Tara (00:51):
Welcome to episode 46. I am Tara Lucke, founder of the Art of Estate Planning. Thank you so much for tuning in today. Now our topic for today was actually inspired by a question in one of our weekly hot seats for the TT Precedents Club.
(01:09):
So you've probably heard me mention it before. Every Thursday in the TT Precedents Club, we get together and we have a live Zoom call and people can ask questions for myself or the other members in the club on the call to answer and it's a real brains Trust mastermind. We've got people of all different experience levels, no question is too silly and it is just such a supportive environment and one of these questions came up and I just thought it was a great one to just talk about generally as well.
(01:45):
So the question is: My clients who have engaged me to prepare their wills, they already have an existing family trust. So do I need to set up an additional testamentary discretionary trust for them or can we just leave everything into the family trust that's already in existence?
(02:06):
And it's such a fair question and I can definitely see that many clients would ask this as well because they're like, why would we reinvent the wheel? We already have a trust. So I thought in this episode we can compare the difference between an inter-vivos family trust and a testamentary discretionary trust and look before we go into the differences, there are some major similarities between them both. They're both discretionary trusts, which means the entitlement to receive income and capital from the trust of the beneficiaries that is at the trustee's discretion. So the beneficiaries just sit there on their hands waiting patiently, behaving themselves, waiting for the trustee to choose them to receive some income and capital that year.
(02:56):
So it is fully discretionary at the discretion the trustees, but there are some other differences and I guess I'll just spoil the ending in that you definitely should set up an additional testamentary trust rather than using the family trust already in existence. And that comes down to managing risk, but particularly the tax treatment. So in episode 45, we talked about accepted trust income treatment and how testamentary trusts get a tax treatment that is not available in any other type of legal structure in Australia. It is truly special. The government recognises that somebody died for the testamentary trust to come into existence and you only get this special tax treatment with a testamentary trust and it's particularly advantageous over existing family trusts. So let's perhaps start there. Okay, so with the accepted trust income treatment for testamentary trust, minors are taxed as adults. So that means they get their full tax free threshold of about $18,000 at the time of recording and then the marginal rates from there.
(04:22):
So at the time of recording this, miners can get about $22,500 tax free of income from the testamentary trust. That's each minor each year under the family trust, miners have to pay penalty tax rates over $417,000, 4-1-7 compared to $22,000 and the tax rates are different with the testamentary trust when they earn over that $22,500, it's just like a 16% tax rate I think on the income above that. And then it steps up like the normal tax rates with the family trust. Everything above the 417, it's about 66% tax and an extra 50% tax penalty until they get to about 1300. And then from there I think it's like 46.5%. So there's no way that you would want to distribute income to mins from an existing family trust. So the starting point is the tax treatment of the testamentary trust is just so much better.
(05:35):
One other thing that I didn't talk about in episode 45 is about accumulating income. And I got to the end of that episode and I thought I probably should include it, it's relevant, but I thought everyone had enough about tax, so I'm going to talk about it now. In the episode 45 I explained that trusts, whether it's a family trust or a testamentary discretionary trust there will flow through vehicle for tax purposes unlike a company. So like the company earns its income, pays its tax, and then the money just stays in the company unless they choose to release some profits through dividends or pay out a loan or something. But trust the status quo or starting point is that the income is allocated and all of it is distributed out by each financial year. So everything that comes in less the expenses goes out of the trust.
(06:33):
It doesn't hold on and retain profits or income. And the reason historically is because accumulated income in a family trust is taxed at the trustee's penalty rate. So you don't do it because it's a penalty like top tax, right? But cemetery trusts do have special treatment where under section 99a sub 2, you can actually apply to the commissioner to exercise their discretion that it would be unreasonable for the income accumulated to be taxed at the trustee's top marginal rate. So it's not just a standard, you are straight up entitled, but if there were genuine reasons why, then you have the option to apply to the commissioner and get it. I think you do it through a private ruling. I've not actually ever had to go through that experience myself, but again, you have the potential to accumulate income in the testamentary trust that you do not have under a family trust.
(07:47):
So on all measures, the testamentary trust just blows the family trust out of the water when it comes to tax treatment. They are just so far superior and they are a very special vehicle. Not everyone can get them. You can't just go and set up a testamentary trust now to operate straight away, right? I'm sure you will know this, but just to make it abundantly clear, the testamentary trust is in the test, data's will, it has to be in there when they die, you put it in the test, data's will when they make their will, it is dormant. Nothing happens, it doesn't exist. It's just lying there dormant or sleeping, waiting to be enlivened and commence when the test data ultimately dies. So you cannot just go and go, oh, I'm going to go off and see an accountant and set up a testamentary trust.
