Tara (00:50):
Hello, I am so thrilled that you are tuning in with me today for the Art of Estate Planning Podcast and today's topic is on the tax free benefits of testamentary trusts.
(01:09):
So please don't tune out from hearing the words tax. I know it's like not the sexiest of topics, but I actually think it is one of the most incredible benefits of using testamentary trusts in an estate plan and one of the most interesting. So I wanted to use this episode to sort of lay a foundation and particularly if you are not taxi, if you do not have a tax background, but you do work in estate planning or you are curious about estate planning in this episode, I'm going to try to explain it in as simplest terms as possible because this is a real exercise for me and for all of us as lawyers because most of our clients will not be from a tax background or have any kind of interest in tax other than paying as little of it as possible. And it is a challenge for us to be able to communicate the tax outcomes and benefits for their estate plan in a way that they understand and that you don't need a tax background.
(02:17):
So let's try and do this together. I'm going to do my best to try and explain it to you and then hopefully that will set you up to try to explain it to your clients. Okay, so let's start at the very beginning, which is I'm always saying if you have an inheritance of $500,000 or more, then you should be considering a testamentary trust. And the driver behind that number is because of the tax-free treatment for minors that testamentary trusts have. So let's look under the hood of the car and well, I should say let's look under the hood of this vehicle, this tax vehicle and see how it actually works. So if we think about a company, and hopefully you all sort of have a rough idea of this, a company earns income from its activities and then it pays tax and the company just pays the tax and the money can stay in the company or they can release the money to the owners through dividends to shareholders.
(03:34):
A trust does not work that way, but I think a lot of people think it might work that way. So let's start with the very first foundational principle, which is that a trust is actually a flow through vehicle for tax purposes. So the trust earns income through, maybe it has a investment property and it receives rent, maybe it has shares or managed funds and it receives dividends. Maybe it's carrying on a business and it earns that business income, whatever it is, it earns that income and then before the end of financial year, each and every year it actually has to pay out all of that income through to the beneficiaries. So the trustee has to decide which of those discretionary beneficiaries in the discretionary trust are going to receive the income that the trust has earned and the trustee can pick and choose amongst those beneficiaries who gets the income and how much.
(04:45):
So it's not like the trust keeps all of its income. We will talk a little bit about accumulating the income when they hold onto it. But generally speaking with family trust, discretionary trusts, testamentary trusts, they all have this feature where the income has to flow through to the beneficiaries. So everything that comes in after expenses has to then come out. So what then happens is the beneficiaries who are deemed worthy by the trustee, the chosen ones who get the income from the trust then report that income in their tax return as part of their taxable income and then they get taxed on that income at their particular marginal rate. So I run the art of estate planning through a trading trust. So each year I receive a distribution from the trust and then I put that into my personal tax return and the amount that I receive from the trust goes in there.
(06:06):
I have an investment property, so if I've made a profit on that rent receiving in above the expenses on the investment property, that income from the rental property goes into my tax return. Let's say the art of estate planning wasn't my full-time thing and I also had salary or wages coming from other activities and that would also be in my tax return. And then basically you add up all the income that I have and that works out what tax bracket I'm at, and then I pay tax on that, all of that income at the appropriate tax bracket and the income that I received from the trust just gets taxed in my tax return at my tax bracket. So that's normally how trusts work. And I explained my situation where I am an adult in the eyes of the law and I receive that income and get taxed at adult rates.
(07:11):
One of the things people like to do with trust is to allocate income to children and there are a set of tax rules which apply specifically when we're allocating income from trust through to kids. So the general rule under the tax legislation is that children are described as prescribed persons when they are earning income and they look at the income that the children earn. They call it unearned income, which is kind of like a weird phrase, but I think if you think about it in the sense of if they go off and they are 15 years old and they get a job flipping patties at McDonald's, they have had to have their personal exertion to generate that income so that income is safe, that income is okay, the income where we are concerned about children, that 15-year-old being a prescribed person is where they didn't have to do anything to generate the income themselves.
