addiction; or
- Liability to third parties, such as bankruptcy claims or the claim of an ex-spouse in family law proceedings.
It achieves this by separating ownership of the Trust assets from the Beneficiary: the Beneficiary does not own the asset, the Trust does and it is managed by the Trustee.
One concern may be to protect the inheritance of minors. A Testator may choose the age that they believe a Beneficiary will be mature enough to manage their inheritance. This is referred to as the preservation age. Until the Beneficiary reaches the preservation age, the Trustee will maintain and preserve the inheritance.
This not only protects the inheritance from the Beneficiary’s own mismanagement, but also allows the Testator to determine what happens with the inheritance in the event that the Beneficiary dies.
A Testator may also want to prevent a Beneficiary from losing their inheritance through bankruptcy or divorce.
In relation to bankruptcy, any inheritance a Beneficiary receives outright is available to pay their debts and, if the Beneficiary is bankrupt at the time the estate is administered, must be paid to the Trustee in bankruptcy. However, if the inheritance is held by a Trust of which the debtor or bankrupt person is a Beneficiary, it will normally be protected from creditors. There may be some risk if the bankrupt Beneficiary is also the Trustee or otherwise has control of the Trust. The Testamentary Trust must be carefully drafted to address this risk.
In relation to divorce, the protection offered by a Testamentary Trust is not bullet-proof. The starting point is the argument that the assets do not belong to the spouse, they belong to the Trust, and are therefore not matrimonial property available for distribution between the spouses.
However, the Family Court has strong powers to penetrate the Trust structure, especially if it can be shown that the Beneficiary is also in control of the Trust. This results in a balancing act for the Testator: on one hand is the desire to ensure that the inheritance in available for the benefit of the Primary Beneficiary and usually the offspring of the Primary Beneficiary, and on the other hand, the less control that the Primary Beneficiary has over the assets of the Trust, the more it is protected from family law proceedings.
The degree of control or influence that a spouse has in relation to the Trust will determine whether the assets in the Trust are part of the matrimonial property pool. Other considerations will be the terms of the Trust, the history of Trust distributions, and the creation of the Trust itself.
Optional vs. Mandatory
If tax effectiveness is the primary purpose for setting up a Testamentary Trust, the Will should include a clause that the Trust is optional, giving the Executor the discretion to decide whether the Primary Beneficiary will receive their share of the estate outright or whether a Trust will be established for their benefit. This allows for there to be consideration of the Primary Beneficiary’s financial status at the time of receiving their inheritance.
If the primary reason for establishing a Testamentary Trust is asset protection, it is recommended that the Trust be mandatory, and the Executor will be given no option to distribute the estate to the Primary Beneficiaries directly.
How we can help
We work with clients to determine whether a Testamentary Trust will be suitable for them. We consider the wishes of the clients, their priorities and values, and the circumstances of the Beneficiaries to draft a customised Testamentary Trust Will that offers the client tax effectiveness and asset protection.