(08:43):
Doesn't work like that. They only can start when somebody dies. And because of this connection with such a tragic event of a person's death, that is why we get the tax treatment. So you only get one shot at having them for each person. They only get one chance. It has to be in their will before they die. Obviously you can have as many as you want, but if you don't get around to doing your will and you die, then that's it. You lost that opportunity versus a family trust, you can go and set up 10 each day if you like for your whole life. There's no limit on anything like that. So testamentary trusts are a very special protected vehicle. So if you get the chance to do one, absolutely go for it. Especially the advice I'd be giving to the person who asks this question in our hot seat because they use the art of estate planning precedents and our precedents have a pathway in there for the testamentary trust to be optional if it turns out they don't need it at the date of death.
(09:43):
So at that point I'd say plan for all the contingencies, better to be safe than sorry, put the testamentary trust in the will. So a couple of other differences. I've actually got in the show notes, a flyer that you can download just comparing the family trust with the testamentary trust. So a few other differences, they're set up by different documents. So if you're familiar with a family trust, you'll know that they're set up by a trust deed or they should, a good one should have trust deed with all of the terms. The testamentary trust doesn't usually have a separate trust deed. It's actually the will of the test data, which is the trust deed. In terms of the vesting date, the family trust will start from the date of establishment, whereas the test symmetry trust it too does start from the date of establishment, but that will be the date of the test date's death, not the date that the will was signed.
(10:45):
So in this scenario, for instance, our family trust that our clients already have its vesting date is already sooner. It's always going to be earlier than the vesting date of the testamentary trust. So it's perpetuity period, and let's say it's 80 years, it is already starting. Imagine a clock ticking down or an hourglass. We're already every day that hourglass is getting lower and lower and lower in terms of the sand and that perpetuity period running out. Whereas with the testamentary trust it's on ice. It doesn't start ticking down until the test data actually dies. And remember with our tax treatment and our asset protection, this is not just for one generation. These are ongoing wealth accumulation vehicles for multiple generations. They're so powerful. So the longer we can have our trust running and operating, the more tax that whole family and bloodline saves, the more protection they have over their assets.
(11:54):
So for me, having that vesting date, starting ticking down at a later date and putting it on ice for now is really powerful. Our tax treatment for minors is different. Accumulating income is different. They are both required to make a family trust election, though that's also relevant to look at in terms of what are we inheriting with the trust. So this family trust, it's already in existence. It might already have made decisions about its assets, its contracts in dealings with third parties. Its tax position that may not actually be something we want to inherit or pass on or contribute more assets to. So for instance, with the family trust election where you have, I think franking credits more than $5,000 or you want to carry forward tax losses, I'm just going off the top of my head here, so there could be other reasons. You need a family trust election.
(13:03):
You have to make an election to limit the people who can receive distributions from the trust. So they basically say you have to nominate a key individual and anyone in their family who's related to them, only those people can receive distributions from the trust and anyone outside of that family net will pay an additional tax. So it's usually fine because it goes down to the whole bloodline and the lineal descendants, which is what most people want to do with these trust structures. The idea is it's sort of to stop you from selling the trust to an completely unrelated person and changing up the beneficiaries and basically selling the trust out of the family group. But with older trust, it might be that this existing family trust named someone who is the grandfather or a person who is deceased or something as the key person from which the family group is radiating around and in however many years time, 20 years time or something, it would actually make sense to name a different person, a younger person to be in the key person for that family group.
(14:27):
So look, I don't know, it's not something that comes up all the time, but my point is we are inheriting decisions made in this existing family trust rather than getting a clean slate. On that same note, what is the terms of the trust deed? Has this trust been going for 10 years? Have there been progress in terms of how we draught our trust deeds in that 10 years time? That would make more sense. Are there actual errors or problems in that original trust deed? Like if I am doing anything with a client's family trust and putting more assets into it, I want to go through the terms of that trust deed with a fine tooth comb and make sure there is absolutely no problems, issues, validity concerns, drafting errors, anything like that that I'm happy with the variation power. I'm happy with the default capital distribution that there's just absolutely nothing wrong with that trust deed because why would you exacerbate if there is a problem, why would you exacerbate it by injecting all the inheritance into it as well.
(15:41):
So it sounds simple. It's actually I think from the lawyer's perspective, more work to do a basic will that gives the assets into an existing family trust than it is to do a testamentary trust, especially if you've got your precedent dialled in with your software integration. Like at the art of estate planning, we integrate with Leap, Actionstep, Smokeball, Clio. So generating a testamentary trust will, that's not the hard part. The hard part is the client strategy. So the hard part when you're gifting to a existing family trust is doing an extensive audit of that family trust. All the changes of trustee, all the change of appoint or successions of control, are those all squeaky clean and in order are the beneficiaries correct? The other thing to think about too is what has that trust been doing? Has the trust just been holding passive low risk assets or does it own risky assets like property, commercial property?
