Tara (00:51):
Welcome back to the Art of Estate Planning Podcast. It's your host, Tara Lucke. And in this episode, I want to share my thoughts on why I hate capital reserved testamentary trusts.
(01:07):
Look, hate is a strong word. I don't want to upset anybody with this episode. So look, if you're preparing capital reserve trusts, if you love capital reserve trusts, that's totally fine. But I want to sort of draw my line in the sand in this episode to explain why the art of estate planning precedents don't include capital reserved provisions and why I don't recommend them or teach them to our members. So you may have well have received this episode that I've sent to you in response to a question that you've asked about capital reserve trusts, or if you've never even come across them, hopefully you've learned something from today. So it's a little bit of a rant. I don't know if it's going to be that long of an episode. We'll see how much I can find to talk about it. It's a bit of a niche topic, but let's dive into it.
(02:05):
So firstly, a capital reserved trust is not even a technical thing. It is a marketing term usually. It's become quite adopted colloquially that people relate it to a trust where it's a discretionary trust where you have a different category of beneficiaries who are entitled to the income and then to the capital. So let's just have a break there. Let's go back to 101, the most fundamental thing so that everybody listening understands. So let's start with what is income and what is capital? And I've explained this analogy before. I think it's a good one, so I'll use it again, but I want you to imagine and picture in your mind's eye an apple tree, a big, beautiful apple tree, right? So the apple, the fruit that is produced from the tree every season is the income. So imagine that is equivalent to the income that a lump sum of capital might generate.
(03:16):
The actual capital is the tree itself, right? So it is the asset that produces the income. So you can each year come and pick all the apples from the tree and take that income. And then the next season for fruit production, the apples will grow again. And as long as you keep your capital base, it will probably keep growing and it will keep producing the income. But if you come along and cut down that apple tree, you have no capital and therefore you won't ever get any income from the apples. So from a very simple approach, translating that to actual assets that are real world capital, imagine you inherit a million dollars or there's a lump sum of a million dollars and perhaps the way that you can earn income from that million dollars, so the million dollars is the capital, you might earn income from putting that million dollars in a bank account and earning interest.
(04:27):
Or you might actually use some of that million dollars to buy interest in a managed fund or listed shares and you receive dividends and that dividend is the income or you purchase a property and you rent it and the income is the rent that you receive. So think about that in the trust context. So the trust receives this lump sum of capital. If it's a family trust, like an Intervivos discretionary trust, then that is usually settled on the trust by a settler. If it's a testamentary discretionary trust, then it's usually an inheritance received in the trust from the will of the testator who set up the trust. So it comes from the estate of the testator. And then the trustee has their powers to invest the capital and generate the income. So in a discretionary trust that is classified as a capital reserved testamentary trust, each year the income is received by the trustee and there is a range of beneficiaries who are entitled to the income.
(05:44):
And that will usually include spouses of the beneficiaries, so everyone in the whole family. And then the people who are entitled to the actual underlying capital will be a different set of people. And that might typically be a much narrower range. So you, for instance, would not include spouses. So spouses are usually the main difference between the income beneficiaries and the capital beneficiaries, but you can really do it in any particular way. And if you had a blended family, then for instance, you might allow stepchildren and stepparents to receive the income, but not the capital. I also just want to clarify how trusts work from a tax perspective. So trusts flow through vehicles when it comes to tax. So unlike a company where the company pays its tax and then the money can just sit there and accumulate in the company, and if they want to release any of that money, then it's paid as a dividend to the shareholders.
(06:58):
And if the shareholders have a marginal tax rate higher than the company's rate, they might pay the top-up tax for the difference between what the company has paid and what their personal rate is paid, and they'll receive a franking credit for the amount their company has paid so that they're not doubling up. Let's just put aside any federal budget changes because obviously they're saying I'm corporate beneficiaries and things that might not be happening, but let's just put all that to the side. When it comes to discretionary trusts, it is actually the ultimate beneficiaries who receive the income from the trust who pay the full tax on the amount they have received at their marginal rate in their personal tax return. There might be a little bit of a change coming where there's proposed to be a 30% minimum income tax imposed on discretionary trusts. For the sake of this conversation, testamentary discretionary trusts are intended to be excluded from that new approach.
