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The basics

Introduction
What are testamentary trusts?
Types of testamentary trusts
What are the advantages of testamentary trusts?
What are the income-tax advantages of a testamentary trust?
What are the disadvantages of testamentary trusts?
When is it worth using testamentary trusts?
Alternative to a testamentary trust - gift to an existing family trust

Introduction

The use of a testamentary trusts in Wills is a very popular succession planning strategy.

The idea that the use of testamentary trusts is reserved only for the "rich and wealthy" is wrong; most middle-class families will benefit significantly from the inclusion of testamentary trusts in their Wills.

What are testamentary trusts?

Simply, testamentary trusts are trusts that are established under a Will.  They only operate upon death of the Will maker.  A Will may include one or more testamentary trusts depending upon the circumstances to be covered.

It need not be the case that testamentary trust is "forced" upon a beneficiary.  It is possible to have a situation where a beneficiary can take a distribution rather than allowing a testamentary trust to operate, if the situation is such that this is a better option.

Types of testamentary trusts

Testamentary trusts can vary in their complexity depending upon the circumstances to be covered.  A short form testamentary trust included in a Will can be one or two pages in length.  These short form trusts will not usually operate for extended periods of time.  If the circumstances demand it, the testamentary trust can be a full discretionary trust extending to 25-30 pages in length.

If it is desired that the testamentary trusts operate for an extended period of time, then the use of a full discretionary trust should be considered.  The main differences are that a full discretionary trust will have extensive provisions dealing with the offices of trustee and appointor in relation to their initial appointment, substitution, removal, reinstatement, remuneration and succession.  Further, greater attention is given to ongoing control of the trust.

What are the advantages of testamentary trusts?

The advantages can be many and varied depending upon the circumstances.  It is important to get professional advice.

One of the main advantages for the inclusion of testamentary trust is the income-tax advantages that can flow from their use.  There are other advantages which include the following:

• the ability to stream income;
• asset protection advantages;
• protection from divorce;
• protection of the beneficiary where they might be under some disability.

It is important to get advice on how testamentary trusts may be useful in your particular circumstances.  Everyone's circumstances are different.

What are the income-tax advantages of a testamentary trust?

The main advantage is in circumstances where there are beneficiaries who are under 18 years of age or beneficiaries who have children who are under 18 years of age.

Beneficiaries under 18 years of age are taxed at normal adult rates on the trust income distributed to them.  This means that they are not taxed at the penalty rates applicable to income distributed to them from other types of trusts such as family discretionary trusts.

Being taxed as adults means they receive the benefit of the tax free threshold and progressive rates of taxation.

For an example of the income-tax advantages - see worked example.

For further detail - see concessionary tax income of minors.

Rather than have your children inherit directly, if they have children of their own who are under 18 years of age, it may be more beneficial to set up testamentary trusts for each of your children.  For an example of the income-tax advantages of this - see worked example.

What are the disadvantages of testamentary trusts?

The first disadvantage is that the preparation of the Will incorporating a testamentary trust will cost more.  However, the benefits can be very significant making any additional cost seem trivial in the wider context.

There will be ongoing need for professional assistance in the operation of the trust and separate accounts and taxation returns will need to be prepared for the testamentary trust.  It does require the undertaking of a cost benefit analysis.

When is it worth using testamentary trusts?

The factors that will have to be considered in whether it is worthwhile using a testamentary trust include the following:

• The size of the estate passing under the Will.  As there are annual operating costs associated with the trust, the benefits that flow must make it an economic proposition;
• The degree of protection that the primary beneficiary may require.  If a beneficiary is at risk of bankruptcy or is suffering a disability, then the formation of the trust may be required regardless of the value of the assets being transferred; and
• The financial circumstances of the beneficiary and how best their financial arrangements can be structured.  Often this is hard to assess as the Will only operates in the future.  For this reason, the ability to have the Will provide for a testamentary trust but allow a primary beneficiary to take a distribution instead of the formation of the testamentary trust is often appropriate.

Alternative to a testamentary trust - gift to an existing family trust

If there already is in existence an existing family discretionary trust that is properly structured, it may be that gifts can be made to the trust from the Will to achieve similar benefits from setting up a testamentary trust in the Will itself.  The existing family discretionary trust deed will need to be examined carefully to ensure that it is appropriate for the circumstances.