(08:20):
So particularly if they're just sitting there and the trust decides to give them a distribution from the trust. So obviously that's where if it was in my case and the art of estate planning trust is earning so much money, I don't want it all to come to me because I'm going to hit that 46.5% tax bracket. I've got two kids I'm going to try and use up their tax rate and give them the income really just to minimise the overall tax that we are playing. Instead of one person paying tax at 46.5%, we might have three people paying tax at around 30 something percent. So that's what this prescribed person's rules are trying to avoid. So the general rule is if you didn't have to actually show up and put in your hard yakka to earn that income, then children can only receive $416 tax free.
(09:23):
So the tax rate on the first $416 of that unearned income they receive is 0% and then between 417 and around $1,300, they pay 66% on their income above $416. And then if anything over 1,308, I think they pay 45% on that. It's really trying to disincentivize wealthy people with their income earned through their discretionary trust just paying it out and using up their children's marginal tax rates. Does that make sense? So that's why if you have a family trust, you might see kids are getting distributions of $416 each year and then that's it. And this is a really important concept to know because testamentary trusts are treated differently. So that prescribed person's maximum of $416 per minor child is for family trusts. The real legal phrase is vivos discretionary trust. So a discretionary trust established during a person's lifestyle, but testamentary trusts get different and more advantageous tax treatment.
(10:48):
And this is where I get really excited. We go to the Income Tax Assessment Act 1936, which is a real piece of work that legislation and you'll start seeing by the legislation references. The sections are all so higgledy pty, they have literally just keep adding in things over the years. It's such a mess, but we will endure. So you can actually avoid a child being taxed as a prescribed person, which means really high tax rates over $416 and tax them as if they were an ordinary adult, which means they just get their tax free threshold of around $20,000. And then normal adult marginal rates from there if, okay, firstly, they are treated as an accepted person under section 1 1 0 2 of the Income Tax Assessment Act. So there'll be an accepted person if they have a full-time job at 30 Jude, they are a minor who is severely disabled, they're permanently blind or they are a double orphan.
(12:05):
So both parents have died. So they can not subject to this $416 cap if any of those things happen to them or if none of those things have happened to them. The income that they receive is classified as accepted trust income under section 1 0 2 Ag. So accepted trust income, this is a concept that's really important to remember. It's accepted E-X-C-E-P-T-E-D, not accepted, A-C-C-E-P-T-E-D. So like the exception accepted trust income. So if you have a look at section 102 AG, that is the one to burn into your brain as the relevant section for testamentary trust. That basically says income of a trust will be accepted trust income to the extent that the amount of income resulted from a will cosol or an order of a court that varied or modified the provisions of a will or a cosol. So that's a lot of technical jargon, but what that means is basically someone died to generate this trust.
(13:23):
This trust only exists because a person died. So we are going to give this trust a tax break when it comes to kids, okay? And this is what I love about testamentary trust. They are the only vehicle that we have in the Australian tax system that allows you to allocate tax-free amounts to children and treat them like they're adults. They don't get pinged with that $416 maximum levit. And the government is doing that because they recognise people are not setting these up as part of their general tax planning or avoidance. Somebody really died. There was a family tragedy behind this structure. So we are going to give everybody a break and allow you to just simplify things and treat the kids as if they're adults. And this is life-changing for families and I want to talk to you a little bit about it. So what that means is let's do a little case study.
(14:30):
So my husband has a testamentary trust in his will and he's got a life insurance policy of a million dollars. So if my husband dies and he sets up a testamentary trust for me and our two together and there's a million dollars of life insurance in that trust now I go see my financial advisor, he invests it for me and we get a 5% return, which is pretty conservative and that generates $50,000 in a financial year. So it's a testamentary trust, it's a flow through vehicle for tax purposes, which means the that $50,000 has to sort of come out of the trust and be allocated to the beneficiaries by 30 June. So one option is that $50,000 comes all to me and I then use it to pay for the family and everything that we do, but I'm still running the art of estate planning.
