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TESTAMENTARY TRUSTS

by Michael Heraghty B. Ec, LL.M. Partner and

T r e s s Co x 1.

LAW YE RS

What is a Testamentary Trust? A testamentary trust is a trust established in a Will. A male who makes a Will is called a testator and a female is called a testatrix. Any Will which forms part of a Will (eg, a Codicil or amendment to a Will) is a testamentary document. Hence, the term `testamentary trust' has developed in relation to trusts which are set up under a Will. The term `testamentary trust' is a generic one, as there are many types of trusts which can be established in a Will. In the 19th century, testamentary trusts were very common in England and Australia, especially trusts which created life estates. A life estate involves a trustee holding property for the benefit of one person for that person's life (eg, the wife of the deceased) and then on the death of the person with the life interest, the property would be distributed to other persons (eg, the children of the deceased). It is only in the last few years that testamentary trusts have become more fashionable, mainly because of the concessional rates of tax which apply to minor children receiving income from testamentary trusts, which I discuss later in this paper. Trusts fall into 2 main categories. First, there are trusts for the benefit of a legal entity such as an individual or a company and, secondly, there are charitable trusts which are trusts set up for a purpose which is `charitable'. In this paper when I talk about a testamentary trust I will restrict myself to a trust established in a Will for the benefit of one or more individuals. This can take the form of a trust which is discretionary or fixed. A discretionary trust is one where the trustee has a discretion as to which of the beneficiaries named in the trust are to share in the capital and/or income of the trust fund. A fixed trust is one where the property the subject of the trust belongs beneficially to the beneficiary but some times the ownership of the property is delayed for the term of the trust because, for example, the beneficiary is less than 18. Most of my comments in this paper will assume that a testamentary trust is a discretionary trust. There is no great magic to the notion of a discretionary testamentary trust because a discretionary testamentary trust is merely a discretionary trust established in a Will. Over the last 20 years, discretionary trusts have become commonplace as vehicles to make investments and carry on businesses. Most accountants and financial planners will be familiar with discretionary trusts as the most popular vehicle chosen by clients for a multitude of reasons, but essentially as a well accepted tax planning structure. The role of a trustee and executor in a Will needs separate comment. The main role of the executor is to get in the assets and pay the liabilities of the deceased and this role is referred to as the administration of the estate. Once the administration of the estate is complete, the executor's duties are complete and if the Will provides for an ongoing trust rather than for property to be given straight away to beneficiaries of the Will. This is where the role of the trustee commences. The terms of a discretionary testamentary trust are contained in the Will and to a large extent, the terms of a normal discretionary family trust are very similar to a discretionary testamentary trust.

In my opinion, a discretionary testamentary trust is not suitable for all clients. The following 3 circumstances are the main situations in which, in my opinion, a discretionary testamentary trust is suitable for a client: (a) The typical husband/wife mutual Will In this situation a husband would leave all of his estate to his wife and the wife would leave all of her estate to her husband. Usually, if both husband and wife are not alive, they both then provide for their estate to be divided equally amongst their children. In this situation, for tax planning reasons, and in a situation where there is mutual trust between the husband and wife, a husband and wife could include a testamentary trust in their Wills that is discretionary in nature for the benefit of their spouse and children. I will detail the tax benefits that flow in these circumstances later in this paper. (b) Provision for a beneficiary with a disability It often occurs that the parents of a child with a disability wish to establish a discretionary testamentary trust in their Wills because the child does not have the capacity to handle financial matters. The parents could also be concerned that the child or someone close to the child should not have control of a large amount of money which could be wasted. In cases of a major handicap, the trust can have other children as beneficiaries so that surplus income can be distributed to those children and if the child with the major disability dies, the capital in the discretionary testamentary trust can be distributed to the surviving children. (c) Protection of Assets In some cases, parents are loathe to leave assets to a particular child because they fear that their relationship with their spouse or de facto spouse is such that a subsequent claim may be made by the spouse or de facto spouse if the assets are left directly to the child. Protection against the child's bankruptcy can also be a factor. These circumstances need to be very carefully considered as, in my opinion, a client should be made aware that at some stage the degree of control which a person seeks to exercise in relation to their assets after their death, may lead to the accusation that they are `ruling from the grave' or `telling their children how to lead their lives'. There are two further estate planning trusts which I deal with in this paper. The first is a superannuation proceeds trust and the second is an estate proceeds trust.

