Have your parents got Wills in place and, if so, do they have discretionary trusts that transfer funds rather than gift you assets and money directly? What about your own personal estate planning goals? Have you considered a Testamentary Trust for yourself?
Most people are aware that trusts provide better asset protection than owning assets in your own name (e.g. in case you’re sued for negligence as a professional or you have personal director’s liabilities). But not as many people are aware of the entirely legitimate tax advantages in having a Testamentary Trust.
Before we get into the specifics of how this works, let’s get back to basics.
What is a Testamentary Trust?
A Testamentary Trust is a powerful estate planning tool that is set up by your Will and only comes into existence after your death. Under a Testamentary Trust structure, assets held by you at the time of your death do not pass directly into the hands of your family members or beneficiaries, but instead pass to one or more ‘discretionary trusts’ controlled by the people you name in your Will (known as the Trustees). The Trustee and beneficiary can be the same person(s) providing complete flexibility while managing the underlying assets.
There are two main advantages of Testamentary Trusts compared to leaving assets directly to your children or other chosen beneficiaries. These are asset protection and tax benefits.
What are the asset protection advantages of Testamentary Trusts?
Your chosen beneficiaries can be provided with the option to not receive their inheritance directly into their own names. This means that assets passing to and continuing to be held in a Testamentary Trust are protected from any existing or future creditors because the assets won’t form part of the personal assets of the beneficiaries.
For example, Jack and Ann have a daughter, Kate, who is married to Nick and they have two children. Kate and Nick have their own hairdressing business, owning two salons. Jack died leaving all his assets to Ann. Ann has now died. Ann’s Will provided for her assets to pass to a Testamentary Trust for Kate.
If Kate and Nick’s business fails and they are declared bankrupt, their personal assets (for example their home) will be available to pay their creditors. Creditors cannot claim the assets held in the Testamentary Trust.
By establishing a Testamentary Trust in her Will, Ann has ensured that her daughter’s family will still benefit even if Kate encounters financial difficulties.
How does a Testamentary Trust protect assets after divorce?
Parents are very often concerned that their children’s inheritance will not be available to be divided if a family law issue arises in the future.
The assets held in a Testamentary Trust may be protected from transfer to a son-in-law or daughter-in-law if the child’s relationship breaks down. The assets are ring-fenced in the Testamentary Trust and can therefore be clearly identified and separated from the other family assets.
However, assets held in that trust may still be taken into account by the Family Court for the purposes of a property settlement. There are various considerations regarding this issue, which can be built into the establishment of Testamentary Trusts and your wider estate plan.
Can Testamentary Trusts work if the beneficiaries are vulnerable or need protection from themselves?
Testamentary trusts are flexible structures that can be tailored to meet the individual needs of the family. If the family includes beneficiaries who require protection from themselves, or are vulnerable to outside influences, Testamentary Trusts can protect the assets as well as provide a structure to support beneficiaries in making financial decisions.
Example 1: Young Children
Kate and Nick have two children: Amy, aged 8 and Tom, aged 12. Kate and Nick have established two Testamentary Trusts in their Wills; one each for Amy and Tom. Kate and Nick have nominated their close friend, Edward to act as trustee of the Testamentary Trusts. Edward will act if both Kate and Nick die before the children are old enough to act as trustees of their Testamentary Trusts and manage their inheritance.
Once the children reach the age chosen by Kate and Nick (they have selected 28 years), Edward can retire from the role, leaving the children in control of their inheritance. Kate and Nick have left it to Edward to decide if the children are ready to take on this role when they reach 28. If they’re not ready, or are facing financial or family law issues in their own lives, Edward can stay in control.
Kate and Nick have also included a request that Edward appoint the children to act as joint trustees if they have reached the age of 18 at the time when Kate and Nick have both died. This would mean that the children would obtain experience in making decisions in relation to their inheritance, but in a protected environment having to act jointly with Edward. Edward retains the discretion to retire, leaving the children in sole control once they reach the specified age.
Example 2: Vulnerable Adult Children
Peter and Susan have two sons: Sam and James, and a daughter, Lucy. Sam is 32 and has a history of gambling problems. Sam accepts he has a problem and has recently obtained counselling. He is in full-time work and has got his life back on track. Sam is aware that his problems have the potential to re-surface. James is 28 and is intellectually disabled. He has a part-time job and lives in a group home.