(15:42):
I'm still earning a really great income and my tax rate is really high. So what I could then do instead is allocate the income to my kids because if I allocate it to me at my really high tax rate, I'm going to be paying it at the top rates like maybe 37%, 46 and a 5% and it's on top of the income that I'm already receiving from the trust that runs the art of estate planning business on top of my investment property, all of that. So because it's a testamentary trust, I can actually allocate income to my two sons, even though at the time of recording this, they're two and five. So it's unearned income. It should, if it was a family trust, be capped at $416 to each of them and then they're paying 66% tax. But it's a testamentary trust. So the income that the trust is generating is accepted trust income.
(16:50):
The kids are not accepted persons in this scenario. They're not disabled, thank goodness they still have one parent alive. They're not double orphans, so they're not accepted persons, but we've got the testamentary trust, which is accepted trust income. So what happens is they can get about the first, at the time of recording, I'll just say at the time of recording, which is July, 2025. This is how the tax brackets are working. They actually, I think so it is a new tax year, so they might change some of the tax offsets and whatever, but based on the information I have at the moment, this is how it works. So we've got $50,000 of income, two children. The first $18,200 of income is tax free because that is our tax free threshold at the time of recording. Then we are going allocate, let's say 22,500 to each of them.
(17:55):
So the difference between 22,500 and the $18,201. So basically levelling up above our tax free threshold, they'll pay tax at the standard tax bracket rate, which is 16% so that it works out to be about $695 of tax. There's a low income tax offset of $700 they can apply. So that will offset, that's $695 of tax, meaning they won't pay any tax at all if each child receives 22,550 from the testamentary trust. So that's about $45,000. If I wanted to just distribute the whole amount to them, then I might end up paying a couple of hundred dollars tax if instead of allocating them 22,500, if I allocated them 25,500, they each might end up paying under a thousand dollars worth of tax, maybe a thousand or $2,000 worth of tax total for that. But if it was taxed solely in my name, that tax would be at my top tax bracket could be 37%, 46.5%.
(19:13):
So we are suddenly paid a lot less tax on all of that income. So that's pretty incredible. And remember that is happening each and every year when their children become adults, it still happens to them. Now they might go off and start working more having their own careers and occupations and eventually they're not going to have their full tax bracket to fill up with the trust income because they're filling it up with the income that they are earning. But while they're kids, and especially in my scenario, there's 15, 20 years potentially while especially if they go off to uni where they're not going to be earning that much, and we are getting tax-free income each and every year, which is just life-changing for a family, especially when they've lost one of their income earners and breadwinners to be able to have that inheritance, not only the underlying capital of the million dollars, but that money that they're using receiving from the trust tax free.
(20:23):
So there's just each year such a larger portion of cash available to pay for things, and that means that the money that I'm earning from my job in that scenario can be invested saved. There's just so much more money around and that is why I love testamentary trust for ordinary Australians and young couples because they just make that inheritance go so much further and have such a greater impact on families. And you know that the wealthy families, they have these testamentary trusts in place for years and years. Obviously testamentary trust are just sort of becoming part of the everyday zeitgeist in the last maybe 10 years, but they've been around for years and years and years. And the wealthy families have all paid top dollar to get these structures in place 30 years ago, 40 years ago, and have been paying so much less tax than anyone else all that time. And it's time for everyday Australians to participate in that because these are the kinds of structures that keep wealthy families wealthy, but they also give everyday Australians a fair go. So that is why I love them so much. Now let's have a little break. I want you to just absorb and digest some of that and we're going to hear from Verushka one of our clients at the Art of Estate Planning.
Verushka (21:56):
Hi, I'm Verushka Benkendorff of Maxwell and Lancaster Solicitors and I'm an estate planning lawyer. Before I started using The Art of Estate Planning Testamentary Trust precedents, I was completely overwhelmed by what to include were our precedents up to date and were they also comprehensive enough to meet the requirements for our rural community. Now that I have started using the art of Estate planning precedents, not only has my own knowledge base expanded, our time drafting has dramatically decreased and we are now offering a more tailored and comprehensive estate and succession planning framework for our clients. I highly recommend that you invest in this fabulous resource. It's a true asset to our firm now. Thank you, Tara.
