Testamentary Trust

A testamentary trust is a trust that is created and established by the testator of a Will. The terms of the testamentary trust are set out by the testator of the Will, who appoints a trustee to oversee the trust on their death . A testator is able to establish multiple testamentary trusts within their Will. For a testamentary trust to be established properly, there needs to be trust property, a trustee, and a beneficiary or beneficiaries. The testator can specify what assets (such as property, land, cash or investments) in their estate will be transferred into a testamentary trust. The testator usually names the beneficiaries of the testamentary trust(s) and may outline the purpose of the trust and what it can be used for. An appointor is usually specified by the testator. The appointor is responsible for hiring the trustee, who may also be named by the testator. It is up to the trustee to ensure that the distribution of the testamentary trust is in accordance with the wishes of the testator or in manner that the trustee determines will be of benefit to the beneficiaries of the testamentary trust. The testamentary trust comes into existence when the testator dies, and the estate has been administered.

Upon the death of a person, they lose all property rights. The decease’s rights and liabilities are then held by their legal representative, either the executor of their estate or the appointed administrator of their estate.

Once the estate has been administered, the property and other assets are then transferred to the trustee of the testamentary trust, who will oversee the distribution of the trust(s). It is important to identify the time the assets were transferred to the trustee or when the trustee first paid income out of the testamentary trust, as this is when the testamentary trust actually came into existence. It should be noted that in most Australian jurisdictions the maximum length of time that a testamentary trust can operate is eighty (80) years. Trusts, however, can be dissolved and assets distributed to beneficiaries at any time.

There are three key reasons that testamentary trusts are created and utilised:

  • There are tax benefits in distributing income from a testamentary trust.
  • They can provide asset protection for vulnerable beneficiaries that may be unable to manage their own financial affairs as they a minor, or incapacitated from disability, illness or elderly, or they are unable to appropriately manage their own finances.
  • Family law protection.

Where testamentary trusts are used for tax benefits, the trust itself may be optional, meaning it is up to the executor of the estate to decided if a trust will be set-up.

If the trust is setup to protect vulnerable beneficiaries, the executor will not have a decision on whether the trust is setup. This is known as a mandatory trust. Mandatory trusts will often limit a vulnerable beneficiary’s access to the estate, by giving control of the assets to the trustee who will then distribute certain amounts the income or capital at the discretion of the trustee.

If the testator is setting up the testamentary trust(s) so that the beneficiaries can obtain tax benefits but does not wish to force this onto the beneficiaries of the trust, the testator can make the testamentary trust optional. This gives the primary beneficiary the assets absolute or takes advantage of the tax benefits.

When the testamentary trust is established, it will either be fixed or discretionary.

  • A fixed trust determines how the trustee will distribute the income or capital to beneficiaries. It may just be fixed for certain beneficiaries and not others.
  • A discretionary trust will give either fettered or absolute discretion to the trustee to determine which beneficiary receives income or capital from the trust, and it what time and in what amount. This gives the trustee the discretion to distribute the trust to beneficiaries in tax effective ways.

There are several benefits of establishing testamentary trusts:

  • The testator can determine how and for what purpose the beneficiaries use the income or capital.
  • The option of capital gains tax rollover, which occurs because the capital gains tax liability is deferred until the beneficiary sells or transfers the asset. This allows the beneficiary to choose when they pay the capital gains tax by timing the sale or transfer of the asset.
  • Tax benefits when distributing income from the testamentary trust to minors, as they can take advantage of the tax-free income threshold when the distribution of income comes from a testamentary trust.
  • A testamentary trust minimises any creditors of the beneficiaries or other third parties getting access to assets held in trust. This is because assets are being held by the trustee on behalf of the beneficiaries rather than help by the individual benefactor.
  • Provides beneficiaries with asset protection, for example, if they are being pursued by an ex-spouse or partner in divorce proceedings.
  • The testator can include accumulated balance of a superannuation fund or life insurance policy into a testamentary trust.
  • The assets of vulnerable beneficiaries can be controlled by the trustee, rather than an external agency like the public guardian and trustee.