2.

Income Tax Division 6AA of Part III of the Income Tax Assessment Act 1936 (C'wealth) (`the 1936 Tax Act') was introduced in 1980 to overcome the use of minor children in reducing family income tax by splitting income from trusts with those children. Prior to the introduction of Division 6AA family trusts were conducted on the basis that children as young as 1 and 2 years old were receiving a full share of income along with other family members. In those days the children paid income tax according to the normal rates payable by an adult so that the family could take advantage of the different marginal rates and the tax free threshold for each family member.

Division 6AA sought to overcome this income splitting practice adopted by families. Division 6AA provides that only certain types of income derived by particular types of individuals pay tax according to the normal marginal rates payable by adults. If a child less than 18 years does not fall within one of the exceptions outlined in Division 6AA, a penal rate of tax applies. There are various types of individuals exempted by Division 6AA but the starting point and most relevant for this paper is to assume that we are dealing with a child who is less than 18 years of age as at 30 June of the relevant year. Section 102AG is the Section which defines `excepted trust income' which is income falling within one of the exceptions in Division 6AA so that the normal adult marginal rates and tax free threshold apply to income derived by a person from that trust. The particular provision relating to testamentary trusts is Section 102AG(2)(a) which provides as follows: `Subject to this Section an amount included in the assessable income of a trust estate is excepted trust income in relation to a beneficiary of the trust estate to the extent to which the amount: (a) is assessable income of a trust estate that resulted from: (i) a Will, Codicil or order of a court that varied or modified the provisions of a Will or Codicil; or an intestacy or an order of a court that varied or modified the application, in relation to the estate of a deceased person, of the provisions of the law relating to the distribution of estates of persons who die intestate.'

(ii)

Division 6AA in its application to testamentary trusts provides that if a child less than 18 years of age receives income from a trust set up in a Will, then the adult tax free threshold and marginal rates of tax apply to that child. The provisions of Section 102AG(2)(a) which refer to the variation of a Will or Codicil (this is an amendment to a Will) by an order by a court in relation to a person who died intestate (ie, a person who dies without a Will) refer to the power of the court to vary the terms of a Will or the normal rules on intestacy under the Family Provision Act. I deal with the Family Provision Act later in this paper. It is best if I give a simple example assuming the tax rates which apply are those applicable to the 2006/2007 tax year, ignoring the Medicare levy. Assume a married man provides in his Will that the whole of his estate is to be left to his wife as trustee of a discretionary testamentary trust with the beneficiaries of that trust being his wife and their 3 minor children. If that man dies leaving an estate of, say, $1 million, which is invested so that it returns 10% during the 2006/2007 tax year, then the result would be as follows:

Beneficiary Wife Child 1 Child 2 Child 3

Taxable Income $25,000 $25,000 $25,000 $25,000 $100,000

Tax Liability $3,360 $3,360 $3,360 $3,360 $13,440

The total tax bill for the family is $13,440 because each family member gets the benefit of the $6,000 tax free threshold and then that income between $6,000 and $21,600 is taxed at a marginal rate of 15% and the balance of income between $21,600 and $25,000 is taxed at a marginal rate of 30%. If the testamentary trust had not existed and the husband had simply left the whole of his estate to his wife and the wife then invested the $1 million at 10% per annum, the wife would pay tax of $29,460. In this simple example there is an annual saving of $16,020 in the family tax bill as a result of the testamentary trust being established instead of the normal Will in favour of the wife.

3.