(16:47):
Is it running a business and if it has any exposure to risk, do we want to be throwing and injecting in passive low risk assets in there? The other thing to think about is what about super? And we have to be really careful if the estate includes super to be injecting that into a trust because if the beneficiaries who could have received that super people who are death benefit dependents and could have received it tax free if they had received it outright from the super fund, but they're going to receive it through a trust, then what we actually need is a super proceeds trust that narrows down the range of beneficiaries of that trust to only people who are death benefit dependent for tax purposes at the date of death. So that will not be the case if you're putting the super into the family trust, you'll pay tax on it that you wouldn't have paid if you'd paid it to a super proceeds trust or directly to the beneficiaries of the super fund.
(17:59):
So there's a lot of things going on there. I would not put an inheritance into a trust that had ever carried on a business or owned commercial property or anything like that because we are mixing our risk profiles of assets and there's a huge advantage in having a clean skin fresh slate for those low risk passive assets. So yeah, be really cautious of those historical issues, especially if the clients are driving this because they want simplicity. It's actually not as simple as it sounds. I think there's actually quite a few concerns.
(18:36):
So I'm just going to take a break there. I'd love for you to listen to one of our clients, Jono, and the beautiful things he has to say about the art of estate planning.
Jono (18:46):
Hi, my name's Jono and I'm a co-founder of Balanced Family Law based in Canberra. A few years ago we decided to invest in the art of estate planning wills and testamentary trust precedents to expand our estate planning service offering to clients and it's been one of the best investments that our firm has made. The precedents are really easy to use from a drafting perspective and also when it comes to advising clients and they're also really easy to use when training staff. We receive lots of positive feedback from our clients on the documents as well as from other professionals like financial planners and accountants. The precedent pucks provide not only will's, precedents, but also template letters, file notes and other documents that you'd need in your estate planning practise and allow us to provide simple and complex estate plans to clients really easily, especially ones that include testamentary trusts. The art of estate planning also offers other precedent packs for letters of wishes, family trust, succession and company, self-managed super fund and trust powers of attorney, all of which we've invested in and have been really good for our clients and our firm. Investing in the art of estate planning precedence, as I said, is one of the best decisions our firm has made for our estate planning practise. So if you've been toying with the idea of doing so, we highly recommend that you do.
Tara (20:15):
Thank you, Jono. So I've talked about the considerations in terms of your strategy, but now I want to talk about the drafting considerations. So let's say you've considered everything and you have decided that yeah, we are going to use like a basic will and gift the inheritance into an existing family trust instead of using a testamentary trust. So here's a few things to think about in terms of your drafting. So do your clause to draught it. I recommend in the TT Precedent's Club in our clause library, we do have a clause for this and we just factor in things like if the trust has been vested prior to the test, data's death, the test data made their will 10 years later, they all decide to wind up the trust. The accountant hasn't looked at the will, no one's remembered this strategy about the will, which would never happen in the scenario of a good accountant who's fully dialled into this.
(21:18):
But these things happen, then you need to have a contingency plan, a gift over a plan B in case that trust no longer exists. So where is it going to go? Then secondly, fact in the succession plan for the trust. So the trust is in existence. Now as we know when our test data dies, all that happens is they stop being a controller of the trust if they were one and they need a replacement. So you do need a succession plan in place for that trust. I strongly recommend using the deed of successor plan building in contingencies there and making sure that it addresses both, both death and incapacity. A lot of people want to just put in a quick clause in the will to nominate a successor controller on the controller's death, but that only deals with half of the succession planning scenario. You still have no plan in place for that family trust if the person loses capacity because the will only applies on death.
(22:27):
So don't do it in the will, do it in a adida successor. And we've got a great episode on that episode 35. Go and listen to that one if you'll want to dive into that a little bit more. So yeah, gift over in terms of drafting it and get the control of your trust, right? Consider all of those historical issues as well. So I do have a downloadable in the show notes if you want to have a quick look at the comparison. Another thing which I'm not going to dive into today, but is thinking about if the assets that you are gifting under the estate plan is a principle place of residence and is going to continue to be someone or a beneficiary's principle place of residence, really looking at how are we addressing the capital gains tax exemption and any land tax that is going to be incurred on an annual basis.
(23:26):
So again, there's different rules for testamentary trusts and these arrangements being established under a deceased estate and a will versus an existing family trust. So that would also be something to think about. Look at the assets that you're actually gifting, superannuation family homes, which for most people is the bulk of their assets. Be really careful about that as well. So hopefully that's given you some food for thought. I think I've covered off everything. I'm sure I might think of more considerations.
(24:00):
My main takeaway is this is not the easy way out and I just don't know why on earth you would forfeit that accepted trust income, tax-free treatment for minors that the testamentary trust gives you in favour of simplicity with a family trust maybe if there are just no children ever, ever, ever contemplated, they just don't need to worry about that. And the estate in the personal estate is very small then yeah, maybe I'd think about it then, but most of the time you only get one shot. If in doubt use the testamentary trust. Thank you so much for tuning in. I really appreciate it. If you've got any thoughts on this, you can always continue the discussion in the Art of Estate Planning Facebook group. I would love to hear for you and I will see you next time. Thank you.
