Estate Planning - Trusts Created By A Will Funded By The Will Maker - Part 3: Types of Testamentary Trusts

Other articles in this series

• Estate Plannnig - Trusts Created By A Will Funded By A Will Maker - Part 1: The Will
• Estate Planning - Trusts Created By A Will Funded By A Will Maker - Part 2: What Is A Testamentary Trust?

Beneficiary Controlled Testamentary Trusts

The main reason for creating a beneficiary controlled testamentary trust is for protection of the principal beneficiary, particularly in a situation of relationship breakdown of marriage or de facto partnership. With the beneficiary controlled testamentary trust, there is considerable protection of assets from the primary beneficiary’s hostile family members.

Unlike other testamentary trusts, the primary beneficiary (rather than the executor) effectively controls the trust once the option to use it has been taken up unless the primary beneficiary is already bankrupt or lacking decision-making capacity in which case control would revert to the executor. 

While a will creating a beneficiary controlled testamentary trust may vary in format, a typical format has the revocation, control and division aspects of the will at the front of the document are followed by the more standard administrative aspects of the will.

There are three main types of beneficiary controlled testamentary trusts:

• Fully discretionary (sole trust or parallel trusts) – A separate trust is established for each primary beneficiary (partner, children sharing the estate) subject to options for the primary beneficiary to choose that as set out in the will. Parallel trusts are an option provided for in the will in the event that a primary beneficiary wants to utilize separate trusts;
• Capital protected testamentary trusts – This is an alternative or additional option set out in the will to the default option of a fully discretionary beneficiary controlled testamentary trust. The capital forms part of the estate of the primary beneficiary or of the children of the primary beneficiary. This type of beneficiary controlled testamentary trust is often established with the possibility of a new domestic relationship in mind.   This trust operates in the same way as the executor controlled capital protected trust with the exception that the primary beneficiary acts as or chooses the trustee; and
• Superannuation death benefit testamentary trust – This is a fully discretionary trust but with a class of discretionary beneficiaries limited to all or some of the death benefits of the deceased.

Another relevant feature of testamentary trusts is the CGT main residence exemption and deceased estates.

When the owner of a main residence passes away, a CGT rollover applies when ownership of the dwelling is transferred from the deceased estate to the beneficiary for whom the property is also or becomes the main residence. The transfer can occur under the will or via the laws of intestacy.   The beneficiary effectively inherits the property and the cost base of the deceased.

An extension of the main residence exemption applies if the dwelling qualified as the main residence of the deceased:

• is sold within two years of the deceased’s death; or
• from the deceased’s death until the property is disposed of, the dwelling was the main residence of:
  • the deceased’s spouse; or
  • someone who had a right to occupy the property under the deceased’s will; or
  • the person who inherited the property.

It is accordingly important to include a right of occupation in a will when dealing with a main residence, particularly if testamentary and protective trusts and life interests are to be created.

Generally, the person can only have one main residence unless they have purchased a new home but have not yet sold the previous one.   Here, the exemption may apply to both properties for a maximum of six months only.

If the property is partly used to produce income (for example to run a business), CGT is payable on the proportion of the home that is income producing based upon floor space.

If a property is a person’s main residence and then that person moves overseas for work and rents out the property, the CGT exemption will generally apply for up to six years assuming that the person has no other main residence during this period.

Capital Protected Testamentary Trusts

We turn next to look at the capital protected testamentary trust. 

The main reason for a capital protected testamentary trust is the preservation of a capital base. The will maker may wish to ensure that the capital component of the inheritance is not run down because of a relationship breakdown involving the principal beneficiary.

Other reasons may include the 30% “parking” rate for income allocated to a company beneficiary.

The trustee is usually the executor of the estate and is not usually subject to a power of appointment by a third party. 

Beneficiaries are taxed on all trust income spent on or allocated or paid to them and receive any available tax credits. Family trust elections may be needed. Loans to the trust may need to be on “arm’s length” rate terms. Income and assets can be counted for Centrelink means test purposes for non-excluded beneficiaries of the trust.

If a will maker assets pass via the trust to a residential beneficiary, no taxable CGT event occurs until the residential beneficiary disposes of them.   Other assets are taxed as a capital gain upon sale or distribution.   The trustee is usually given an express power to pay any CGT liability that may fall upon a beneficiary. 

Education Testamentary Trust

Another type of trust created in a testamentary context is an education testamentary trust. 

The main reason for an education testamentary trust is to provide income and benefits to children or grandchildren (or other dependents or relatives of the surviving parent or grandparent). An alternative to this non-fixed trust is a fixed education trust.   The education trust (other than a child support trust) established during a person’s lifetime will not usually qualify for accepted income tax concessions.