Protection of Assets Discretionary trusts have long been used as a means of protecting assets. There is clear authority that the interest of a discretionary beneficiary of a discretionary trust does not amount to a proprietary interest and in that sense, from the point of view of, for example, the Bankruptcy Act, the discretionary beneficiary does not own any property. When death duties applied in New South Wales and at a Federal level, discretionary trusts were used frequently to minimise death duties relying on this principle, although there were many anti-avoidance provisions introduced over the years to overcome some of the arrangements which were implemented. The usual circumstances in which protection of assets is a factor in a testamentary trust is a fear that a beneficiary may become bankrupt or might be the subject of a claim under the Family Law Act or the Property (Relationships) Act. A discretionary testamentary trust will give some added protection to an individual beneficiary if a claim is made against him or her under any of those Acts. For example, if a child of the deceased person goes bankrupt, then if his or her only `interest' in his or her father's or mother's estate is as a discretionary beneficiary of a testamentary trust, then there would be no `property' which the Trustee in Bankruptcy could seize in the event of his or her bankruptcy. Likewise, I suggest that added comfort would be given to a person facing a claim from a spouse or de facto spouse under the Family Law Act or the Property (Relationships) Act if their only interest in their parent's estate is as a discretionary beneficiary of a testamentary trust. As I have said previously, these propositions are very much generalisations as the particular circumstances of each case and some of the anti-avoidance provisions of those 3 Acts may well overcome the use of the testamentary trusts in some circumstances. For example, it may well be that if the conduct of the trustees over a number of years has been to distribute a set amount of income to a particular beneficiary, then I would venture to say that under the Family Law Act and the Property (Relationships) Act that those circumstances would be a factor to be taken into account by a Judge in making an order in a property and/or spouse or child maintenance dispute.

4.

Beneficiaries with a Disability In my experience, a typical situation which arises where a discretionary testamentary trust is relevant is where a child suffers from a severe form of disability, eg. schizophrenia, and the parents of the child are concerned that the child will be properly looked after their death. At the same time, the parents are concerned that if a large amount of their estate is given to the child without any restrictions or conditions, the child may fritter away his or her inheritance and be left destitute and/or the child may fall under the influence of some other person who assists the child in frittering away their inheritance. Discretionary testamentary trusts in these circumstances have existed for many years and those circumstances are obviously a case where a discretionary testamentary trust is bordering on the mandatory. I will give you an example of a situation which may apply to a particular family. Assume that there is a husband and wife in their mid-50s who have 4 children, one of whom suffers from severe schizophrenia. The 4 children are all over 18 years of age. In normal circumstances, the husband and wife would make a mutual Will leaving all of their estate to each other and then provide that their estate would be shared equally amongst the 4 children if their respective spouse was not alive when they died. In these circumstances, the parents are obviously concerned that a person with a major disability may not have the capacity to handle a large amount of money and a discretionary testamentary trust in favour of the child with the disability could be established in respect of ¼ of the estate with trustees to administer that trust. It needs to be considered whether the majority of trustees are family members, especially those members of the family who might otherwise benefit under the discretionary testamentary trust, eg. the other 3 children, so that someone independent may make a decision as to what is an appropriate amount of income and/or capital to be distributed from the discretionary testamentary trust for the benefit of the child with the disability. The trust may also provide that the other 3 children and their children are beneficiaries so that in the event that the income generated by the trust is more than is needed to maintain the child with the disability, then the trustees have the discretion to distribute that surplus income to the other 3 children or their children. In the event of the death of the child with the disability, the capital remaining can be distributed to the other 3 children or their children. The circumstances which apply vary in each particular case and the nature of the disability needs to be taken into account as well.

5.

