Testamentary trusts and tax planning

What is a Testamentary Trust

A testamentary trust is a trust that is established under a valid will. A testamentary trust functions in a similar way to a discretionary trust. This structure allows a lot more flexibility in the way profits are distributed from the estate and therefore can be a very tax-efficient way of structuring your will. Where a normal will distributes the assets of the deceased to the beneficiaries, usually within three (3) years of the death, a testamentary trust extends this period to be in line with the wishes of the deceased. For example, the deceased may not wish the children or grandchildren named in the will to have access to the capital of the estate until they are of a certain age (e.g. they receive their inheritance on their 21^st birthday).

What are the advantages over a standard Will

This type of will has a few main advantages. Firstly, the deceased can guarantee that the beneficiaries will be of an age that they believe is mature enough to look after the funds. For example, if an 18-year-old received an inheritance, they might be more likely to spend the money on discretionary items, whereas a 30- or 40-year-old may be more likely to invest the funds.

The second advantage is with regards to tax. Any earnings from a deceased estate that are distributed to a minor (someone under 18) are taxed at adult marginal rates. Whereas if funds were inherited by an adult and then invested into an investment trust, distributions to the minor from an investment trust are taxed at the below rates:

Thirdly, there is flexibility in who you distribute to each year. The trustee is able to vary the pattern of distribution made each year. If the trust has a beneficiary whose income significantly reduces in a year, then more income can be distributed to that person.

It should also be noted that any capital distributed from a testamentary trust to beneficiaries under current ATO guidelines has the capital gain disregarded. For example, a property held by the trust can be distributed into a beneficiary’s name and capital gains tax would not be payable.

There are similar compliance requirements for testamentary trusts to family trusts. For example, a tax return and financial statements need to be prepared and submitted each year.

See following pages for tax rate tables and example scenarios.

Tax rate tables for 2017/18 financial year

Minor tax rates

Income	Tax rates for 2017–18 income year
$0–$416	Nil
$417–$1,307	Nil plus 66% of the excess over $416
Over $1,307	45% of the total amount of income that is not excepted income

Adult tax rates

Taxable income	Tax on this income
0–$18,200	Nil
$18,201–$37,000	19c for each $1 over $18,200
$37,001–$87,000	$3,572 plus 32.5c for each $1 over $37,000
$87,001–$180,000	$19,822 plus 37c for each $1 over $87,000
$180,001 and over	$54,232 plus 45c for each $1 over $180,000

Example scenarios

Example scenario 1

John’s deceased estate consists of $1 million total funds. These funds can be invested each year at a 5% return to generate income of $50,000. John had no living spouse, but has 1 daughter who is married (earning $70,000 per year and her husband earning $90,000 per year). The daughter and her husband have 3 children (3, 7 & 9 years old). A basic will may simply distribute the estate to the daughter and these funds would then be invested in her name. This basic scenario would add $50,000 to her taxable income, increasing it to $120,000 and increasing the tax paid by $18,735. These investments would then be used for normal living costs such as school fees, mortgage etc.

In contrast to this, a testamentary trust would retain the capital of the trust and distribute the profit to the grandchildren each year. The three grandchildren would receive $16,666 of income each per year, which may be spent by the parents on similar costs to maintain the children. This distribution is received tax-free if a testamentary trust is used to best effect.

Note: Scenario 1 would work equally well if there were less assets in the deceased’s estate and there were minors involved in the remaining family.

Example scenario 2

John’s deceased estate consists of $2 million total funds. These funds can be invested each year at a 5% return to generate income of $100,000. John had no living spouse, but has 1 daughter who is married (earning $180,000 per year and her husband earning $60,000 per year). The daughter and her husband have one child (3 years old). A basic will may simply distribute the estate to the daughter and these funds would then be invested in her husband’s name because he is earning the lesser of the two incomes. This basic scenario would add $100,000 to his taxable income, increasing it to $160,000 and increasing the tax paid by $37,885.

In the second year after the death of John, the daughter is made redundant and struggles to find work, dropping her income to $20,000. Suddenly, having the funds invested in her husband’s name is not tax-efficient. A testamentary trust in this situation may change its distribution pattern so that $37,000 goes to the grandchild and $63,000 goes to the daughter. This distribution would incur $23,754 in tax, saving the family $14,131 because the daughter and granddaughter are in lower tax brackets.