Guide to Testamentary Trust Bypass and Asset Release

In this blog post, I am going to answer this question: How to get assets out of a testamentary trust?

To answer this question, there are two scenarios to consider. Under the first scenario, the estate is still in administration phase and the assets have not yet been contributed into the testamentary trust, while the second scenario arises where assets have already been contributed into the testamentary trust.

First Scenario: Assets Have Not Yet Been Contributed Into the Testamentary Trust

Is it possible to bypass the testamentary trust if it is ultimately determined that the testamentary trust established by the will is actually unnecessary for some or all of the inheritance?

For instance, the beneficiaries and executors have determined as part of the estate administration that they do not want to utilise the benefits of the testamentary trust (for a recap on those benefits, see our blog post “What Is a Testamentary Trust"), or the assets are not large enough to justify the testamentary trust, or there has been some radical change to the law or beneficiaries’ circumstances.

Power to Bypass the Testamentary Trust

The outcome and options available to the executor and beneficiaries will depend heavily on how the will is drafted. The Art of Estate Planning Precedents’ testamentary trust templates include a power to bypass the testamentary trust, which means that there is a mechanism for some or all of the assets to be gifted directly to one or more of the primary beneficiaries of that trust instead.

It is essential that the will drafter includes a bypass power and mechanism that is tailored to achieve the testator’s overall legacy goals, balancing their desire for flexibility and certainty.

The default approach in The Art of Estate Planning testamentary trust precedents is that the executor drives the process and must obtain consent from either the surviving spouse (if they are living and have capacity at the time of the decision) or all the primary beneficiaries who are living and have capacity to consent. It is important to clarify the consent process for incapacitated or underage beneficiaries when drafting your bypass clause.

Historically, it is not common for testamentary trust wills to include a power to bypass the trust, on the assumption that the testator has made an express decision that the inheritance should only be held via a testamentary trust.

I am personally of the opinion that it is important to build sufficient flexibility into the testamentary trust strategy. Even the most well crafted estate plan cannot factor in unexpected legislative developments and changes to beneficiaries’ circumstances.

For instance, the introduction of the foreign person surcharge land tax and stamp duties, the repeal of the Foreign Investment Review Board deceased estate exemption for estate assets, increasing superannuation balances, and the growing popularity of special disability trusts for vulnerable beneficiaries are all legitimate reasons that a testamentary trust may not fulfill its intended purpose.

Checks and Balances

Testators and beneficiaries often have different opinions on the importance of the testamentary trust.

It is common for a beneficiary who has not had exposure to testamentary trusts to feel overwhelmed by the concept of receiving their inheritance through a testamentary trust, especially if they have not had the benefit of education about the long term asset protection and tax flexibility advantages that the testamentary trust can offer. A knee jerk reaction of rejecting the testamentary trust can be a common response.

Testators’ objectives can also vary wildly. Some testators may simply like to include the option for their beneficiaries to take advantage of the benefits of a testamentary trust, whereas others may feel strongly about ruling from the grave and see a testamentary trust as a critical element to achieving that goal.

I am of the opinion that it is better for the executor to make the decision about whether to bypass the testamentary trust, rather than permit the beneficiaries to elect to receive their inheritance directly. Requiring the executor to drive the process creates space for the beneficiaries to receive advice about the advantages and disadvantages of utilising the trust.

We want to prevent a situation where we have an uninformed and overwhelmed beneficiary making this decision. Even if the beneficiaries want to bypass the trust, if the executor is not in agreement, then the beneficiaries do not have the power to do it on their own.

Another check and balance is that the beneficiaries must provide their consent. If the testator has appointed an executor who may not have all of the beneficiaries’ needs at heart (for instance, there is a blended family) then the executor cannot alone elect to bypass the testamentary trust if the beneficiaries do not agree.

Contribution to a Special Disability Trust

The Art of Estate Planning Precedents’ will templates also include an express clause confirming that the power to skip the testamentary trust can also be used for the purpose of making a distribution to a beneficiary directly, so that they may contribute the inheritance to a special disability trust established for that beneficiary.

Under section 1209(R) of the Social Security Act 1991 (Cth), a principal beneficiary has three years from the date of the testator’s death to contribute an inheritance into a special disability trust.

Second Scenario: Assets Have Been Contributed Into the Testamentary Trust

Once the testamentary trust is up and running, the only way to release capital from the trust is to rely on an express power in the trust deed to make capital distributions and/or loans to beneficiaries.

Should funds be released as a loan or capital distribution?

The most appropriate method for releasing capital from the trust will depend heavily on the purpose of the release and the long term intention for those funds. For instance, it’s common for beneficiaries to wish to use the trust capital to purchase a home or pay off an existing mortgage on their home.

Assuming the testamentary trust deed contains the necessary powers, the funds can be released from the trust as either a loan (ideally secured against the property and repayable on favourable low interest terms) or a capital distribution.

What is the difference? Once a distribution of capital is made, the family law and bankruptcy protection offered by the testamentary trust over that amount is lost forever. That amount will become intermingled in the beneficiary’s personal assets and exposed to the beneficiary’s risk.

There is also no ability to recontribute the capital back into the testamentary trust in the future to access excepted trust income treatment on any future income it generates.

Releasing the funds to the beneficiary via a secured loan means that there is still protection in the event that the beneficiary goes through a relationship breakdown and family law settlement or they are sued personally. Depending on the terms of the loan agreement, if those events happen to a beneficiary, the trustee of the testamentary trust can call on that loan to seek repayment and has priority ahead of the unsecured creditor or spouse.

Structuring the release of capital as a secured loan means the beneficiary can preserve the family law and bankruptcy protection over those sums and leaves open the door to eventually repay the funds back into the testamentary trust (for instance, on the ultimate sale of the home) to contribute to the excepted trust income earning potential without forever losing the benefits of the testamentary trust.

If there is a family agreement that a beneficiary is being "paid out" of their entitlement in the trust, then releasing the funds as an interim capital distribution may be an appropriate approach.

Winding Up a Testamentary Trust

While testamentary trusts can exist for 80 years from the date of the testator’s death (and 125 years in Queensland, and indefinitely in South Australia), it may be necessary to end the trust before the designated vesting date.

Every testamentary trust deed should include:

• A power for the trustee to nominate an earlier vesting date than the perpetuity period,

• A power for the trustee to exercise their discretion to distribute the capital to beneficiaries on the vesting date, and

• A default distribution clause if the trust has vested and the trustee has not exercised their discretion to select which beneficiaries are entitled to the capital of the trust.

The trustee should obtain tax and stamp duty advice before taking steps to make a capital distribution or vest a testamentary trust.