Memorandum or Letter of Wishes In any case where a discretionary trust is established, whether that discretionary trust is a normal family or trading trust or a testamentary trust established under a Will, it is very important for the person who creates the trust to leave a Memorandum of Wishes giving guidance to the trustee on what their wishes are in relation to the distribution of capital and income of the trust. Say, for example, in the situation outlined above of the husband leaving a wife and 3 young children, the Memorandum of Wishes would probably indicate that it is the wish of the husband that his wife would take the benefit of the whole of his estate, but for family reasons some of the income might be distributed to his children. In this way, the husband leaves no doubt in the mind of the trustee that the discretionary testamentary trust is a means to achieve

the best end result for the family and the overriding concern which should be taken into account by the trustee is that the wife of the deceased is to receive the benefit of the whole of the estate. Likewise, in the case of the schizophrenic child, detailed instructions can be included in a Memorandum of Wishes as to the care of the child and the amount of income to be applied for that child and other particular matters of relevance. A Memorandum of Wishes is so called because the document is not legally binding on the trustee but merely an expression of the intention or wishes of the person concerned. The trustee can ignore the Memorandum of Wishes, but of course the mere term `trustee' implies that a person has been put in that position by the deceased because the deceased trusts that person. If the Memorandum of Wishes contains material which the deceased requires to be kept confidential, then that can be achieved as well. 6. Family Provision Act It comes as a surprise to a lot of people that someone dissatisfied with the amount left to them in a Will may be able to challenge that Will under statutes such as the New South Wales Family Provision Act, if they fall within a limited category of persons. When you hear of someone `challenging' a Will, that usually refers to a dissatisfied relative of the deceased making a claim under the Family Provision Act. There is a limited category of people who may make claims under the Family Provision Act. A claim involves an application to the Court to vary the entitlement which the applicant received under the Will. Evidence is produced to the Court of the relationship between the applicant and the deceased, the financial resources of the applicant and other relevant matters so that ultimately a Judge determines whether in all the circumstances the deceased had a moral obligation to provide for the needs of the applicant and adequate provision has been made for the applicant in the Will. Say, for example, a man has had a mistress for many years unbeknown to his wife and when he dies, the wife finds that her husband of 40 years leaves the whole of his estate to his mistress. The wife would have the right to commence an action under the Family Provision Act seeking an order from the Court that the Will be varied so that she became entitled to some part, if not all, of the estate of the deceased. Of course the circumstances surrounding the case will determine how much, if any, of the estate the wife receives. In these circumstances, the legislature felt it right that people such as spouses, children, ex-spouses, some dependants and others should have a right to make a claim on the estate where they are dissatisfied with their bequest because of the special relationship between themselves and the deceased. The categories of people who can make a claim under the New South Wales Family Provision Act are as follows: (a) (b) (c) the spouse, de-facto spouse or same sex partner of the deceased; a child of the deceased; a person with whom the deceased person was living in a domestic relationship at the time of the deceased person's death; a former spouse of the deceased;

(d)

(e)

a person who was at any particular time wholly or partly dependent upon the deceased and who is a grandchild of the deceased or was at that particular time or any other time a member of the household of which the deceased was a member.

The category (e) applicant does not have to have any particular relationship to the deceased, but merely needs to show that they were a member of the deceased's household and at that time were dependent upon the deceased. One point in passing which needs to be borne in mind is that there is provision in the Family Provision Act for a person to give up their rights to make a claim under that Act and this normally occurs where a couple divorce. Part of the finalisation of a divorce usually involves the execution of a Deed by the husband and wife whereby they each agree to give up any claim against the other's estate. This sort of Deed is not automatically effective. A specific Court order under the New South Wales Family Provision Act is the only effective way to release the deceased's estate from a claim by an ex-spouse. As you can see from the wide category of people who are entitled to claim under the Family Provision Act the fact that a testamentary trust is a discretionary trust, means that, particularly with adult children, there is fertile ground for a dissatisfied person to mount a claim under the Family Provision Act if they are dissatisfied with the income and/or capital they receive from the trustee of the trust. This is the reason why I consider that the situations in which a discretionary testamentary trust is advisable are limited. You can imagine that if I adopted, as a solicitor, a practice of preparing a Will for every client so that it incorporated a discretionary testamentary trust without regard to the circumstances, this might lead to many claims under the Family Provision Act. For example, a dissatisfied child might argue they should have been entitled to a fixed equal share of the estate rather than a delay occurring before they became entitled to their share. In addition, because the trustee has a discretion as to the amount of income and/or capital which a beneficiary receives, family jealousies and examples of inequitable treatment could lead to claims being made under the Family Provision Act. Accordingly, one needs to be very careful of the circumstances in which a discretionary testamentary trust is recommended to a client and in every case in which I prepare such a trust, as with any Will, I am at pains to explain to the client the provisions of the Family Provision Act and the categories of people who are able to make a claim under that Act. 7. Superannuation Proceeds Trust A superannuation proceeds trust is a trust that is specially drafted to receive superannuation benefits in the event of the death of the member. The circumstances in which such a trust is an appropriate estate planning vehicle is when a superannuation fund member has died and it is determined that it would be preferable for the superannuation proceeds to be paid into a trust and held on behalf of the beneficiary or beneficiaries concerned. The main advantage of a superannuation proceeds trust is that income which flows to a minor beneficiary is classified as `excepted trust income' and consequently minor beneficiaries are entitled to the tax free threshold and taxed as adults in accordance with the normal marginal tax rates applying to adults in the same way as for a testamentary trust. Superannuation proceeds trusts are governed by Section 102AG(2)(c)(v) of the Tax Act.

