A properly drafted testamentary discretionary trust is one of the most effective estate planning tools available today.
What is a testamentary discretionary trust?
A testamentary discretionary trust (TDT) is a trust established by your will.
Following your death, your estate is distributed to the TDT, rather than to individual beneficiaries, and managed by trustees who can stream the income and capital of the TDT as appropriate.
The beneficiaries of a TDT are usually your surviving spouse (if any), your children and grandchildren, and any trusts or companies in which your spouse, children and grandchildren have an interest. However, the beneficiaries of the TDT can be tailored to suit your wishes.
The trustees of the TDT are chosen by you and it is their job to administer the TDT for the benefit of the beneficiaries. The trustees have the discretion to choose whether and, if so, how much of the income and capital to distribute to the beneficiaries.
There is also an appointor of the TDT, who has the power to change the trustees of the TDT, and to decide when the TDT is to be wound up.
Advantages of testamentary discretionary trusts
The primary advantages of TDTs are as follows.
A TDT provides a mechanism by which inheritances can be protected, as far as possible, from attack in family law or bankruptcy proceedings.
Where an inheritance passes to a beneficiary absolutely, he or she has full ownership and control of the assets comprising the inheritance. While giving the beneficiary full ownership and control of their inheritance is fine if everything goes smoothly, it can be disadvantageous if things do not go according to plan.
For example, if the beneficiary separates from his or her spouse, then the inherited assets could be attacked in the course of matrimonial property settlement proceedings.
Similarly, if the beneficiary becomes bankrupt, the inherited assets can be accessed by a trustee in bankruptcy for the purpose of paying creditors.
However, where an inheritance is placed in a TDT, it is controlled by the trustees of the TDT, and is kept separate from the personal assets of the beneficiary.
The TDT provides the inheritance with protection against attack in family law proceedings, as the assets of the TDT do not form part of the matrimonial assets which are to be divided between the parties to the relationship. The existence of the TDT can be taken into account in arriving at a property settlement, but only as a resource available to the beneficiary – the TDT cannot be attacked directly by the beneficiary’s spouse.
Similarly, in bankruptcy proceedings, the assets held in the TDT do not form part of the beneficiary’s personal assets which are available for division amongst his or her creditors.
Avoiding the ‘Ferrari factor’
A TDT also provides a mechanism by which inheritances can be protected against being squandered by beneficiaries themselves.
If a beneficiary has uncontrolled access to an inheritance at a young age, he or she might not use it wisely. It might be used for purposes such as partying or purchasing fast cars – what we call the ‘Ferrari factor’ – rather than for purposes more beneficial to his or her maintenance, education and advancement in life.
By placing the inheritance in a TDT, the trustees of the TDT can exercise control over how much is distributed to the beneficiaries, when, and for what purposes. It is possible to draft the terms of the TDT in such a way as to provide that the TDT must run until the beneficiaries reach a particular age before the TDT can be wound up and distributed to the beneficiaries absolutely.
In short, a TDT can be used to provide for the needs of beneficiaries for maintenance, education and advancement while they are young, while delaying absolute control of the inheritance until they have (hopefully) matured and gained some life experience.
A TDT can also provide significant tax advantages compared to other trust structures, especially where there are minor beneficiaries.
For example, in the case of a family discretionary trust established during a person’s lifetime, Commonwealth tax legislation allows only a small amount of income to be distributed to a minor beneficiary tax-free and then any further income is taxed at the highest marginal rate.
However, in the case of a TDT established under a will, each minor beneficiary is treated as an adult for tax purposes. This means that each minor beneficiary has the benefit of the usual adult tax-free threshold, and so income of the TDT distributed to a minor beneficiary below this threshold will not be subject to tax. Further, any income distributed to a minor beneficiary above the tax-free threshold is taxed at normal marginal rates, rather than at the highest marginal rate.
Thus, by splitting the income of the TDT between beneficiaries, a substantial saving in terms of taxation can be achieved when one looks at a family unit as a whole.
Default vesting of inheritances
A properly drafted TDT contains default provisions whereby, if the TDT either cannot come into effect or fails for some reason, the income and capital will vest in the intended beneficiaries anyway. This provides a greater degree of certainty as to how your estate is to be distributed in the event that, through some unforeseen calamity, the TDT cannot come into effect or fails.
Disadvantages of testamentary discretionary trusts
The potential disadvantages of TDTs are as follows.
If income or capital of a TDT is determined to be distributed to a beneficiary and is credited to that beneficiary in the TDT accounts, but not actually paid to the beneficiary at that time, there will be an accumulated debt owed to that beneficiary by the TDT.
When the time comes to wind up the TDT and distribute the capital, the beneficiaries may find the capital substantially eroded by the need to discharge the debt, unless the beneficiary in some way forgives the TDT from the payment of the debt at that time.
Accordingly, there is a need for careful monitoring of the accounts of the TDT.
In order to obtain the maximum possible asset protection advantages from a TDT, there must be at least two trustees at all times.
The need for multiple trustees arises because, if there is only one trustee who is also a beneficiary of the TDT, then technically he or she has sole control of the TDT, and as such has the ability to distribute all of the income and capital of the TDT to himself or herself.
There have been family law and bankruptcy cases in which property held in discretionary trusts has been successfully attacked, on the basis that what appears to be a discretionary trust is in fact under the sole control of a single trustee who is also a beneficiary, and as such the appearance of discretion is just a ‘sham’.
As there should always be two or more trustees of a TDT, it is important that the trustees be chosen on the basis that they can be relied on to work together effectively in the administration of the TDT.
In the event that the trustees are unable to agree on what to do, then there may be a need for a very expensive application to be made to a court for directions as to how the trust should be administered.
Lack of case law
We have not seen a case where a TDT has been ably and forcefully contested in a court of law for many years. In other words, there are no leading cases about TDTs that we are aware of.
However, the wording of Commonwealth tax legislation as it currently stands makes it clear that TDTs are accepted and we have seen income tax rulings given by the Australian Taxation Office in favour of the establishment of TDTs.
The operation of a TDT requires a reasonable degree of control, similar to that of a family discretionary trust, with recourse to accountants, financial planners and lawyers as required. This all involves a cost.
Tax and duty issues
It is necessary to be very careful in making in specie distributions – that is, distributions of physical assets rather than cash – from a TDT to a beneficiary. Such distributions can have unintended consequences in terms of tax and transfer duty.
Where an asset is left to a beneficiary absolutely in a will, that asset can be distributed to the beneficiary in specie without either the estate or the beneficiary incurring capital gains tax or stamp duty liability.
Assets can be distributed in specie from your estate to a TDT on the same basis.
However, if it is subsequently decided that an asset should be distributed in specie from the TDT to a beneficiary, this could give rise to capital gains tax liabilities on the part of the TDT, and stamp duty liabilities on the part of the beneficiary.
We would be happy to provide you with further advice about TDTs as part of our estate planning work for you.
If you are interested in incorporating a TDT into your will, please contact Clayton Hellen of our office on 07 3009 8458 or firstname.lastname@example.org