Asset planning and structuring is a critical component of generating wealth during your lifetime. It is equally important to ensure your assets are protected on your death so that they pass to your beneficiaries in the way that you envisaged. For this reason, making sure your estate plan is tax-effective and provides some asset protection in the event of a family breakdown are important factors to consider. This article explains how a discretionary testamentary trust in your Will could help achieve these aims.
What is a testamentary trust?
A testamentary trust is simply a trust created under a valid Will. A testamentary trust can take many forms. The most widely known example is a bare trust which simply holds funds until the intended beneficiary reaches a nominated age. Interestingly, the most commonly nominated age used to be 18 but we are increasingly observing clients nominate an older age. Of course, this is a personal choice but it is worth beneficiaries understanding that the nest egg they are counting on may hatch at 30 rather than 18!
The focus of this article, however, is on discretionary testamentary trusts. These are more complex trusts under which income and capital can be distributed to a range of beneficiaries in a range of circumstances. The benefits? Asset protection (including, in some circumstances, family law protection) and potential tax structuring advantages for the beneficiaries.
How does a discretionary testamentary trust work?
The testator nominates a trustee (often the primary beneficiary of the trust) who controls the trust and is ultimately responsible for distributions of both income and capital. It is ultimately up to the testator how much control they wish to give to a trustee. A trustee can be given absolute discretion as to how to distribute income and capital. Alternatively, we can limit the distribution of capital to set amounts or for a limited range of beneficiaries.
A typical example of this is where the trust entitles one class of beneficiary (for example, children) to access the income of the trust (for example, interest, dividends, rental payments) with another class of beneficiary (for example, grandchildren) entitled to the capital.
Drafting a trust in this way enables a testator to preserve assets for multiple generations.
Why use a discretionary testamentary trust?
One of the key reasons for establishing a testamentary trust under a Will is to provide asset protection to beneficiaries. For example, discretionary trusts can provide significant protection against claims by creditors of an insolvent beneficiary (and can therefore be extremely useful where beneficiaries engage in high risk investments or business). They can also protect beneficiaries in the event of family law proceedings as, provided the relevant beneficiary does not control the trust, the trust property will not form part of the divisible property of the relationship.
Taxation benefits of discretionary testamentary trusts
Discretionary testamentary trusts also provide significant tax flexibility to beneficiaries. The taxation benefits of such trusts are twofold.
Firstly, minors are taxed as adults in regard to any income received and this means that minors can take advantage of adult tax-free thresholds in relation to any distributions.
Secondly, income can be streamed to a wide range of beneficiaries thereby enabling advantage to be taken of multiple adult tax-free thresholds – the more children or grandchildren a testator has, the greater the benefit the trust can provide.
For example, Margaret is a successful doctor and her income is taxed at the top marginal tax rate. Margaret, who has three minor children, recently inherited $500,000 from her mother by way of a discretionary testamentary trust. During the last financial year, the trust had an investment return of $30,000. Margaret resolved to allocate the income equally between her children. As this income was generated by a trust created under a will, Margaret’s children are taxed at adult tax rates and the result for Margaret is that no tax is paid on the trust income.
Are there any drawbacks?
While the protection offered by a testamentary trust is valuable, it is important to note that this protection is not absolute particularly where a beneficiary has a high degree of control over the trust. The asset protection afforded by discretionary testamentary trusts is substantially reduced where the primary beneficiary is also the sole trustee of the trust (and therefore in control of the trust). While it is advisable to appoint an independent trustee or co-trustee to assist in the management of the trust, this can be difficult in practice as many testators are loathe to take control away from their intended beneficiaries.
The complex nature of these trusts may mean that not all testators are able to understand how a discretionary trust will work and may be unable to satisfy the requirement for knowledge and approval of the content of their Will. The circumstances of the testator or of a particular beneficiary may also be such that a discretionary testamentary trust is not the most appropriate vehicle for passing assets to a beneficiary (for example, because of the type of assets within the estate or because of a disability of the relevant beneficiary).
The estate planning team at SWS Lawyers can provide you with specialist advice and draft tailored testamentary trust wills that deal with your specific circumstances.