Chapter 03 – Testamentary trust

A testamentary trust is simply a trust created on the death of a person.  Strictly interpreted, all wills create testamentary trusts. However, some wills go into more detail than others and deliberately set out to create a particular type of trust with a significant life of its own after the death of the testator.

There are numerous types of testamentary trusts. And each type contains many individual variables such as term, permitted investments, decision making processes and so on. A good resource has been created by Comasters Law Firm and this can be accessed here: Comasters explanation of testamentary trusts.

Why use a testamentary trust?

Testamentary trusts are powerful tax planning and asset protection tools for the beneficiaries under the will. For example, children under the age of eighteen are not taxed at penalty rates on income derived through a testamentary trust (as is usually the case with other types of unearned income). Further, assets held in a testamentary trust are generally not taken into account in determining old age pension entitlements. 

Testamentary trusts can be used to protect valuable family assets from the risk of a spendthrift family member or a family member who is not a good business person or investor and who stands a good chance of getting themselves in financial trouble.

For example, a particularly worrying son may be given the benefit of certain assets (for example, a family home) but be unable to sell that asset. The family home may then go to the grandchildren in equal shares on the death of the son. This may sound like an extreme option, but at least the son gets a roof over his head during his life which he can’t lose, no matter what else he may do.

By way of further example, a daughter may divorce her husband, say, three years after a client’s death. If the client leaves her share of the estate to her directly then it will be up for grabs in the Family Court.  However, if her intended share of the estate was instead left to a family trust that she and her siblings controlled then she would not legally own that share of the estate. Therefore, her ex-husband should not be able to seek a share of the trust assets.

Testamentary trusts are critically important if a parent believes that a child may be in financial difficulties, whether because of spendthrift ways, poor business acumen, poor choice of a marriage partner or just plain bad luck. Parents will most likely want their assets to benefit later generations generally and not a child’s creditors generally. Testamentary trusts allow parents to ensure that this is what happens.

Testamentary trusts are generally bankruptcy proof. However, recent amendments to the Bankruptcy Act (inspired by some well documented and public bankruptcies) have made this a more complex area and specific legal advice should be sought if you believe that this could be relevant to a particular client’s circumstances.

Advantages of (discretionary) testamentary trusts?

The advantages of testamentary trusts include:

  1. Maximising the prospects of an old age pension for a spouse and, ultimately, children. For example, John and Betty are married old age pensioners. They have investment assets worth $240,000 and they own their home. Betty dies. Her will leaves her share of the investment assets to John. Consider:
    1. what happens to John’s pension after Betty dies? Well, since he now owns $240,000 of investment assets he no longer gets the full old age home owner pension. $240,000 is below the assets test limit for married old age home owner pensioners but is above the assets test limit for a single old age home owner pensioner.
    2. if Betty’s will had left her share of the investment assets ($120,000) to a trust for the benefit of John and her children then John would have continued to get the old age pension. Because John does not own the assets in the trust they don’t count for the assets test.
    3. as a caution, in some cases Centrelink can ignore the trust and include its assets in old age pension assets test calculations. The terms of the testamentary trust will be critical to ensuring that this does not happen;
  2. Income tax advantages. All of the tax advantages of discretionary trusts become available plus income distributed to John and Betty’s under age 18 children and grandchildren will not be subject to the penalty tax normally levied on unearned income derived by children under the age of eighteen years and instead will be taxed as if it was income derived by an adult. This can save tens of thousands of dollars of tax a year;
  3. Asset protection. For example, in the case explained at item 1 above, it could turn out that John had guaranteed a business debt of his son some time earlier. His son goes broke and the creditor invokes the guarantee given by John. The assets in the testamentary trust cannot be touched by the creditor. This protection endures as long as the trust endures and cannot be broken down unless the trustee gives some sort of charge over the assets of the trust (and MLA Lawyers’s standard document does not allow the trustee to do this.) So the testamentary trust protects the children as well as the widow or widower.

This asset protection is important and includes protection against divorce. Nearly one half of Australian marriages end in divorce. The proportion is higher for younger people. This means that if clients have 3 kids, one of them will probably be divorced. Few people wish to benefit their ex-sons-in-law or ex-daughters-in-laws. Testamentary trusts protect assets against divorce as well as bankruptcy. We will go through some examples to demonstrate the usefulness of a testamentary trust.

Scenario 1: John and Betty and their three infant children

In this example John and Betty are married with three children aged under 12 years and they put in place wills which provide for all of their estate to pass to a discretionary testamentary trust for the benefit of the surviving spouse and children. Five years down the track John dies suddenly of a heart attack, leaving Betty to cope with the mortgage and three kids at private school. The setup of the discretionary testamentary trust upon John’s death is depicted in the diagram Scenario 1. Betty is joined as executor and trustee of the estate and as trustee of the testamentary trust by Bill who is an old trusted family friend.

Bill and Betty are able to delegate the day to day operation of the trust to Betty so that she can continue to access funds as required. Having Bill as an additional trustee helps Betty feel better protected if and when she enters into another relationship, as she will not be in sole control of the trust. Betty receives significant life insurance proceeds and super benefits upon John’s death and, on advice, pays all these funds into the testamentary trust. The funds are used to invest in property and listed shares.

The income from these investments for the years following is significant and is able to be distributed to each of her three children to cover their private school fees. Because this income is derived in a trust established on John’s death, income can be distributed to beneficiaries under 18 at usual adult marginal rates. This means there are now four taxpayers instead of just one to share the distributions, resulting in a significant tax saving each year until the children reach 18.

John-Betty-their-three-infant-children

Scenario 2: John and Betty and their three adult children

In this example John does not die from his heart attack but survives and ten years down the track all the kids are grown up and are at university studying to be doctors with no thoughts as to getting married or having children. John and Betty decide to simplify their wills so that each of them can inherit each other’s estate without the need for a testamentary trust but still allow for a testamentary trust to be established upon the death of both of them. Five further years on and John and Betty are killed in a car accident leaving the three children to manage their affairs and to cope with their own new families (all three got married and had 2 kids each in the last few years). All their parents insurance and super is paid into their estates and into the testamentary trust and invested in property and shares.

This time the income can be split 12 ways (the three children, their spouses and their children) so the potential tax savings are significant. Also, because all three children are involved in the control and benefit from the trust, the trust assets are well protected if one of the children’s marriages were to break down (as the statistics suggest one of them will).

John-Betty-their-three-adult-children

Complex wills with special provisions (e.g. blended families or beneficiaries with disabilities)

The last two sections dealing with “standard” type wills (whether or not they include discretionary testamentary trusts) will fit most clients, perhaps as much as 80% – 90% of cases.

The other 10% – 20% will require extra attention and more complex strategies as a result of specific circumstances such as:

  • the desire to prevent a particular person, for example an ex-spouse, from being able to receive capital or income from a trust;
  • the desire to make sure a particular person, such as a disabled child, is adequately provided for; or
  • the need to minimise the effect of likely challenges to a will.

We stress that complications should always be considered by a recognised expert and a financial planner should not go it alone in his or her advice.

The skill for you to learn in this area is not how to solve these more complex issues or to come up with strategies to address them (as tempting as that may sometimes be) but rather to recognize when a particular client or matter falls within that 10% – 20%, so that you can obtain specialist advice.

There is a series of questions at the end of Dover’s fact finder (part of the Financial Services Guide for all of our advisers). These are designed to elicit information, which will help identify any specific or more complex issues.

The Dover Group