(08:09):
So we'll just focus on testamentary discretionary trusts from here on and treat them as the flow through vehicles that they are. So basically what happens is the trustee collects in all the income that it has generated and it must send that income somewhere by the end of the financial year by 30 June. So it will typically distribute the income to one or more beneficiaries. So it has to distribute it to a person who is a beneficiary. You are breaching your trustee duties and the terms of the trust if you give the income to someone who is not a beneficiary unless it's under a loan agreement or something like that. So only people who are named or fall within the classes of beneficiaries can receive a benefit and then you have to look at their entitlements. Is it income or capital or both? So each financial year, the trustee passes a resolution documenting their exercise of discretion about who is entitled to the income of the trust.
(09:23):
If the trustee does not do that, they may have actually elected to accumulate the income, which means they're not allocating it to anybody and it's almost becoming part of the capital. There's special tax rules about that too. Or if the trustee has completely neglected to do anything, then there are typically default income distribution provisions in the trust deed and it will actually say which of the beneficiaries get the income for that particular financial year in the absence of the trustee exercising their discretion. So usually that's like the primary beneficiaries who are living, if more than one, then an equal shares as tenants in common. You'll usually see something like that. So the income has to come out of the trust each financial year, basically. When it is a family trust and the trustee accumulates the income, so it forms part of the capital and isn't distributed, you usually have the trustee being taxed at the highest marginal rate as a penalty.
(10:35):
So they really are disincentivizing you doing that. For a testamentary discretionary trust, you actually can apply to commissioner discretion to have it taxed at the standard adult tax rates instead of the penalty tax rate. You don't get the tax-free threshold, but you just get the sort of lower tax rates moving through the brackets from there. You do need commissioner discretion, but you can apply for that through a private ruling. And that concessional treatment is there to recognise that we shouldn't be forcing inheritances and the income from the inheritances to come out of the trust because of the protective purpose of that trust. Okay, so to recap, usually people use a capital reserved trust because they want to allocate the income to their spouse, but protect the capital for their bloodline or lineal descendants. So it's usually a tax strategy and they're trying to have their cake and eat it too, where they want to make sure that it's not exposed on a relationship breakdown to divorce proceedings, but they want to utilise the lower tax rate of a spouse.
(11:56):
So to be a total cliche, let's say you've got parents who create a capital reserved testamentary trust for their adult son and he is married and they are in their mid - 20s to mid 30s and building their family in that phase. Or maybe the wife is a stay at home parent and homemaker. So the idea would be that the testators want to protect the actual capital inheritance from a divorce between their son and his wife, but because say their son is also a high income earner, they want the son to have the opportunity to actually stream income earned from the inheritance between obviously his minor children, but also his spouse. So if that spouse is a homemaker and not earning income from wages or salary, then they will have the full tax-free threshold and then the low marginal tax rates from there on. So it is a good way to make sure that you're paying a lot less tax on the income earned from the inheritance.
(13:22):
Now, that's what it is. Hopefully that's made sense. And I'm sorry, I've really tried to sort of start at the basics. So if that was very, I'm telling you everything you already know, sorry about that. I just want to build the foundations, especially when we're talking about tax so that everyone's on an equal footing, because I know there's some of you who are not tax lovers. So why do I dislike capital reserve trust? Firstly, I actually think they achieve nothing from a family law perspective. I think they actually undermine the family law protection. They're terrible for family law. If you have a look at episode 84, which is the sort of summary episode from our family law series, so I went through a whole bunch of cases from sort of the 18 years after Hennen and Spry. Yeah, so from around 2008 until recording this in 2026, we analysed all the cases where family trusts and testamentary trusts have been the subject of property settlement proceedings under the Family Law Act and looked at how those trusts fared in protecting assets.