Tara (22:45):
Thank you, Verushka. Now I want to just make something clear, and you might be asking this question if you've sort of been paying attention. So under 102 AG, all that is needed is that the trust was generated from a will or a cotis soul. So I've been focusing on testamentary discretionary trust, but what about those bare trusts or fixed trusts? So for instance, a basic will where a client dies, leaves everything to a child who is under 18 and basically the inheritance or their share of the inheritance is held for that child on a bare trust until they reach a set age like 18 or 21 or 25, and there's no discretion. It's just all there for that sole beneficiary. That trust is also eligible for the tax-free treatment of accepted trust income treatment. The income that is allocated to that minor is going to be tax free, but that's where it stops.
(23:51):
And the difference between the testamentary discretionary trust and those bare trusts or simple trusts for minors is that the testamentary discretionary trust, it keeps going for the life of the trust for multiple generations and for more than that single minor. So one of the common questions that comes up is does it have to be a child of the test data? And there's no requirement for that. Any minor beneficiary, any beneficiary of the trust can get the tax-free income treatment. So for instance, if you don't have children yourself or you've got a testator who doesn't have children and they want to benefit nieces and nephews, go ahead. If you want to benefit godchildren or your best friend's kids, go ahead. There's no requirement for any kind of relationship or connection with the test data. They just have to be included in the class of beneficiaries in the trust.
(24:54):
So the benefit of the testamentary trust is if we go back to the scenario where my husband touchwood dies and leaves a trust for myself and our children, is my children will ultimately inherit that trust or hopefully I'm old and I'm running it still for the family and my children have children of their own, and I can then start using the tax-free amounts to allocate the income to my grandchildren and to pay for the grandchildren's private school fees, all of their education costs. And if we want to go to my nieces and nephews and their children and any minor in that whole family who's included in the class can benefit. So it can go through to children, grandchildren, great-grandchildren, on and on and on for the duration of the trust. The trust can go for up to 80 years and some jurisdiction At the time of recording, we are looking at the 1st of August, 2025 change in Queensland to the perpetuity period, extending it from 80 years to 125 years.
(26:08):
How many generations is that? It's just incredible. So this is one of the key advantages that a testamentary discretionary trust has over a basic or simple will. And yeah, it really just has such a huge life-changing impact. I was talking to a friend the other day and we were just like, oh, the private school fees, they're are a lot each and every year and we are trying to do the best thing, but based on what is available to us at the time of sending the children to the private school and those fees are huge, and imagine if we could pay for those fees with pre-tax income, tax-free income at the moment we're earning our income, paying our tax on it and then using what's left to pay for our children, going to education, all their sports and extracurr curriculars, the piano lessons, the gymnastics, the soccer, all of it.
(27:10):
Imagine if you could use tax free income to pay for that. And I keep saying it, but it's a life changing for young families. Now I do want to mention that there are some integrity rules. So it's not just a total free for all. If you keep reading 102 AG of the Income Tax Assessment Act 1936, there are some integrity rules. There's some that have been there for a really long time. So firstly, the income that the trust earns must be from an arm's length dealing. You can't sort of just have these close relationships where you're really just trying to funnel cash through the testamentary trust to get the tax free income. So you have to look at the nature of the investments. You cannot have earned the income from an agreement whether purpose, whether direct or indirect was to secure accepted trust income treatment. Now you might think that that is who would do that, but there actually is a very famous case of first's case where they have done that and do various things. So it all has to be above board and in particular. So those integrity rules have always been there. There was a new integrity rule which was introduced to take effect from one July, 2019 in 102 AG.
(28:43):
Yeah, I told you this legislation was a mess. So yeah, two capital was introduced and they tied up the integrity provisions even further to basically limit injections into the testamentary trust of assets. So now the income in the testamentary trust has to be earned from an asset that was acquired by the trust from the estate of the deceased person's will who created the trust. Firstly, you have to have the testamentary trust in the will at the date of death. You can't really set up one after the event. There are some exceptions to that, but they are very, very narrow and they really don't work at all in the same way as a testamentary trust. So we'll just park that, but you have to have the testamentary trust in the will at the date of death. And so that's why if someone's on the fence, I would always just say, let's put the testamentary trust in the will, let's make it optional.
