Testamentary Trusts – Are they a good idea?
A Testator’s Testamentary Trust is a special type of Will. Financial planners often recommend them but what are they and are they a good idea?
Normally, the Will appoints an executor and gives to that executor the power to gather in the deceased’s entire estate and distribute out to named beneficiaries. Those beneficiaries will receive the entire capital of the estate and any interest/income which has been earned on those assets in the time between the date of the deceased’s death and the ultimate distribution of the capital assets. The executor has no discretion as to the distribution of the assets, nor the income; they will pass in strict compliance with the relevant proportions which have been allocated to each of the beneficiaries in the Will.
In a Testamentary Trust, what happens instead is that the Will-maker leaves the estate to a successive line of family members usually starting with the first beneficiary being that person’s spouse and then going onto the children, grandchildren, great-grandchildren etc. Each of the lines of beneficiaries are entitled to receive the income which is generated from the assets made up in the Trust and (usually) can even receive direct distributions of the assets/capital itself. Under the law against perpetuity, the Trust can’t be expressed to have a life span beyond 80 years and therefore at the expiration of this period, the Trust will automatically cease and the beneficiaries who are in existence at that time will receive the capital (sometimes called the corpus) of the estate. Typically, the Trust arrangement will also give to the executor the power to terminate the Trust early that is inside the 80 year period at the Trustee’s discretion.
Generally, there are three main reasons why people are attracted to the idea of Testamentary Trusts, and each will be discussed in turn below:
Tax Benefits
For nearly 30 or more years now, the establishment of Trusts have been considered a very effective means of minimising tax by distributing a core source of income out into the hands of multiple beneficiaries who might all have lower tax thresholds. For example, a single individual who earns $180,000.00 a year would pay tax of approximately $57,000. Whereas if that same income was distributed out amongst three beneficiaries, all of whom had not received any income from any other source, then the tax payable would be approximately $12,000. Collectively, this totals $36,000 in tax, which is $21,000 cheaper than tax being paid in the hands of one person.
These tax savings however come with a catch! Where any distribution is made to persons under the age of 18 years (minors), only the first $400* is tax free. Any income over $400 is taxed at the top marginal rate of 47% (and can be as high as the penalty rate of 66%). If however, a special Testamentary Trust has been established and the income distributions are made out to minors under this Testamentary Trust then these tax penalty rules do not apply. The minor would receive the first $20,500* of income tax free, and any income above $20,500* would be taxed at the standard marginal rates for an adult. This could result is substantial tax savings.
Further tax benefits may also be available to beneficiaries of Testamentary Trusts, in particular with regards to the payment of capital gains tax. If correctly drafted, the Testamentary Trust may provide relief against the payment of capital gains tax, so that tax is not payable until the CGT asset is sold by the beneficiary at a much later date.
Protection from Family Law Claims (Divorce Proofing)
Often the worry for the Will-maker is that the marriage or de facto relationship between any of his/her adult children and that child’s spouse/partner might break down at some future time, with the result then that the deceased Will-maker’s assets might then be claimed as part of the property settlement entitlements of the ex-spouse or partner.
To some extent, this worry is well founded. Unless the couple have already been separated for at least two years (and in the case of married couples, have already been divorced for at least one whole year), the inheritance will form part of the asset pool and will be available for division between the adult child (the family spouse) and his/her ex-spouse (the non-family spouse). It is important here though to note that just because money received under a direct inheritance will be treated by a Family Court Judge as divisible with the non-family spouse, it does not automatically follow that they will receive a share of it. Where the non-family spouse was not specifically named in the Will, had not made any special (above and beyond) contribution to the welfare of the deceased during their life time, there are no young children to the relationship and the non-family spouse has reasonable income from independent employment, Family Courts would normally be expected to wholly quarantine the estate proceeds away from the non-family spouse if separation happened shortly after the inheritance monies were received. In a situation however where the inheriting spouse and his/her partner stay together for another 10+years after receipt of the inheritance or they separate sooner but with young children who are primarily in the care of the non-family spouse and/or that spouse has a much lower earning capacity, any of these factors can give rise to a claim on the inheritance money in proportions potentially ranging anywhere from 30%-70%.
