Testamentary Trusts and other Strange Animals

11 Oct Testamentary Trusts and other Strange Animals

From time to time clients have approached us in relation to setting up a ‘testamentary trust’ as a mechanism for sensible estate planning.  Often this occurs following a conversation the client may have had with his or her accountant.
Clients are also often advised by their accountants to set up a family trust during their own lifetimes as a vehicle for either investment or the conduct of a business.  Family trusts are relatively common but their essential nature is often still a mystery to the client.

What is a trust?

A trust is established when a person (the settlor) transfers property or assets to another person or to a company (the trustee) to hold, not for the trustee’s own benefit, but for the benefit of another person or range of other persons.  At its very simplest a trust might be constituted where a nominee holds the property on behalf of a friend or family member who is in that case the beneficiary.  Other trusts, of course, can be a little more complicated.

The most obvious case of a trust is where, on the death of a person, his or her estate is transferred to an executor to hold on trust for the benefit of the testator’s heirs.  The estate property is vested in the executor but, naturally, does not belong to him but to the ultimate owners as beneficiaries.  Some wills set up arrangements where property is vested in the executor/trustee for many years with benefits to flow from time to time to various named beneficiaries before final distribution to the ultimate recipients.

Trusts can also be set up during one’s lifetime.  A more sophisticated example of this kind of trust is the common family trust.  Such trusts are often also called discretionary trusts because it is usually a feature of them that the trustee holds the trust property for the benefit of a range of specified potential beneficiaries, with the trustee having the discretion as to which of these beneficiaries he will ultimately pay benefits.  Obviously, this structure can be used as a mechanism for directing income to a range of specified beneficiaries, usually members of the immediate family of the person setting up the trust, with consequent tax benefits.

Another motive in using the discretionary trust mechanism is often to protect one’s assets from attack by potential creditors.  Because property is transferred into the trust it ceases to be the property of the person doing the transferring.  The property thereafter belongs to the trust.  It is held by the trustee on the terms of the trust documents, although, if the transfer was made to defeat creditors, it can be reversed pursuant to the Bankruptcy legislation.

It is important to bear in mind that a person who has settled property on a trust cannot then purport to give that property away to his beneficiaries in his will.  A will disposes of property owned by the testator and, in this case, the trust assets no longer form part of the original owner’s estate and therefore are outside the scope of his will.
In such circumstances special arrangements need to be put in place to deal with the problem.  One possible solution is for the original owner to leave an expression of wishes in which he sets out his intentions for the trust and hopes that the trustee will carry them out.  He cannot of course legally bind the trustee in this way, but from a practical point of view, this is often the best that can be done.  This expression of wishes is usually prepared by a solicitors in conjunction with a will.

What is a testamentary trust?

At its simplest, a testamentary trust is simply a trust arrangement set up in a will.  In other words, when property is vested in an executor/trustee by the terms of the will, with the benefit of that property to go to someone else, a testamentary trust in the broad sense is created.

However, usually your accountant will mean something more specific when he recommends seeking advice from your solicitor about setting up a testamentary trust; he probably has certain tax advantages in mind.
In broad terms the general rule is that trusts established for the benefit of children, grandchildren or other minors (i.e. children under 18) attract penalty rates of tax.  However, these penalty provisions do not apply to trusts set up by will.  These trusts are called testamentary trusts.  By this mechanism a minor can receive the benefit of the full tax-free threshold (currently $6,000.00) and the ordinary marginal rates thereafter on income channelled to him by a trust set up under a will.

By way of example, if a testator leaves an income stream to his wife and two surviving minor children, the family as a whole has the benefit of a tax-free threshold of $18,000.00 on income.

It is worth considering this kind of structure where your estate is sufficiently large to permit the investment of substantial capital sums over a lengthy period after the date of death, with income to be directed to minor children or grandchildren, thereby enabling the estate to obtain the benefit of the substantial tax savings.

In smaller estates, a surviving spouse may need as much of the capital as he or she can get in order to house and otherwise provide for the family and this consideration would obviously outweigh possible tax benefits on income.
However, testators with large estates and young children or testators with adult children (already well set-up in life) and infant grandchildren could well use a testamentary trust to maximise the income available for distribution among infant grandchildren.

For advice in relation to trusts, either family trusts or discretionary trusts, contact Stephen Remington.