Tax Tip 171: An example of how Testamentary Trusts can Save Heaps of Tax

Testamentary Discretionary Trusts (TDT) set up in a person’s will can save the family a fortune in tax as well as give other benefits.


These benefits include the general benefits of a discretionary trust such as the ability to stream the income to the lower tax payers in the family. The trust itself doesn’t pay any tax if the income of the trust is distributed. The recipients of the income will pay tax at their marginal tax rates.


But with trusts set up under a will there are extra tax benefits because the income can be distributed to minor children who are then taxed as adults would be. This benefit is not available with trust set up during a person’s lifetime because children will pay penalty tax rates of up to 66%.


The tax saving can be demonstrated by a simple example comparing 2 situations of a family – with a TDT and without a TDT in the will.


Example

Bob dies with a large number of investment properties. Rental income is $80,000 per year after expenses. Bob is married and has 4 kids.


Situation A: Bob dies with a will giving everything to his spouse.

The spouse will receive the rental income going forward and it will be taxed by adding it to the other income of the spouse.

If the spouse was on the top rate of tax the tax payable each year would be $37,600.

A huge amount of tax.


Situation B: Bob dies with a will leaving everything on a testamentary trust with Spouse in control

The trustee of the TDT will receive the rental income going forward. This could be the spouse or a company controlled by the spouse.

The trustee could then distribute the income of the trust to the 4 kids - $20,000 each.

Each kid will be taxed as an adult would and can get the tax free threshold and the low income tax offset so no tax would be payable at all.

This family could save $37,600 per year in tax!


Not to mention the tax savings on CGT when or if a property is ever sold. Additionally there are great asset protection benefits if the spouse would re-partner and/or if any of the beneficiaries became bankrupt or incapacitated.

 

I presume the deceased has to set up the TDT prior to passing on?

 

No. Well yes. A dead person cannot do much but a post death testamentary trust could be set up by the beneficiaries within 3 years of the death. Very restricted though as the only beneficiaries can be those who would have been entitled to benefit under the intestacy laws. In NSW that could mean just the surviving spouse and not the children.

 

If the trustee of the testamentary trust is a company, is trustee succession governed by the
1) deceased's will,
2) testamentary trust deed
3) will of the director of the trustee company or
4) will of the shareholder of the trustee company?

Say the adult child of the deceased is director / shareholder of the trustee company, and control eventually passes to the deceased's grandchildren when they become adults.

 

Depends on who owns the shares and the constitution of the company.
Usually the primary beneficiary would be the appointor of the trust and they would set up the company post death. They would therefore control who would own the shares and the structure of the company constitution.

 

Good example of some of the complexities of a TT being created and then advice needed to ensure at that time its structure suits the parties. I have just dealt with a family implosion that resulted from trusts being badly managed just prior to and after death. Basically one member of family got nothing and two others ripped into the trust assets and almost nothing ended up in the TT despite what wills said. All while the deceased was alive under enduring POA.

 

Can a TT retain undistributed profit/income and if so what is the tax rate?

 

Yes if the deed allows it. Top marginal tax rate.
A bucket company could potentially be used instead.

 

A TT can have a tax rate of 0%. And multiple tax free thresholds each with a share of tax credits.

 

I guess I was thinking about if the TT had a one-off windfall such as a CGT event, whether the profit could be paid out to beneficiaries over multiple years to maximize their tax-free thresholds etc.
But as Terry points out, having a company hold the assets as trustee might be better anyway.

So as mentioned on one of the other threads, the will needs to allow the trustee to appoint another trustee (ie the company) ??
Q: what if the will doesn't allow for this - and the trustee is unwilling or unable to continue as trustee?

@Paul@PFI when/how would TT have 0% tax rate?

 

But this won't change the taxation aspects.

 

The will would need to allow the trustee to be replaced somehow. If it doesn't an application to the Supreme court might be needed.

 

And you DONT want the public trustee to be the one handling the issue if its the LPR

 

Can TT have classes of beneficiaries that include unborn beneficiaries at time of death?

Can TTs receive further contributions from sources other than the deceased estate?

Can one TT thats close to vesting date transfer assets into another existing TT?

 

1. yes
2. yes, but the s102AG rates won't apply to income from this.
3. yes, if the next trust is a beneficiary, but this will likely trigger CGT and the income from the transfer won't be s102AG income

 

1. It can also become a estate nightmare if not completely valid. I saw a TT that excluded new children after remarriage.Ended in very costly court action to determine what the TT meant. Court found that a child of one beneficiary was provided despite TT saying was not.
3. Unusual for a recent vesting date to apply to a TT and become a concern. Poor drafting maybe. TTs are not a 75 year old issue. Perpetuity is always a risk however. Many TTs prevent distribution to a recent trust and legal advice is best. The Reinhart case encountered that concern. But was not tested. Issue is less about risen to another TT but to any type of trust

 

How does a TT work in this scenario:

Homer passes away, and his will creates a TT for Bart, the only beneficiary at the moment. Bart is overseas, and a non-resident for tax purposes. Homer is worried that Bart will just burn through his inheritence while abroad, so wants the capital preseved for when he returns home.

The TT initially holds the PPOR of Homer and some cash. The PPOR gets sold after while and the proceeds invested in shares and interest bearing deposits.

Each year Bart gets a distribution from the TT, being some interest, some franked dividends, and some unfranked dividends. The capital is not distributed, the trust deed states that capital can only be distributed and the trust would up when Bart comes home to Australia.

How are the distributions taxed? Are they:
A: Hit by the 45% rate
B: Taxed at the normal non-resident rate of 32.5%
C: Taxed at 10% withholding for interest, franked dividends not taxed, unfranked taxed at 15% as per the DTA with the country Bart is a tax resident of

Could Bart direct some of the distributions into his super fund as concessional contributions taxed at 15%?

 

Yes that would work
trust income retains its character so it comes out as dividends etc. So the tax rate will vary depending on what the income is, C would be the answer.

Bart could make a contribution to his superfund and these would be taxed at 15% on the way in as income of the superfund.

 

Thanks Terry!
Thinking about this a bit more, if the answer is C then there wouldn't be any point making concessional super contributions. If the TT had rental income to distribute that would be taxed at 32.5%, then concessional super contributions @15% would be worthwhile.

 

The trust should't distribute to the SMSF as it could be taxed at the top marginal tax rate.