(14:39):
And we summarised it all in episode 84. And there's basically a set of factors and criteria that need to be analysed that the court will take into account as to how much protection or exposure the trust offers. And one of those factors is who are the beneficiaries? Is it set up so that both parties to the relationship can benefit? And then another factor is who has actually benefited. So they look at the capital and also the income. So if you have trust records where the spouse parties are both beneficiaries, but there's also a trail of money actually flowing to them as income distributions, then that is really going to build the case that both parties to the relationship were intended to benefit from this trust rather than the case that we're really trying to build, which is that going back to my sort of study, the adult son is a custodian of the wealth for the full bloodline.
(15:54):
The real intended beneficiaries are the testator's grandchildren and so forth. And the spouses of everybody is not intended to benefit. So we are really just benefiting that lineal descendants. As soon as you have income distributions going to that spouse, you are undermining that whole argument. So really to be safe, you have to fully exclude the spouses completely. Arguing that they can only have income but not capital really doesn't achieve anything. And I want to explain why I think that. It's Tara jumping in real quick to let you know that this episode is brought to you by our online course, Testamentary Trust: The Essential Guide for Australian Lawyers. Deepen your understanding of testamentary trust with our 10-hour online course. Whether you're starting out, switching specialties or refining your skills, this self-paced course will enhance your confidence and expertise when working with testamentary trust. It's literally everything that I know about testamentary trust.
(17:06):
We start with the core principles of trust so that you have a solid foundation. Then we add in practical will drafting tips and explanations, skip you through popular TT strategies for common client demographics, and we wrap it all up with tips for client communication and marketing. Kick that lingering imposter syndrome to the curb, or if you're an old hand testamentary trust already, let us train your team so that they too can become testamentary trust pros with our online course, Testamentary Trust: The Essential Guide. Okay, so I want to explain why I think the difference between the income and capital entitlements is really worthless. So let's go to the Income Tax Assessment Act 1936, particularly sections 95 and 97. So you might have a sense or a good sense of what you think is income and capital, right? So obviously rental income, interest income, dividend income, sale proceeds, like cash sales from selling inventory, right?
(18:19):
But when it comes to trust law and tax law, it's not actually that intuitive. And there's a bit of a disconnect between our ordinary concept of income and what is actually taxed as income under the Income Tax Assessment Act. So basically what happens, there's a disconnect from accounting bookkeeping purposes and what goes in a tax return and a person is actually taxed on. So the big issue or the big area where there is a disconnect is capital gains. So sale proceeds from the sale of the capital asset. Now, I'm sure you all know what a capital gain is, but just so we're clear, it's basically the sale proceeds you receive less the cost of acquiring that asset and the cost of any sale. So if I bought an apartment for $800,000 and then I sell it for a million dollars, then my capital gain is $200,000 and I'm only taxed on the 200,000.
(19:37):
But obviously there's different rules depending on whether if you started a business from nothing and then you sell it for a million dollars, well, you basically are taxed on the million dollars. And then there's rules about small business concessions and things like that, discounts and things like that. But just to sort of reiterate the gain, and then when you are dealing with an asset that was inherited, then often the time you inherit the cost, they call it the cost base, whatever it cost the test data, so it's carried through. So just so you know what a capital gain is. So usually we're selling a capital asset and then we're receiving that capital. We're converting a property into cash. But in our mind, if we go back to the apple tree, that is still capital, right? And when we are talking about accounting concepts, it's capital.
