The tax and asset protection advantages of Testamentary Discretionary Trusts.
Testamentary discretionary trusts can be of value for taxation and asset protection purposes.
A testamentary trust is merely a trust created under a Will and only takes effect on death (as opposed to one created during life called an “Inter Vivos Trust”). A testamentary “discretionary” trust is a trust created under a Will where the trustee can exercise discretion in the payment of income and capital of the trust to the beneficiaries. In many ways this type of trust operates in the same manner as a discretionary family trust.
The advantages of a testamentary discretionary trust stem from the trust structure where control is separated from ownership.
Under a simple standard “Mum and Dad Will” (that is, all assets pass to the survivor of the spouses and then on the death of the survivor, everything passes to the children) the assets vest absolutely in the hands of the nominated beneficiaries. Therefore the beneficiaries legally own and absolutely control the assets that they inherit.
The thinking behind a testamentary discretionary trust is different.
Under this structure the ultimate control and legal ownership of the estate assets rests with the trustee. This means the beneficiaries do not legally own the assets of the trust; they merely have a right to be considered in the distribution of the income or capital of the trust. The trustee decides which beneficiaries will receive income and capital from the trust and in what proportions.
It is this testamentary discretionary trust regime which allows for some of the following benefits to be achieved:
- Protection from bankruptcy. We live in uncertain financial times and the incidence of bankruptcy is on the increase. If a bankrupt beneficiary inherits assets in his/her personal name they will pass to the Trustee in Bankruptcy. A correctly structured Testamentary Discretionary Trust will protect the inheritance as it will not form part of the beneficiary’s estate for bankruptcy purposes and will, if properly structured, not pass who the control of the trustee in Bankruptcy for the benefit of the creditors of the principal beneficiary.
- Divorce and relationship breakdown. Statistics show the average marriage will not last more than 8.8 years. De facto relationships can be similarly short-lived. An inheritance held within a properly structured Testamentary Discretionary Trust is, under the present law, unlikely to be subject to a Family Court Order in the event of marriage or relationship breakdown. The Court may treat the assets in the Trust as a financial resource available to a particular party but under the present law can not transfer assets within the Trust to the other spouse.
- Taxation Advantages. Taxable income generated by the Trust can be allocated among the beneficiaries of the Trust in a tax effective manner. Each beneficiary pays income tax on his/her allocated share of income, according to his/her normal marginal tax rates. Unlike income from an Inter Vivos Trust, beneficiaries under 18 years of age are taxed at normal adult rates and not at penalty tax rates.
Case Study – Meet Robert and Elizabeth Armstrong
Robert and Elizabeth Armstrong have two children, Claire aged 5 and Penelope aged 7. Elizabeth died suddenly leaving assets of $500,000.00 (excluding the family home).
Elizabeth’s Will included a Testamentary Discretionary Trust under which Robert along with Claire and Penelope are potential beneficiaries.
The annual income of the Trust is $30,000 and Robert as Trustee resolves to distribute the income equally between Claire and Penelope. As Claire and Penelope have no other income the payments to them are tax free.
If Elizabeth’s Will had not included a Testamentary Discretionary Trust the income of $30,000 would have been added to Robert’s taxable income as a teacher of $100,000. He would have paid tax of approximately $36,000 as opposed to tax of approximately $24,900 (on his salary). Thus, in one year alone the testamentary discretionary trust has saved the family $11,100 in income tax! ($36,000 – $24,900) (Figures are for purposes of illustration only).
Testamentary Trusts in cannot be created retrospectively and must be included in the Will made before death.
The tax benefits outlined above are not limited to parents with children under 18 years of age. They are also available to grandparents who are, for example, assisting with the payment of grandchildren’s school fees.
It is important to understand that Testamentary Trusts are intended to benefit your chosen beneficiaries and will provide no benefit to you personally.