(29:54):
And then you've got the choice, whereas you only get one shot at this, you have to have it in there. If you don't put it in there and then you die, then it's game over. There's just no opportunity to leverage test entry trust. So put it in the will if you are ever in doubt or on the fence. So the trust needs to be in the will and then the asset going into the trust needed to be owned by the test data of the will at the date of death basically. Or there's actually, it's unclear to me if the right to receive that asset was enough and it got paid into the estate after the test data's death and then into the testamentary trust, I think that could be okay, but you'd probably want a private ruling. But just to keep this really simple first principles, the test data needed a testamentary trust in it and the test data needed to own the asset that will end up in the testamentary trust when they died.
(30:57):
Now, if you read the language of 102AG sub 2AA, you'll see that they totally recognise that assets might be sold and those sales proceeds reinvested into other assets and they let you trace it through so you can totally change up the assets in the trust as long as there's a tracing and a record that the asset generating the income originally came from an accumulation of income or capital from property that the Eder owned when they died, then you are cool. It's okay. But what that means in practical circumstances is you cannot inject assets into a testamentary trust. People go, oh, I've got a family trust and a testamentary trust. Can I just move the assets from the family trust into the testamentary trust? No, no, no, no. Not to mention the tax and stamp duty of doing that, but you will mess up your accepted trust income treatment in the testamentary trust.
(32:01):
So you can't do that. I can't just go, oh, I'd like to put my investment property into my testamentary trust. Nope, I can't do that. My husband needed to own the asset when he died. It also means we can't have these combining of testamentary trust. So back in the day, if we keep going with this scenario of my husband died, he has created the trust for myself and my children on my death, I have to create a new separate testamentary trust. Historically, people used to go, okay, when I died, I'll just pop my assets into that testamentary trust my husband created. So we've just got one combined mega testamentary trust. Keep it nice and simple. You cannot do that. I need to create a new and separate testamentary trust for the assets which I owned at the date of my death. Also, you cannot borrow in the testamentary trust.
(32:58):
Any income generated from an asset that was purchased from borrowings in the testamentary trust will not generate accepted trust income treatment. Now, the problem with this is 102AG sub 8, so where you've got some income in the testamentary trust that will be classified as accepted trust income treatment because it ticks all the requirements and then you've got other income that will be not accepted trust income because doesn't, it breaches one of these integrity provisions. You cannot just say, okay, well let's give the accepted trust income treatment, we'll allocate that towards the kids and the stuff that's not accepted. Trust income treatment, we'll allocate that towards the adults. That's not how it works. The kids or miners are assessed proportionately on all of the income. So if they get $20,000 of income and 10,000 of that is accepted trust income and 10,000 is not accepted trust income, they're going to be paying over 50% tax rate on the $10,000.
(34:19):
And what this does is it just messes up all of the accepted trust income treatment and the ability to use tax-free amounts for children. So it's really vital that we preserve the accepted trust income treatment of the assets in the trust, and we don't breach these integrity rules by trying to inject assets that the test data didn't own into the testamentary trust. So that's fine. You just need to know that this is a special tax vehicle. The accountants need to be on board in terms of the record keeping, and you just accept that what's in the trust at the establishment is what you've got to work with. And then you grow the investments from there. So you can always sell and reinvest them, but you can't just throw in extra assets. So that's probably a lot to get your head around 30 minutes or so on tax training you have done so well give yourself a big pat on the back by yourself, a special treat because you did it, you listened to all the tax stuff and hopefully that makes sense.
(35:33):
I'd gone into the sections, the legislation, I think in terms of explaining it to children, I mean to children, to clients, what all you need to tell them is the headline facts that testamentary trusts allow you to allocate tax-free amounts of about $22,000 per child each and every year of income that you cannot do with a family trust. There is no other tax structure that gives you this tax treatment. It means the inheritance will go so much further and it will mean your family will have so much more money available because of this tax environment, because you're paying so much less tax. So I just keep it high level. I don't think you need to go into it, but for anyone who asks now and hopefully you understand the background to it too. Thank you so much for tuning in, especially on a very technical topic like this. It really means so much to me, and thank you. I'll see you next week.
