A Testamentary Trust is an often discussed but rarely understood mechanism by which assets are inherited following someone passing away. If used correctly, a Testamentary Trust can be immensely useful, particularly regarding tax benefits and asset protection. However, the opposite also applies: heavy penalties may result if established and operated incorrectly.

There are several types of trusts, including unit trusts, family/discretionary trusts and superannuation trusts. However, Testamentary Trusts are one of the most beneficial. They intend to provide for beneficiaries long into the future and thus may be operated for many years, consequently compounding the benefits (or losses) over time.

Although benefits include asset protection and estate planning,  the most valued benefits of a Testamentary Trust relate to tax. Inter-vivos trusts (a trust emerging between living persons, rather than from a deceased estate), whilst beneficial, may fall short of the unique benefits of a Testamentary Trust.

However, authorities are increasingly cracking down on Testamentary Trusts, which makes it all the more important to know what you can or can’t do.

What is a Testamentary Trust?

A Testamentary Trust is a trust resulting from a deceased person’s estate, usually specified within their will. They only come into existence following a person’s death. Upon their passing, the executor will administer the deceased’s assets and subsequently distribute them to the beneficiaries, potentially into the Testamentary Trust resulting from the will.

It’s important to note, though, that a will does not necessarily entail, or allow for, the creation of a Testamentary Trust.

What are the tax benefits of a Testamentary Trust?

Tax benefits of a Testamentary Trust include:

  • Favourable treatment for income distributed to minors
  • Lower taxation applied to income left undistributed
  • Eligibility for the 50% CGT discount

Firstly, income from a Testamentary Trust, when paid to a minor, is generally taxed in line with the normal marginal tax rates which apply to most adult Australian employees. In addition, the tax-free threshold also applies, allowing $18,200 of income before taxation commences.

In comparison, income from an inter-vivos trust, when paid to a minor, is taxed at penalty rates between 45% and 66%.

This is a significant tax advantage of utilising a Testamentary Trust with minor children. The same scenario can also apply to other family members, particularly those who may not be working, as the beneficiaries of a Testamentary Trust are generally wide and varied.

It’s essential to remember that any assets transferred into a Testamentary Trust that were not originally bequeathed as part of the deceased estate in question will not attract this tax benefit. Income attributable to the additional assets will be taxed at the penalty rates if distributed to minor children, just like an inter-vivos trust.

Secondly, income generated within any trust is not also taxed within the trust if all income is distributed to beneficiaries within a financial year.

However, when income remains undistributed, a Testamentary Trust receives advantages over an inter-vivos trust via the manner in which undistributed income is taxed.

A Testamentary Trust will generally be taxed at standard marginal tax rates, thus being able to make use of the tax-free threshold before being exposed to the marginal tax brackets.

An inter-vivos trust, however, will instead be taxed at the highest marginal tax rate possible: approximately 45% (excluding Medicare and other levies).

Thirdly, where property of an estate is passed to a beneficiary of a Testamentary Trust, the ATO has indicated that the capital gain of the asset is not to be assessed until the beneficiary liquidates the asset – Capital Gains Tax (CGT) is not applicable upon the transfer.

Additionally, a Testamentary Trust (subject to the Income Tax Assessment Act) can utilise a 50% discount on CGT assets held for more than 12 months, a privilege not extended to company structures.

Real-life examples

Calculations can show how valuable Testamentary Trusts can be when used appropriately.

*Please note that surcharges/levies have been ignored for the below calculations.

Distribution of Income

George receives $1,500,000 as an inheritance from his late father:

  • Scenario 1: George takes the inheritance in his own name, invests the funds, and pays tax at 45%, being his marginal tax bracket.
  • Scenario 2: George takes the inheritance within a Testamentary Trust and distributes the income to himself and his wife Jane, who doesn’t work.
  • Scenario 3: George takes the inheritance within a Testamentary Trust and distributes the income to his wife and children.
 Scenario 1Scenario 2Scenario 3
Total Investment$1,500,000.00$1,500,000.00$1,500,000.00
Total Fin Year Income$75,000.00$75,000.00$75,000.00
  George (husband)$75,000.00 @ 45%$32,500.00 @ 45% 
  Jane (wife) $32,500.00 @ 0-19%$15,000.00 @ 0%
  Nick (child)  $15,000.00 @ 0%
  Elizabeth (child)  $15,000.00 @ 0%
  Paul (child)  $15,000.00 @ 0%
  Zac (child)  $15,000.00 @ 0%
Total Tax Paid$33,750.00$17,292.00$0.00
Total Income Remaining$41,250.00$57,708.00$75,000.00

As mentioned, the benefits can be significant.

Similarly, the tax benefits of Testamentary Trusts which relate to undistributed income and CGT can also give beneficiaries a tax advantage in the hundreds of thousands, if not tens of thousands, of dollars.

A Testamentary Trust has several advantageous tax benefits that can provide great value. Still, they do remain complex arrangements that are best left to the expertise of a legal professional. Given the complexity of a trust, it can be very costly to unwind the assets and structures once it has been established if done incorrectly.

At Turnbull Hill Lawyers, our Wills and Estates team have extensive experience in dealing with establishing and ongoing management of Testamentary Trusts and resolving any issues that arise.

Contact us if you’d like to ensure that you’re utilising the benefits your loved one has left behind.

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