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For beneficiaries incurring high personal tax rates, the significant savings possible make them an attractive option.
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How testamentary trusts can take the sting out of tax
24 February 2023
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Testamentary trusts are trusts established by a will and only come into operation on the death of the will maker. Testamentary trusts can be drafted to contain very rigid requirements to protect the capital for a vulnerable or young beneficiary or can be flexible to provide a beneficiary with a wide range of options to minimise tax and maximise inheritance protection.
Giving a beneficiary of an estate the option to inherit via a discretionary testamentary trust means they do not have to inherit assets personally and can instead pass all or some of their inheritance into a trust, depending on their circumstances at the time. This may be an attractive option for those who are concerned their beneficiaries could face the prospect of bankruptcy, divorce or legal action.
There can also be significant tax savings for beneficiaries who pay high rates of personal tax and therefore would pay a high rate of tax on the income generated from the estate assets if those assets were left to them directly in a will.
How can a testamentary trust be tax effective?
The potential for tax savings is significant when income from a fixed or non-fixed testamentary trust (or a child superannuation pension or annuity) is distributed to benefit a child or grandchild under 18 years of age. This is because the income is “excepted” by section 102AG of the ITAA 1936 from the higher income tax rates that otherwise apply to children under 18 years on receiving unearned income.
The marginal income tax rates currently applicable to testamentary trust income per individual beneficiary (beneficiary not also receiving other forms of income) regardless of age currently are:
==
==
Testamentary trust income – minor beneficiaries
|
INCOME TAX – RATES 2022-23 |
|
|
Taxable income |
Tax on this income |
|
$0 – 18,200 |
NIL |
|
$18,201 - $45,000 |
19c for each $1 over $18,200 |
|
$45,001 –120,000 |
$5,092 plus 32.5c for each $1 over $45,000 |
|
$120,001 – $180,000 |
$29,467 plus 37c for each $1 over $120,000 |
|
$180,001 and over |
$51,667 plus 45c for each $1 over $180,000 |
Note: Income tax rate (before levies and rebates – tax payable is reduced by franking credits).
Case study
The tax effectiveness of receiving distributions from a testamentary trust can be seen in this case study.
Kim leaves behind her husband John and two minor children, Tess and Jessica. Her estate comprises of an investment property valued at $500,000 and cash of $300,000. John is on the highest marginal tax rate of 45 per cent, plus Medicare levy.
If John invested the $800,000 from Kim’s estate at 4 per cent per annum and generated $32,000 of income that year, he would pay tax (at 47 per cent) of $15,040, leaving him with $16,960.
If instead Kim established a testamentary trust in her will for John, the amount of tax paid by John could be significantly reduced. Using the same figures, if $32,000 of income was generated in that year, John could choose to distribute that income between his two children Tess and Jessica who earned no income that year and could use the tax-free threshold of $18,200. As a result, the family would pay no tax on the income generated through the assets in the testamentary trust.
If the beneficiary is a parent or grandparent of children under 18 years of age and would face relatively high marginal tax rates on any income from inherited assets themselves, testamentary trusts can be particularly attractive. The potential tax savings from income of a testamentary trust being spent on the child or grandchild, instead of forming part of the adult’s income, may effectively subsidise the education and maintenance of the child or grandchild.
Income tax streaming
For the time being at least, the trustees of non-fixed testamentary trusts can be given the power to stream different types of income or deemed income (for example taxable capital gains and interest income) to different beneficiaries. Franking credits from dividend income, however, must be distributed in the same proportions as the dividends and will be forfeited when the dividend is distributed from a non-fixed trust to beneficiaries, unless certain conditions are satisfied. For example:
- The beneficiaries have a fixed entitlement to the trust capital, i.e., the trust is a capital reserved trust.
- The trust is a deceased estate, or an estate testamentary, or an executor managed testamentary trust of less than five years duration.
- The trustee has made an election to become a “family trust” for taxation purposes and be subject to the rules that apply to trusts that have made those elections.
Comparison with child pensions and annuities
Unlike most superannuation pensions and annuities, testamentary trust income does not also qualify for a 15 per cent rebate. This means that testamentary trusts may only be a preferred income tax option when:
- Child superannuation pensions or options are not available, e.g., because of an inflexible superannuation fund, lack of superannuation funding, or because the minor beneficiaries are grandchildren of the deceased and were not also financial dependants of the deceased
- Access to the capital is needed, e.g., for a family business, to fund geared purchases or to clear personal debts such as home mortgages.
Transfer cost advantages
Beneficiaries of testamentary trusts may change from year to year if the testamentary trust is non-fixed. Like other non-fixed trusts, a non-fixed testamentary trust can in most circumstances transfer the beneficial enjoyment of the trust, for example the income generated from year to year, from one discretionary beneficiary to another without incurring transfer costs such as CGT, GST and state duty.
Assets passing into a testamentary trust do not trigger the payment of CGT (by virtue of sections 128-10 and 128-15 of ITAA 1997), GST or state duty on the transfer of assets from legal ownership by the deceased to legal ownership by the executor or administrator of the deceased estate and then to the trustee of the testamentary trust or cash proceeds of a life insurance policy or superannuation death benefit.
CGT on assets passing from a testamentary trust to a beneficiary
There would also appear to be significant CGT relief under section 128-10 of the ITAA when assets originally belonging to the deceased are transferred from the trustee of a testamentary trust to a beneficiary – this relief was confirmed by the ATO in Practice Statement LA 2003/12. This relief does not extend to assets acquired by the executor of the deceased estate or the trustee of the testamentary trust. A transfer of trust assets from a trustee to a beneficiary should not normally be a taxable supply for GST purposes, but state duty on such a transfer may be an issue in states and territories such as NSW that do not have the trustee-to-beneficiary exemption from duty which applies in Victoria.
Suzanne Jones is a partner and head of estate planning at Coote Family Lawyers.
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