Tax Tip 405: Injecting Funds or Assets into a Testamentary Discretionary Trust

Testamentary Discretionary trusts are one of the greatest ‘structures’ out there because the income of the trust can be distributed to minor children who will be taxed at adult tax rates.

This means someone with 4 kids could die and leave their shares to a TDT which could generate $80,000 pa in income with virtually no tax payable.

But the trouble with TDTs is that someone has to die for them to be established and that person has to have enough assets to be able to make the TDT worthwhile.

This lead to some people to setting up TDTs with $1 and then others injecting other assets into them after the person died. The laws around this changed many years ago and have been tightened up about 3 years ago as well.


Now basically cash and other assets can be injected into a TDT, but the income generated from this injection will not be ‘excepted trust income’. This means it will be taxed in the hands of children at children’s penalty tax rate.


Example

Homer dies and leaves $200,000 cash to a TDT. His daughter Lisa injects $800,000 cash into the TDT after the funeral so it has $1mil.

She then wants to distribute all of the $40,000 income of the trust to her 2 children.

Because only a portion of the trust assets derived from a deceased estate this will mean apportionment is needed for the income of the trust.

20% of the trust assets derived from Homer and 80% was injected after so only 20% of the income will be excepted trust income and taxed in the hands of children at adult tax rates. The remainder will be taxed at children’s rate of tax – up to 66%.

 

Yes care must be taken to understand the issues concerning a TDT. A discretionary trust and TDT may need to sit beside each other due to the injection limits. In some cases a fixed trust may even better provide for a fixed share of income for respective "beneficiaries". These are all issues I would generally expect a client obtains LEGAL advice at the time of addressing the will and estate matters for proper advice. There may be need to protect some beneficiary estate interests from themselves, creditors, spouses etc. A well drafted will may even allow the executors to consider all things and make these choices to optimise outcomes.

I like US laws. They allow a spouse to inherit from a deceased person and to set this inheritance aside in their trust and it isnt counted as matrimonial property in many cases. This may allow the wife to inherit from her parents and set this aside so her scumbag husband cant later take half. Its like a TDT but can be created by the beneficiary rather than the decased in their will.

 

Can new assets be bought from the income generated within a testamentary trust? i.e can a property be bought from equity dividends received within a testamentary trust?

If so, will the income generated by these new assets be able to be distributed to beneficiaries like a traditional testamentary trust?

Thanks,
WSLA

 

Yes to both - as long as the will allows it.

But there are various tax issues to consider.

 

have been looking at this and was thinking of setting up TT and using income to kids to service loan in my name and negative gear, but in reality with income from trust would be neutral, but am told that banks will not consider TT income for serviceability... i wonder if other lenders would consider?

 

It is possible for the trustee of a testamentary trust to borrow

 

Who is going to die to create the TT?

 

But would the income on assets purchased using income from the trust (and therefore not cash distributed to beneficiaries) still have a s102AG nature?

 

s102AG considers the property of a testamentary trust generating ‘excepted trust income’ is limited to:

• property originally transferred into the trust from the deceased estate;
• undistributed trust income or capital arising from property originally transferred into the trust;
• further accumulations of income or capital arising from the abovementioned undistributed trust income or capital.

If income is distributed and not reinvested then the reinvestment problem arises. But a timing where the undistributed income is invested and then produces some windfall gain prior to distribution may not pose a concern. The primary concern to s102AG is injections to the TT rather than use of the trust capital incl of undistributed income.

 

Legal Tip 318: An Individual Lending Money to a Trust of Which they are the Trustee

in this vain?

Borrow outside in own name, lend to trust, trust then buy's property?

If so, that would mean new funds and excepted income issue? I guess could keep neutral trust P&L...

aim would be to build asset base for kids, not cash flow

 

The trustee may have no legal obligation to pay interest and the loan interest is potentially non-deductible ?
Net trust income could be negative ?
Land tax issues ? Trusts tend to pay more land tax than other owners.

Is that a TT ? TTs cannot borrow and produce 100% excepted income.

 

Income generated by the trustee borrowing could still be excepted trust income in my opinion

 

The ATO’s website isnt so assurring

“Property of a deceased estate includes real property and money from the deceased estate. It can include, accumulations of income or capital from property of that deceased estate, and conversions of such property from one asset type to another. For example, if a trustee of a testamentary trust sells a rental property transferred to the trust from a deceased estate and invests those proceeds in shares, the income from those shares is income from property of the deceased estate.”

The ATO website goes another step further to provide this example:

(a) A testamentary trust is established with an initial amount of $500,000 from the deceased estate. A family trust contributes a further $500,000. The testamentary trust then borrows a further $1 million and purchases a rental property for $1.9m, with the balance of $100,000 used as working capital for the property.

(b) $50,000 is received in net rental income from the property. The minor beneficiary is presently entitled to 50% of the income, being $25,000. Of the $25,000, the excepted trust income is only $6,250 – being the extent to which the income derived was sourced from the initial $500,000 transferred to the deceased estate.

The effect of that example seems to be that if the trust received $500,000 from the deceased estate and used that $500,000 to borrow further funds to acquire a property, then only part of the income from that property would be excepted trust income. The excepted trust income would only be the income that was generated from the original contribution.

As such, it appears that if the trustee borrows from assets (which otherwise would generate excepted income) to acquire assets, then that % of assets will not generate excepted income

The above example (originally in the EM) was removed and a different example can be found on the ATO website which seems more expansive in its example- Search using QC 16509 in the site search box. This includes a borrowed element and other funds from a disc trust. Both reduce the excepted income.

But its also worthwhile to understand that a borrowing may reduce NET trust income so it is trivial and so the marginal tax rate is less a concern for a minor or other taxpayers.

 

yes I read that, hence my comment on excepted income
i am not sold on the merits of TT's, land tax surcharge here in Vic, cost to run etc.
They can be really good if selling and reduce CGT and/or cashflow from positively geared rental or other investments
my aim is to give the kids a house each, there might be easier ways like letting them live in the IP's in the future and/or sell PPOR tax free and give them the cash to buy whatever they want

 

Consider making the testamentary discretionary trust as optional in the will, to do be decided by hte executor on consultation with the individual beneficiary. Also giving a right to reside to a beneficiary can help Alleviate land tax if they are living in that property.

 

Best not to take legal advice from an ATO website which is vague.

 

if assets are provided via a will to minors in their names directly (not via a trust), income generated will be taxed at punitive rates, only way is via a TT, correct?

 

Not necessarily

 

assume as part of their will i.e deceased estate and then property in their names? Would ATO then treat this income as part of deceased estate which would not attract high tax rates?? So no need for a TT?

 

No. Inherited property income is not excepted income. The excepted income issue for a minor is that non-earned income (ie from investments) is not excepted and then subject to punitive rates. Excepted income is subject to scale tax rates and a threshold. A basis example is a 15 year old working at Maccas.

Your income if you are under 18 years old

A TT trust is one exception as tax law allows testamentary income to be excepted where it arises from a estate interest arising from death and a will that makes the child entitled to the trust income and benefits. The basis for this is to allow certain trusts to hold estate interests without costly tax harm to child beneficiaries.

There are other ways to avoid excepted income without a TT. A insurance bond is a example. The child may be a death beneficiary of the bond and only receive the benefit when they are no longer a minor. The tax will have been paid so the child is not subjected to tax or CGT. The typically receive the benefit at a age when they are mature to understand the impacts. However it exposes that benefit perhaps to loss to a divorce, bankruptcy and creditors. Or waste. eg gambling, drug addiction etc where a TT may better safeguard this.

Estate planning guidance by a solictor can address the TT and issues