Managing Testamentary Trusts – Tax Implications and Challenges (Part 2)

Introduction

Imagine a Trust so powerful that it could not only protect your family’s wealth but also offer significant tax advantages long after you’re gone. Welcome to the part 2 of Testamentary Trusts, a cornerstone in sophisticated estate planning. In Part 1 of this series, we explored the basics of Testamentary Trusts and their role in asset protection. To recap a Testamentary Trust is a discretionary trust set up through a will, coming into effect upon the will-maker’s death to manage and distribute their assets, including property.

It’s a strategic tool for asset protection, ensuring that a deceased person’s estate is reserved for chosen beneficiaries—typically children or immediate family—and shielded from claims by new spouses, their children, or creditors. This legal mechanism is demonstrated by the case of Bernard & Bernard [2019], which showcased its effectiveness in excluding trust assets from matrimonial disputes in Australia. 

As we delve further in Part 2, we aim to dissect the financial nuances, from tax benefits to potential drawbacks, and share management strategies that could maximize your trust’s effectiveness. The most prominent tax advantages include:

Tax Benefit: Tax Treatment of Income Distributed to Minors

When considering the creation of a Testamentary Trust within the framework of Division 6AA of the ITAA 1936, there are notable tax advantages to be aware of.

• Division 6AA of the ITAA 1936 typically imposes higher tax rates on distributions made to minors (individuals under 18 years of age). However, when such distributions are made from a testamentary trust, they are considered ‘excepted trust income’.
• Unlike ordinary trusts, where income distributed to minors is taxed at penalty rates, income from a testamentary trust is taxed at standard adult marginal tax rates. This can result in significant tax savings, especially where the income would otherwise be taxed at the highest marginal tax rate.

Tax Benefit: Income Splitting

• A Testamentary Trust allows for income splitting among family members. Beneficiaries of the trust may include children and grandchildren who are taxed at adult marginal rates on the income received from the trust.

• By distributing income among several beneficiaries who may have lower income, or no other income, the overall tax burden on the income generated by the trust’s assets can be reduced.

Tax Benefit: Capital Gains Tax (CGT)

• Capital gains can be distributed to various family members in accordance with the trust deed and at the trustee’s discretion. Depending on the beneficiary of the trust, a 50% discount on capital gains may be available for the sale of assets.
• Testamentary trusts may also provide benefits regarding capital gains. Beneficiaries receiving capital gains through a testamentary trust may be able to access the 50% CGT discount, even if the assets were held by the trust for less than 12 months, provided the original owner held them for at least 12 months.

Example: Tax Benefit in Action

Scenario: Let’s consider the case of Richard, whose father left him an investment property and shares through a Testamentary Trust. Richard’s two children, Ron and Tracey, are also beneficiaries of this trust. Both Ron and Tracey attend private school and have no income of their own, making them ‘excepted persons’ under Division 6AA of the ITAA 1936.

During the financial year, the Trust generates a profit of $40,000 from the investment property. As the trustee, Richard has the discretion to distribute this income.

Richard decides to distribute the $40,000 profit equally between Ron and Tracey. Since they are minors with no other income, this distribution falls under the special tax provisions of a Testamentary Trust.

Tax Implications: Normally, income distributed to minors from a standard trust is taxed at a high penalty rate. However, in the case of a Testamentary Trust like Richard’s, Ron and Tracey’s income is taxed at standard adult marginal tax rates. This can result in substantial tax savings. For instance, if each child receives $20,000, they would be taxed far less (up to NIL) than if the income were distributed to Richard, who might be in a higher tax bracket.

Disadvantages

Higher Establishment Costs – The initial fee to set up a Testamentary Trust is typically higher than that of a simple will. While a simple will may cost less than a thousand dollar, a will that includes a Testamentary Trust could range from $2,500 to $5,000.

Ongoing Costs – There are no ongoing costs associated with a Testamentary Trust until it is activated upon the Testator’s death. Once activated, the Trust must obtain a TFN and lodge annual tax returns. The cost of preparing the annual return typically exceeds a thousand dollars and can amount to several thousand, depending on the number of properties and assets held in the Trust.

Centrelink Benefit – If your spouse is a beneficiary and has control over the trust, Centrelink will consider both the trust’s assets and income as belonging to your spouse, which could affect their eligibility for Centrelink benefits. Control can mean directly managing the trust or merely having the potential to benefit from it.