Lucy is the eldest at 35 and is an accountant. Peter and Susan’s Wills establish 3 Testamentary Trusts one for each of the children.
Lucy will act as joint trustee with Sam for Sam’s trust. This means that Sam and Lucy make decisions together regarding Sam’s share. If Sam’s gambling problems re-surface, he will not be able to withdraw funds from his trust to gamble without the agreement of his sister.
James’ intellectual disability means that, while he is able to live independently, he needs support in making financial decisions. Lucy and Sam will act as trustees of his fund to manage his inheritance.
There are very important considerations that need to be worked through with your financial advisor regarding the above example.
How does a Testamentary Trust contribute to tax advantages?
As well as asset protection, there are significant tax benefits that can be realised in a well-planned Testamentary Trust structure. Testamentary trusts are ‘discretionary’, which means that the trustee decides how the trust assets are invested and distributed.
The trustee can decide which of the beneficiaries receives the income from the trust. This means that the trustee can make distributions from the trust in a tax effective manner, for example by distributing income to beneficiaries having the most attractive marginal tax rates.
Tax advantages for beneficiaries under the age of 18?
Beneficiaries under the age of 18 (e.g. children and grandchildren) receiving distributions from a Testamentary Trust are not subject to the usual penalty tax rates applicable to minors and instead have an adult’s tax rate.
A flat rate tax equal to the highest individual tax rate of 45% is applied to all investment income of children under 18 years for assets held personally. These penalty tax rates do not apply to income which comes from Testamentary Trusts.
When children receive income from Testamentary Trusts, they are taxed at ordinary marginal rates. This means that children can take advantage of the low income tax offset and more generous tax rate thresholds, which can significantly improve the net worth provided by your estate.
For example, Sarah dies leaving David a widower with three young children all in private schools. Sarah’s estate included a life insurance policy of $1,500,000 which is now invested to generate $60,000 per annum (4%return). If the life insurance policy passed to David all the income would be included in his tax return and he would pay tax on it at his marginal rate. If David was on the top marginal rate of 45%, he would pay tax of $27,000.
If the insurance policy passes to a Testamentary Trust established by Sarah’s Will, David can decide to distribute the $60,000 Testamentary Trust income equally between the three children taking advantage of their lower marginal rates. If each child received $20,000 per annum, the tax payable is $0 as they are within the tax free threshold.
In this example the Testamentary Trust provides a tax saving of $27,900 per annum.
When does a Testamentary Trust come into existence?
Testamentary trusts are established only after the death of the person making the Will (“Will maker”). Testamentary trusts can operate for a period of up to 80 years from the date of death of the Will maker.
Who makes the decisions around a Testamentary Trust?
The trustee is given powers by the terms of the Testamentary Trusts to invest and distribute assets and income to persons who are beneficiaries, so has control of investment and distribution decisions relating to the Testamentary Trusts.
Once the Testamentary Trusts are established the person nominated as the Appointor has ultimate control over the Testamentary Trusts as they have power to remove and replace the trustee(s) and appoint additional trustees.
Who can receive benefits from a Testamentary Trust?
The children or the person who is to be the main beneficiary of the Testamentary Trust is usually nominated as the “Primary Beneficiary”. The spouse and relatives of the “Primary Beneficiary” can receive benefit, but only if the trustee decides that they are to receive a benefit. Just because they are members of the class of beneficiaries does not mean they have any rights over the assets held in the Testamentary Trust.
What are the costs involved in managing a Testamentary Trust?
When the Testamentary Trusts come into existence, there will be costs to maintain the structure, including the cost of preparing and filing a tax return for the trust. Again, these costs will vary depending on the type of assets and investment activities carried out by the Testamentary Trusts.
Do you need help setting up a Testamentary Trust?
BlueRock’s Law and Private Wealth teams have extensive experience setting up Testamentary Trusts as part of the estate planning process. We work together to bring you a well-considered and robust plan that will set you and your family up for long-term profitability and security.
This article is intended as general information only and should not be considered as advice on any matter and should not be relied upon as such. The information in this article has been prepared without taking into account any individual objectives, financial situation or needs. You should therefore consider the appropriateness of the information in regards to these factors before acting, or seek advice before making any financial decisions.