When a member of a lump sum superannuation fund dies the Trust Deed usually provides that the trustee of the superannuation fund has a discretion to pay the member's benefit to one or any number of the dependants of the deceased or to the estate of the deceased. If the trustee of the superannuation fund determines to pay the whole or part of the deceased member's benefit to a trust for the benefit of a minor dependant of the deceased then income flowing to that minor from the trust would be taxed as if the minor was an adult. One particular restriction on superannuation proceeds trusts is the capital requirement contained in Section 102AG(2A) of the Tax Act. That Section provides that the concessional tax treatment applying to `excepted trust income' can only apply if the terms of the superannuation proceeds trust provide that the trust property vests in or will belong to the beneficiary or beneficiaries when the trust ends. A trust of this nature would normally end when the minor beneficiary turns 18. Superannuation funds restrict payments on death to the estate of the deceased member or the dependants of the deceased member, so a superannuation proceeds trust is usually only applicable where it is established for the benefit of minor children of the deceased.

8.

Estate Proceeds Trust An estate proceeds trust occurs where a person has received a gift under a Will and within 3 years after the death of the deceased, transfers part or all of the property represented by that gift to a trust for the benefit of a minor. Section 102AG(2)(d)(ii) of the 1936 Tax Act provides that income flowing to a minor from such a trust is `excepted trust income' and like testamentary trusts and superannuation proceeds trusts, the minor is taxed in the same way as an adult in relation to that income. Again Section 102AG(2A) of the 1936 Tax Act provides that the assets of the trust must belong to the beneficiary when the trust comes to an end. There are restrictions on the level of assets that can be transferred to an estate proceeds trust. The amount is effectively limited to the amount that the beneficiary would have received had the deceased died without a Will. If a person dies without a Will then the relevant State legislation sets out a formula on how the estate is to be distributed upon the death of that person. In general terms where a person dies without a Will in New South Wales leaving a spouse and children then, except for special rules dealing with the matrimonial home (which passes to the spouse), the first $200,000 of the estate passes to the spouse and the remainder is split 50% to the spouse and the remaining 50% amongst the children. If a man left the whole of his estate to his wife, the wife could, within 3 years of his death, transfer to a trust for the children part of the amount she receives from the estate and income flowing to the children may qualify as `excepted trust income'. The 2 main requirements are, firstly, that the amount transferred to the trust is no more than the amount that each child would have received from the estate had there been no Will and, secondly, the child must be entitled to the assets of the trust when it comes to an end.

For further information please contact: Michael Heraghty Partner TressCox Lawyers 135 King Street SYDNEY NSW 2000 Business Direct: Mobile: Email: (02) 9228 9208 0410 347 936 [email protected]

1 September 2006

Copyright in this Paper belongs to Michael Heraghty and it cannot be reproduced, copied or used without his written consent © 2006 Michael Heraghty

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