For other beneficiaries who might not have control, Centrelink applies a ‘control test’ to determine how much of the trust’s income and assets should be attributed to them for means-testing purposes. If a beneficiary has a significant controlling role, such as being a trustee or appointor, they may be considered the ‘controller’. Consequently, a portion or the entirety of the trust’s assets and income could be counted in their means test. This attribution could also extend to situations where an associate of the beneficiary is the trustee. In such cases, any distributions to non-controlling beneficiaries could potentially be seen as gifts.

Beneficiaries without control over the trust will have any income distributions assessed under Centrelink’s standard income tests. It’s important for beneficiaries currently receiving Centrelink benefits to get professional advice to understand the impact that an inheritance through a testamentary trust might have on their Centrelink assessments.

Pro Tips for Maximising Testamentary Trusts Benefits:

1. Plan for Tax Implications:
   • Structure it in a way that helps to legally reduce your family’s taxes.
   • Structure the beneficiaries in a way that they can leverage the Testamentary Trust’s potential to distribute capital gains tax in an efficient manner.
   • Work with an accountant who understands the tax outcomes, especially considering the distribution of income.
2. Consult a Professional:
   • Seek legal advice to navigate the complexities of setting up a Testamentary Trust tailored to your specific circumstances.
   • Consult with accountants when the testator passes away to activate the Tax File Number (TFN) and the Testamentary Trust.
3. Review Centrelink Impact:
   • Investigate how the trust may affect beneficiaries’ Centrelink benefits, especially if they have control over the trust.
   • Consult with your legal team regarding this so the beneficiaries do not suffer an adverse effect on their Centrelink benefits.
4. Educate:
   • Educate the Testamentary trustees and beneficiaries about their roles and the trust’s workings to avoid misunderstandings and mismanagement.
   • Educate them about the tax implications, asset protection, and tax strategies behind the Testamentary Trust.
5. Understand Costs:
   • Prepare for the initial establishment costs and
   • Ongoing management expenses of the trust.

Reference and Glossary Items

Reference

1. Bernard & Bernard – https://www.familylawresources.com.au/bernard-2019-famca-421-5-july-2019-henderson-j/ 
2. DIV6AA of the ITAA 1936 – https://www.ato.gov.au/law/view/view.htm?docid=EV/1051924150871&PiT=99991231235958#:~:text=Subsection%20102AG(1)%20of%20the%20ITAA%201936%20provides%20that%20where,in%20the%20opinion%20of%20the
3. Marginal Tax Rate – https://www.ato.gov.au/Rates/Tax-rates—Australian-residents/ 
4. Penalty Tax Rate – https://www.ato.gov.au/rates/Tax-rates-if-you-re-under-18-years-old/ 
5. Centrelink Income Test – https://www.servicesaustralia.gov.au/income-test-for-age-pension?context=22526 
6. Centrelink Control Test – https://www.servicesaustralia.gov.au/private-trusts-and-companies?context=22526 

Glossary

1. Testamentary Trust: A type of trust created as per the instructions in a person’s will, which comes into effect upon their death.
2. Beneficiary: An individual or entity who is designated to receive benefits or assets from a trust or estate.
3. Trustee: A person or organization appointed to manage and administer a trust’s assets on behalf of its beneficiaries.
4. ITAA 1936: Income Tax Assessment Act 1936, a key piece of legislation governing income tax in Australia.
5. Division 6AA: A specific provision within the ITAA 1936, which deals with the taxation of minors’ income.
6. Marginal Tax Rate: The rate at which the last dollar of a taxpayer’s income is taxed, which increases as income rises.
7. Capital Gains Tax (CGT): A tax on the profit realized from the sale of a non-inventory asset that was greater than the amount realized on the sale.
8. CGT Discount: A reduction in the taxable gains on an asset, typically 50% for assets held for more than 12 months.
9. Testator: The person who has made a will or given a legacy.
10. Income Splitting: The practice of dividing family income so as to fall into lower tax brackets, thereby reducing the overall tax burden.
11. Centrelink: A program by the Australian Government that delivers social security payments and services to Australians.
12. Means Test: An assessment of an individual’s financial resources to determine eligibility for certain benefits or services.
13. Appointor: In the context of a trust, this is the person who holds the power to appoint or remove trustees.
14. Estate: The total property, assets, and liabilities left by an individual at death.
15. Asset Protection: Strategies implemented to protect assets from creditors or lawsuits.
16. Matrimonial Disputes: Legal disputes arising between married or de facto couples, often related to the division of property and assets.
17. Generational Wealth Preservation: Strategies and planning undertaken to ensure wealth is passed down and preserved through multiple generations.

We offer a 15-minute free consultation to discuss your tax, property investment and business needs. Book your complimentary consultation now.

Book Now