(20:37):
But in Australia, we get taxed on our capital gain. So under the Income Tax Assessment Act, Section 95 actually treats amounts that may not have necessarily been income according to ordinary concepts as income. And because of that, a lot of trustees include powers for the trustee to classify and reclassify different receipts as either income or capital. So if we think about the capital proceeds and we use the inheritance to buy a property and then we sell it and turn that property into cash plus the profit that we made on it, well, if you're thinking about a capital reserved trust, who's entitled to that? The capital beneficiaries or the income beneficiaries? Because under section 95, those capital gains are income. But I think most of us would say, "Well, actually that should be capital and preserved just for the capital beneficiaries." So it is very easy for a trustee, and especially a trustee who's a beneficiary who might only be an income beneficiary or whatever, or who wants to try to manipulate these provisions.
(22:12):
If they know what they're doing, if they get professional advice, they can sort of sidestep this distinction between who's an income and capital beneficiary on particular transactions. So you could very easily give that capital gain to an income beneficiary depending on the way that your trust deed is drafted, the definition of income. Are you using the Section 95 net income definition or some other distributable income definition? Is there a power for the trustee to classify receipts or not? So because of this complexity under the tax legislation and the distinction between the accounting income according to ordinary concepts at trust law versus net income and adjusted net income under section 95 of the Income Tax Assessment Act 1936, I think that the distinction in the trust deed is very easy to sidestep and really not very effective at all. So look, if you're a tax lawyer listening to this, I've probably really butchered that explanation.
(23:26):
I've tried to take the line to make it easy for non-tax people to understand. And to be fair, I wouldn't say that I'm an absolute expert on that either. I think maybe the message, however, is if you yourself are drafting wills or family trust deeds and trying to make them a capital reserved trust and you do not understand the interaction between section 95 and 97 of the Income Tax Assessment Act, you should proceed with a lot of caution because I don't think what you're going to do is effective to achieve the objectives you're after. I also think you need to be really dialled in to the state of the family law cases to understand that as well, because I personally think having any spouse who, unless they're like a surviving spouse of the couple of the testator, having any spouse as a beneficiary of a testamentary trust wipes out our family law asset protection case.
(24:38):
The safest thing to do is to have no spouses all together. If you're talking to your clients who are making their wills and they want to benefit from the spouse, and though they don't understand why the spouse isn't included, firstly, you can sort of explain the family law thing. But I usually sort of say to them, look, your child's spouse is going to benefit indirectly anyway. This testamentary trust and the inheritance is an enormous value to the family unit as a whole. It can go to the kids. It really eases the pressure of the family expenditure because the inheritance income can be distributed tax-free to the children, and generally they're going to benefit anyway without them having to actually benefit directly. At the time of recording, we can also include other trusts and companies as beneficiaries of the testamentary trust. There is talk under the federal budget announcements that that may be removed.
(25:43):
So this strategy may not be available for a long time, but at the time of recording it in August 2026, you can do back-to-back trust distributions if the adult child beneficiary has a family trust of their own that does benefit their spouse, that trust is going to be a beneficiary of the testamentary trust and you could distribute from the testamentary trust to that family trust to the spouse. You do have to be careful that the vesting date of the family trust is no later than the testamentary trust. And look, I still don't like that because if they trace it through and see the benefit from the testamentary trust is ultimately going to that spouse, I still think the family law courts can just really look at the true position as to what is happening. And just because we've interposed an entity in the middle, I don't think that's going to stop it.
(26:40):
But if you're super desperate to do it, then that is another way to do it as well. So look, this is a pretty dense episode. If you understand the nuance of the capital reserved trust and you accept the risks, then go ahead and do them. I personally hate them. I think they sound great. They sound perfect. Clients love the idea. They do sound really good. Why wouldn't they? But if you peel back the layers of the onion, there's a lot more complexity and nuance to it. And when you really align what we're trying to do with our objectives, which is protecting it truly for the lineal descendants, then I think the capital reserved trust, it doesn't give us our cake and eat it too. It actually just undermines our full objectives altogether. If you are listening to that and you disagree or you think I've missed an important point, you want to have the conversation going, I would be more than welcome to hear.
(27:47):
We can always chat about it in the Art of Estate Planning Facebook group. Otherwise, thank you so much for tuning in and I'll see you next week.
