Legal Tip 215: Strategy of Borrowing from a Testamentary Trust instead of Winding it Up

Testamentary Discretionary Trusts (TDT) are the best sort of trust out there, but someone has to die for them to come into existence. So, they are relatively rare. Also, the capital of the trust has to come from the deceased for the extra tax benefits to work (excepted trust income).


So, I cringe when clients approach me wanting to wind up a TDT that their parent has left them in control of.


Their idea usually goes something like this. I have a $1mil loan on my main residence and the trust holds $1mil worth of assets. If I wind up the trust, I can pay off my home loan and save interest.


It is a valid point, but once a TDT is closed it can’t be reopened again, and even if kept open new capital can be injected, but income generated from it would not qualify as except trust income and would not get the concessional tax treatment in the hands of children.


There is a simple way around this though, and that is to get the trustee to make you an interest free loan.


Example

Bart’s dad Homer dies and leaves $1mil to a trustee of a TDT set up under his will. Bart has a $1mil home loan so winds up the trust and pays off the loan.



Lisa is in the same position, but she controls a separate, but identical trust. Lisa gets the trustee to lend her $1mil interest free which she uses to pay off her loan. She has not no deductible debt now. So, she uses the $3,000 she was paying the bank each month to pay back the trust.

The trust now has money with which to invest. The income from these investments can go to Lisa’s children tax free – because they can each earn $20,000 pa tax free so it will be ages before the trust’s income is more than this.

Meanwhile Bart is making the same investments as Lisa, but he receives the income himself and is taxed at 47%



Over the next 15 years or so Lisa would have probably repaid the full $1mil back to the trust so it is now generating about $40,000 per year in income which comes out tax free to her kids.

Once the kids start working, she will have to reassess where the income goes, but until then there are huge savings.


Tip – Don’t wind up a testamentary trust without careful consideration and legal advice.

 

Great example @Terry_w.

Slightly off topic, but is it possible for the Trust to borrow money (eg from a separate Discretionary Family Trust), invest this money and the proceeds from this borrowed money still be distributed to minors using the tax free threshold? Or would this be treated in the same way as an additional capital injection?

 

The TDT can borrow to invest with the income diverted to minor children at adult tax rates, but there are various anti avoidance measures in the legislation (s102AG) so any loans need to be on arm's length terms (to get the minor children tax benefits) sot he trustee should seek legal advice.

 

Does this also apply to minor children or only those over 18?

 

any children or other beneficiaries
but minors are good because they usually don't have any other income from working or investing.

 

Thanks @Terry_w - family members looking at this now. Provision for a TT is in the will but only a few $K in the estate able to go into the trust so it would need to access additional funds from somewhere to make it worthwhile. Will make sure specific legal advice is sought before locking anything in.

 

has the testator already passed?

It might be possible to make a trust distribution to them before the testamentary trust comes into existence.

 

Testator has not passed, however the TT would only be for the benefit of the family of one son (my father who has 3 brothers). I expect making a substantial distribution now may require the will to be re-done to ensure this distribution is not pooled into the estate to be divided between all the brothers. There are also issues of impacting the pension and not wanting his Mum to spend the $ before she dies.

Personally I think that in this situation, the potential benefits of the TT may be outweighed by the potential negative impacts on family relations. As it's not my $, I can only offer what I feel to be sensible suggestions...

 

in that case it might be better not to increase the wealth of the testator where it could go to other family members.

But i have done it once for a client where son A gifted large sums to mum and mum changed her will to make that money and its earnings go to son A and then the rest was split evenly between Sons A and B. the mum did die about a year after the will was made and all went according to plan.

 

Should/can a TT have a corporate trustee?

In the famous words of Monty Python

 

Yes the TDT would ideally have a company as trustee, but this can be set up after death to save money.

 

What happens if parents own a PPOR house and one investment property and both of these properties pass on to the Testamentary Trust? Will there be NSW stamp duty, capital gains tax and/or land tax applicable when it goes to the Testamentary Trust?

 

There are no stamp duty or taxes when assets pass into a testametnary trust.
Going forward there will be land tax considerations, but if there is a live interest in a property and the beneficiary live in it as their PPOR it might be classified as their main residence in NSW for land tax purposes. It would also potentially qualify for the main residence exemption for CGT.

 

Bit of a side question. Do Testamentary Trusts have Appointors? And does the will have to name the Trustee (even if it's a new company created as part of the estate proceedings) or can that be left to the Executor?

 

Depends on how it is set up.

I think it is a good idea to have appointor(s) in discretionary trusts. And the trust certainly needs a trustee, but it can be the primary beneficiary or the appointor who can then appoint a company

 

I know the thread specifically says Testamentary *Discretionary* Trust, but can a TT be set up
as a UT? Probably a good way to avoid family feud in the future.

Rgds,
FXD

 

Yes it can.
Could have the units owned by separate TDTs too.

 

Hi Terry. If you were wanting to borrow from the testamentary trust for investment into an asset such as a business or property, does the loan have to be interest free? If so, how does the trust earn an income that can be paid back to minor children? Thanks.

 

Can be at market rates