For parent Will-makers who are concerned for child(ren) in rocky marriages/relationships to spouses or partners who fit into some or all of the categories above, establishing a Testamentary Trust may be the answer. With such a Trust, the adult child could argue in any future separation with his/her partner that the assets bequeathed under the Will should be excluded from the assets available for division because those assets are locked up under the Trust for 80 years with limited to no power to demand distributions of either the income or the capital. In adjudicating on such an issue however, Family Courts will closely analyse the Trust structure, and in particular look at who occupies key positions of control within the Trust such as appointor, trustee and beneficiary. Any option given to distribute capital as well as income and/or options given for an early voluntary termination (ie before 80 years) of the Trust will also be carefully considered. Where the adult child or a close relative is nominated to all of the key positions (and this is typical) and the Trust contains capital payment and/or early termination powers (also typical) the Trust might be found to be the “alter ego” of the adult child and if so, the Trust property will be put into the pool of assets available for division; in other words the Trust will fail to have achieved its defence objective. A Testamentary Trust where someone other than the adult child occupies all key control positions and has no early termination clause does stand a much better chance of holding up against a family law attack but at what price? If the money is locked up under such a restrictive Trust and the adult child falls into hard financial times (for example where they or one of their children become very sick) the relief that might have come from full access to the inheritance money might be denied and so the question begs which is the greater threat or lesser evil! Also even where the Trust property has been successfully excluded from the pool of divisible assets, the income or capital which might potentially come out from the Trust can still be taken into account by the Court as a “financial resource” in the hands of the relevant adult child. In this way the non-family/non-receiving now ex-spouse can argue for a greater share of the other assets which are available for division between he/she (for example their own former matrimonial home) and so again by this indirect means, moving the assets into a Testamentary Trust has not achieved a full and complete protection from family law attack.
In situations where the worry relates to the Will-maker’s own spouse or de facto partner, ie that the surviving spouse/partner might go on to remarry or repartner a “gold digger”, the principles and potential protections set out above are the same.
If “divorce proofing” an inheritance is the real goal, then the better protection by far is to have the adult child and his/her partner sign up a special agreement known as a “Binding Financial Agreement” (BFA) which can be recognised as a complete bar to any family law claim against inheritance money. Where a BFA is not an option then a Testamentary Trust might be worth a go but as said, they have their weaknesses.
Bankruptcy Proofing
The worry here is probably best described with a scenario. Take a young adult male child in their mid to late 20’s. His parent dies unexpectedly and leaves the estate to the son. If by chance at the time however, the son is in desperate financial straits and possibly already tipped into bankruptcy then the Trustee in Bankruptcy will take the parent’s estate money and use it to pay the creditors.
Most case law suggests that under a Testamentary Trust, even if the Trust gives power to take out capital or end the Trust early, the Trustee in Bankruptcy would not be able to take the capital or intercept income to pay down/off the creditors for the duration of the bankruptcy which would be 3 to 5 years.
In saying that, there is a fairly recent Federal Court decision which suggests that the capital of the Trust may be available to the Bankruptcy Trustee if the Court finds that the beneficiary has effective ownership of the Trust property, for example, by being the sole trustee and/or the sole appointor. This Federal Court case analysed the “alter ego” approach adopted by the Family Courts when making property settlement orders. Any threat from this decision however may be overcome by careful consideration when appointing the trustee/s and appointor/s.
Cost of a Testamentary Trust
As can be seen, Testamentary Trusts, if correctly drafted, can provide protection against the possibility of bankruptcy and potential family law claims. The Trusts can also provide tax benefits, in particular to beneficiaries who are minors. However, before setting up a Testamentary Trust, the cost of the Trust should be considered. Firstly, to draft a Testamentary Trust, the legal fees would be anywhere between $2,000.00 to $5,000.00 or above per Will. Next, are the annual costs of maintaining the Trust. Once the Trust is established on the death of the testator, Trust tax returns will need to be prepared and this will usually involve a cost each year in the range of $2,500.00 – $5,000.00 or above. Next, because tax laws are always changing, the need to review the Testamentary Trust is much greater than it would be with a standard Will, therefore meaning regular trips back to the lawyers and the accountants possibly once a year or at least once every three years to make sure that the existing Will is still compliant with current laws.
In circumstances where the creation of the Trust achieves significant tax savings or indeed divorce or bankruptcy proofing is an important consideration, these costs of preparing the Trust are potentially miniscule compared to the financial benefits that they create, but in each case, careful considerations of the cost versus the benefit must always be made.
Michael Zande is the Principal of Zande Law, Solicitors with over 25 years’ experience in practice. Michael and his team have had extensive experience in drafting of Wills and Administration of Deceased Estates. Please feel free to review our firm and staff profiles at www.zandelaw.com.au
The information in this article is merely a guide and is not a full explanation of the law. This firm cannot take responsibility for any action readers take based on this information. When making decisions that could affect your legal rights, please contact us for professional advice.
*These figures are periodically adjusted by the Australian Taxation Office and so have been rounded off for the purposes of this article.