Two key considerations in any estate plan are:
- What are the tax consequences flowing from the distributions made in a Will?
- Is there anything that can be done to minimise the tax payable by the estate and the beneficiaries?
One very effective way of planning for this and reducing the eventual tax liabilities of beneficiaries is through the use of Testamentary Discretionary Trusts.
Testamentary Discretionary Trusts are quite similar to regular Family Trusts (also known as Discretionary Trusts) that someone may establish during their lifetime. In both cases, as with all Trusts, there is a Trustee who is appointed to manage assets on behalf of a defined group of potential beneficiaries. The beneficiaries don’t have a set entitlement to receive anything (this would be a “fixed trust” as opposed to a “discretionary trust”). The Trustee makes all the decisions about how the income and capital of the trust will be distributed to the beneficiaries.
A key difference between a Family Trust established during someone’s lifetime (or “inter vivos”) and a Testamentary Discretionary Trust which only comes into effect after somebody’s death to hold inherited assets pursuant to a Will, relates to the tax treatment of these Trusts.
With a Testamentary Discretionary Trust, a minor beneficiary (a child under the age of 18) is taxed as an adult. This means that any income distributions from the trust that are paid to the minor beneficiary will be taxed at adult marginal tax rates. The good news here is that these adult marginal tax rates include a tax free threshold for distributions less than $18,200. This effectively means that the first $18,200 distributed to a child from a Testamentary Discretionary Trust is tax free. An example of how this can significantly benefit the total tax paid for an estate is set out below.
Family Trusts on the other hand, do not have the advantage of minor beneficiaries being taxed as adults. With a Family Trust, a minor beneficiary can only receive $416 before tax will be applied. For any distributions of income to a minor beneficiary in excess of $416, penalty tax rates will apply and this can be as much as $0.66 per $1.00.
Case Study – Tax treatment of Testamentary Trusts
Jim (aged 75) and Jane (aged 71) have three adult children (Bill, Ben and Beth). Each of Bill, Ben and Beth have 3 children (Jim and Jane’s grandchildren). All of the grandchildren are under 18 years of age. Jim and Jane always intended to leave their estates to each other initially and then to their children in equal shares if they were both to pass away.
Jim and Jane die suddenly in an accident. Let’s examine the tax treatment of their Wills with and without the benefit of Testamentary Discretionary Trusts.
Without Testamentary Discretionary Trusts
If their Wills do not include the option for the Bill Testamentary Discretionary Trusts then Bill, Ben and Beth will receive their inheritances directly into their own names. They will have to pay tax on any income earned at their own personal tax rates.
Assume for this example that they each receive $1,000,000 and they are each working in high income earning professions and are therefore paying the highest marginal tax rate.
If they invest their inheritance and earn 5% on their $1,000,000 that is additional income of $50,000.
If their taxable income is over $135,001 then they will be paying 37% tax on the income earned on their inheritance, which equals $18,500.
If they are each in this tax bracket, then the total tax paid on their estate income would be $55,500.
With Testamentary Discretionary Trusts
If Jim and Jane included the option for their children to receive their inheritances via Testamentary Discretionary Trusts, then the tax treatment would be very different.
Using the assumption from above, each of Bill, Ben and Beth receive $1,000,000, but it isn’t held in their name, it is instead “owned” by the Trustee of a Testamentary Discretionary Trust established in the Will to benefit them and their descendants.
The Trustee of each Testamentary Discretionary Trust will invest the funds and again will each earn 5% interest on the investment, resulting in income of $50,000 each for the trust.
The Trustee of Bill’s Testamentary Discretionary Trust can elect to distribute this income to Bill’s three minor children in equal shares so each child will receive $16,667. This is less than the tax free threshold and so no tax is payable.
The Trustees of Ben and Beth’s Testamentary Discretionary Trusts could do this same thing and in doing so, the family could potentially save $55,500 in tax each year.
All because of some careful and considered estate planning by Jim and Jane.
As this example shows Testamentary Discretionary Trusts really do make such a difference when it comes to the tax treatment of estates and inheritances.
If your Will doesn’t include the option for Testamentary Discretionary Trusts, then your beneficiaries will miss out on these potential tax advantages outlined above. If you’d like to review your Will, or discuss this further, contact our Wills and Estates lawyers on +61 3 9822 8588 or email HERE to find out how we can help you.
