In the 2018 Federal Budget, there was a curious announcement about the concessional tax rates available for minors who receive income from testamentary trusts. It stated that concessional tax rates in testamentary trusts will only apply to income derived from assets that are transferred from a deceased estate or the income that is generated by the selling or investment of those assets.
What was curious is the announcement merely reiterated what the law currently states. The rationale behind the announcement appears to be that some trusts have been able to inappropriately obtain the benefit of lower tax rates in testamentary trusts after putting assets into testamentary trusts that were unrelated to the deceased estate.
This article outlines how using testamentary trusts can provide estate planning certainty for clients with minor children, while also allowing tax-effective distribution of income between family members. We also use a case study to explain how accidentally intermingling assets that are subject to concessional tax rates with those that aren’t in a testamentary trust can significantly increase the amount of tax that needs to be paid.
A testamentary trust is a trust that is created within and by a person’s Will but which doesn’t take effect until after their death. A testamentary trust may be created using specified assets, a designated portion of an estate or the entire remaining balance of an estate. Multiple testamentary trusts may be created by one Will.
Creating a testamentary trust offers a number of benefits, including taxation advantages and the protection of beneficiaries.
Protection of beneficiaries
Directing some or all of a parent’s assets to a testamentary trust can address the issue of protecting children from making poor investment decisions (or poor spending decisions!) because the parents can control when a child has access to funds after they die. Typically, the testamentary trust will stipulate that children do not have access to capital until they are age 21, 25 or even 30.
In addition to minor beneficiaries, clients may have other beneficiaries who will benefit from not having direct control over an inheritance. These can include spendthrift beneficiaries, those with gambling, alcohol or drug addictions or people who are easily influenced by others.
Taxable income generated by the trust can be retained by the trust or allocated to the beneficiaries in a tax-effective way. The trustee can be given discretionary powers in relation to the distribution of income so this can make a testamentary trust a flexible tax-planning vehicle.
Beneficiaries pay income tax at their individual marginal rates on the amount of income they receive from the trust. However, unlike tax on income from other sources, beneficiaries of testamentary trusts under age 18 are taxed at normal adult rates.
Ordinarily, the tax rate applied to income of minors provides a tax-free threshold of only $416 with a flat rate of tax of 66% on additional income above $416 up to $1,307 - and from there upwards a flat rate of tax that’s equal to the top marginal tax rate. Accordingly, the potential for tax savings when trust income is allocated to children can be very substantial.
This is the issue that caused the Federal Budget announcement. Only assets that arise from testamentary sources or from the death of another person, are entitled to the taxation advantages of testamentary trusts. In the event that any non-testamentary sourced assets are added to the corpus of the trust then the tax concessions will be lost.
Case study - Lander
Lander is a single parent aged 42 who has two minor children. He dies leaving $2 million to his two minor children to be held in a testamentary trust established in his Will.
The testamentary trust pays each child $44,000 per year with each child facing a tax liability of only $6,7271 because they are being taxed at normal adult rates and not the higher child tax rates, as detailed previously.
Lander’s mother, Carol, then wins $500,000 in y-lotto and decides to use the money to benefit her orphaned grandchildren. Given the children already have a trust established, Carol decides to pay the $500,000 into the testamentary trust. Owing to the trustee’s ignorance, the $500,000 is accepted.
This error means instead of each child only having to pay tax of $6,727, their tax liability will soar to $20,680 because of the much higher taxation rates for children. The difference in taxation rates means the children will now have to pay an additional amount of $13,953 in tax.
As can be seen by the difference in tax, accidentally intermingling assets in a testamentary trust can cause taxation to increase significantly. In the Lander case study, a better alternative could be for Carol to use her y-lotto winnings to purchase education or investment bonds that name her grandchildren as the beneficiaries. This means they will have access to money in the future without paying the very high tax rates applicable to minors.
Professional estate planning advice can provide your clients with peace of mind that their wealth will be managed and distributed to beneficiaries according to their wishes in the most tax-effective manner possible.
What should you do next?
If you have any concerns in relation to your clients’ potential use of testamentary trusts in their estate planning and would like to consult one of our estate planning lawyers, please call us on 1800 882 218.
1. Includes Medicare levy but excludes any tax offsets. There is no separate tax return for a testamentary trust, it is the same return as for an ordinary trust but the Commissioner is requested to assess it as a testamentary trust (ITAA1936 s99 not 99A).