A Complete Testamentary Trust Guide: Tax, CGT & Asset Protection

In our two-part series last year, we explored testamentary trusts in great depth, including how they are created under a will and why they have become a central pillar of modern estate planning. This article works as a practical follow-on guide. Rather than repeating the full theory, we focus on the finer and often misunderstood operational rules that families, executors and trustees must know. The aim is simple: give you a concise but detailed explanation of the tax, distribution and administrative issues that affect how a testamentary trust actually operates day to day.

A well-designed testamentary trust can preserve family wealth for decades, but small administrative mistakes can also lead to unnecessary tax, disputes and compliance issues. This guide outlines the core rules you should be aware of before managing or advising on a testamentary trust in Australia.

What Is a Testamentary Trust?

A testamentary trust is a trust established under a person’s will, taking effect only after they pass away. It is separate from the deceased estate once administration has concluded. In some situations, the executor may begin dealing with assets in anticipation of the trust, but for tax purposes, the trust is generally treated as operating only once the estate is finalised.

These trusts remain popular because they allow for controlled, flexible distribution of family wealth, protect vulnerable beneficiaries, assist with income streaming for families, and offer significant tax advantages, especially where minor children are involved.

However, to operate a testamentary trust effectively, trustees must understand how various tax rules interact with the trust structure.

Capital Gains Tax: How The ATO Treats Testamentary Trust

Under the ATO’s administrative approach, the trustee of a testamentary trust is treated as if they were the legal personal representative of the deceased when applying capital gains tax rules. The effect of this is important: there is no capital gains tax event simply because assets move from a deceased estate to the testamentary trust, or from the trust to a beneficiary, provided there has not been an earlier disposal.

Family Trust Elections and Franking Credits

One of the most commonly misunderstood issues when operating a testamentary trust is whether the trustee needs to make a family trust election to pass on franking credits.

The short answer is yes. The trustee of a discretionary testamentary trust must make a family trust election if they want to stream franking credits to beneficiaries and satisfy the 45-day holding period rule. Without the election, franking credits may be denied, even if the testator intended beneficiaries to receive the full tax benefit.

This requirement often surprises executors and families who assume testamentary trusts automatically access franking credits. Failing to make an election can result in beneficiaries receiving fully franked dividends with no ability to use the credits.

A family trust election requires the trustee to nominate a test individual. This nomination defines the family group for tax purposes and determines which individuals and entities can receive distributions without triggering family trust distribution tax.

Two points often cause confusion:

• A deceased person cannot be named as the test individual [ATO ID 2014/3].
• The test individual has no rights or control under the trust deed.

If the most logical person has passed away by the time the trustee is ready to make the election, a living individual must be selected. This can unintentionally restrict distributions, especially where blended families or inter-generational trusts are involved.

Because families often misinterpret the role, advisers should communicate clearly that the test individual is only a tax reference point and nothing more.

Distributions Outside the Family Group and the Family Trust Distribution Tax Rules

Once an election is made, distributions to anyone outside the defined family group can attract family trust distribution tax at the rate of 47%. Trustees must carefully assess who falls within the group before distributing income or capital.

This rule can lead to conflict with the testator’s intentions. For example, a will may permit distributions to a wide list of relatives or family friends. But if those individuals fall outside the family group for tax purposes, distributions made to them will be taxed at 47%, even though the will allows them.

Trustees may need to weigh up whether the benefit of accessing franking credits or tax losses justifies these restrictions. In some cases, transferring assets in-specie to the individual may be a more suitable option.

Tax Treatment of Minors: Excepted Trust Income 

One of the widely known tax advantages of testamentary trusts is the ability to distribute income to minors at adult tax rates. This only applies where the income is excepted trust income, which generally includes income derived from assets that originated from the deceased estate.

After legislative changes from 1 July 2019, this concession no longer applies to income earned from assets injected into the trust from unrelated sources. This includes gifts, loans or new investments that were not funded by the deceased’s original assets or reinvested proceeds.

In practice, trustees may need separate accounting to divide income from estate-originating assets and income from post-death contributions. Incorrectly treating all trust income as excepted can lead to amended assessments and penalties.

How State Taxes and Foreign Person Surcharges Apply to Testamentary Trusts

Each Australian state has different rules regarding foreign person surcharge taxes on land and certain property transactions. When drafting or operating a testamentary trust, advisers should consider whether any beneficiaries may qualify as foreign persons now or in the future.

Many wills include default exclusions for foreign persons to avoid surcharge land tax or surcharge stamp duty. However, this is not always ideal. What happens if a future generation moves overseas and renounces Australian citizenship? They may unintentionally be excluded from benefiting under the trust.

Modern drafting generally includes a power allowing trustees to amend the deed later, including the ability to exclude or re-include foreign persons when required. This avoids permanently locking out beneficiaries while still allowing compliance with state taxes.

Why Early Professional Advice Improves Testamentary Trust Outcomes

Testamentary trusts offer powerful tax planning advantages, asset protection and family wealth preservation opportunities. However, they are also regulated by a complex mix of capital gains tax rules, family trust election requirements, excepted income rules for minors and state-based surcharge provisions.

The best results occur when advisers are involved before the will is drafted. But even after death, careful administration and clear communication can prevent unnecessary tax and family disputes.

Understanding the rules above ensures trustees, executors and families can use a testamentary trust in the way it was intended: to build, protect and pass on wealth across generations.

What’s Next?

Operating a testamentary trust effectively requires more than understanding the terms of the will. Decisions about family trust elections, the test individual, distribution strategies, minor beneficiaries, state taxes and asset movements can significantly shape the long-term outcomes for your family. The earlier you address these issues, the more flexibility you have to minimise tax, avoid unnecessary restrictions and preserve the intent of the person who created the trust.

If you would like personalised guidance on how these rules apply to your situation, the Investax team can help you understand the tax implications, structure options and administrative steps needed to operate your testamentary trust with confidence.

Reference

CGT ATO Deceased Estate 

ATO ID 2014/3 

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