The trustee of an education testamentary trust is usually the executor of the estate and is not usually subject to a power of appointment by a third party.  

The trustee of an education testamentary trust pays tax on behalf of the income beneficiaries for as long as they remain under 18 years of age on all trust income spent on or allocated or paid to or for them with credit for any tax already paid (e.g. dividend franking credits).    Restrictions apply to any losses, loans or benefits. Trust assets are included in the surviving parent’s means test calculations. 

If assets were owned by the will maker are distributed to beneficiaries in an education testamentary trust, no taxable CGT event occurs until the beneficiaries dispose of them.   Otherwise, capital profits are taxed as a capital gain for the selected capital beneficiary. 

The trustee can usually bring all or part of the trust to an end at any time and distribute all or part of the capital to the residual beneficiaries. 

Protective Trust

Another testamentary trust is the protective trust which is established for vulnerable people. The priorities for a protective trust will be:

• Care and accommodation of the protected beneficiary;
• Other essential needs such as food, clothing and education; and
• Quality of life benefits such as entertainment and recreation.

The terms of trust for a protective trust for a vulnerable person are very different from a discretionary family trust. Protective trusts are close to the default “prudent person” rule that applies to all trusts to the extent that the terms of trust are not defined. 

In establishing the protective trust, the following issues will need to be specifically addressed in the will:

• Care, accommodation and support services – finding suitable accommodation and carers can be a major difficulty but can make an enormous difference to a vulnerable person’s quality of life;
• Quality of life where it is usual that the trustee be given examples of what sort of expenditure should be incurred if surplus funds are available for recreation, holidays or travel; and
• The limited rights of residual beneficiaries who usually only are relevant on the death of the principal vulnerable beneficiary. The presence of residual beneficiaries helps protect trust assets from challenge such as by a spendthrift or gullible principal beneficiary. 

Special Disability Trust

Another type of testamentary trust is a special disability trust. The major purpose for a special disability trust is to provide in a single trust for the care and accommodation of a child, other relative, friend with a severe disability or principal beneficiary living in Australia.   The trust can also have up to a threshold of assets and income generated on those assets being free of Centrelink and Veterans’ Affairs. That threshold is currently $551,750.00. Another benefit of a special disability trust is the protection of trust assets from the principal beneficiary, creditors or unsuitable next-of-kin such as an estranged natural father.

In a special disability testamentary trust, the trustee must be either a professional trustee or be at least two Australian resident individuals.   The power to replace the trustee may be held by an appointer. 

Whilst benefitting from a Centrelink/Veterans’ Affairs asset and income means testing threshold exemption, the principal beneficiary is taxed on trust income spent on permitted care and accommodation with credit for any tax already paid. If the constraints of a special disability trust are an issue, such as the limitation of expenditure on care and accommodation, an “all-needs” protective trust can be established instead of or as well as the special disability trust. If trust assets were owned by a will maker pass via the trust to the will maker’s nominee, no taxable CGT event occurs until the residual beneficiary disposes of those trust assets. Other trust assets will be taxed as a capital gain on the sale of those assets. 

An "All Needs" Protective Trust

An “all-needs” protective trust is another type of testamentary trust the object of which is to financially protect the beneficiary who is vulnerable but who has not been assessed by Centrelink/Veterans’ Affairs as having a severe disability. A protective trust can be established so that it is free of the constraints of a special disability trust such as the requirement to support both the vulnerable beneficiary and any children.  

The vulnerable beneficiary is taxed on all trust income spent on or allocated or paid to or for the beneficiary with credit for any tax already paid such as dividend franking credits. Both income and capital are included in the vulnerable beneficiary’s pension means test calculations.

If trust assets that were owned by a will maker pass via the trust to the residual beneficiary, no taxable CGT event occurs until the residual beneficiary disposes of them. Other trust assets are taxed as a capital gain on sale or winding up of the trust where the gain arises for the benefit of the vulnerable beneficiary, the vulnerable beneficiary’s dependents or the residual beneficiaries. 

Wills will often contain provisions giving the executor, with a consent of the principal primary beneficiary, the discretion to bypass a beneficiary controlled testamentary trust in certain circumstances. Those circumstances are where it is not appropriate for the testamentary trust to be established. An example might be where a particular primary beneficiary has no use for the trust or because new laws have made the trust undesirable. Another reason might be to only distribute a portion of the primary beneficiary inheritance to the trust because of land tax considerations in States like New South Wales.  

This article is intended only to provide a summary of the subject matter covered. It does not purport to be comprehensive or to render legal advice. No reader should act on the basis of any matter contained in this article without first obtaining specific professional advice.