Navigating the intricacies of estate planning and management can be daunting, especially when faced with the unfamiliar term “testamentary trust.” Understanding its role and benefits can be crucial for beneficiaries. This article will demystify what a testamentary trust is, its purpose, and when it may benefit beneficiaries to consider establishing one.
Significantly, just as there are multiple reasons why a family trust might not be a good idea, many reasons also impact a testamentary trust.
What is a Testamentary Trust?
A testamentary trust is a legal arrangement that originates from a will and comes into effect upon the death of the person who made the will, commonly known as the “testator.” Unlike a living trust, created and operating while the person is still alive, a testamentary trust is established only after the testator’s death. It is set up as a part of the probate process—the legal process to administer and distribute a deceased person’s estate.
The trust manages and distributes assets from the deceased person’s estate, typically overseen by a trustee. The trustee is responsible for managing the assets, making investments, and distributing assets or income to beneficiaries, all by the terms set out in the will.
A testamentary trust is one of the many estate planning strategies that go beyond a simple will.
Key Features of a Testamentary Trust:
- Originates from a Will: The terms of the trust, including what assets go into it, who the trustee will be, and who the beneficiaries are, are defined in the testator’s will.
- Posthumous Activation: Unlike living trusts, which are active during the life of the individual creating the trust, testamentary trusts are activated only upon death.
- Probate Involvement: Because it originates from a will, a testamentary trust is subject to probate, meaning that it must go through a legal process to validate the will and oversee the distribution of assets.
Probate is the legal process through which a deceased person’s will is validated, and their estate is administered and distributed according to the terms of the will or state law if no valid will exists. A court oversees this process, often called a probate court, ensuring that debts owed by the deceased are paid off and that the remaining assets are distributed to the designated beneficiaries or heirs.
- Trustee Management: A designated trustee manages the assets within the trust, making decisions about asset management, distribution to beneficiaries, and any other stipulations as per the terms of the will.
Why is a Testamentary Trust Created?
- Asset Protection: Assets held within a testamentary trust can be shielded from creditors. This is particularly beneficial for beneficiaries who may be financially irresponsible or have significant debts.
The degree of asset protection for a testamentary trust varies significantly depending on the trust deed in the original will and how the trust assets are used. If the testamentary trust assets are used at the trustee’s discretion to fund lifestyle assets directly, the court might be more inclined to think that the trust and trustee’s assets are the same.
- Tax Advantages: Distributing income through a testamentary trust can lead to tax benefits, especially if beneficiaries are minors or have lower tax rates.
A child receiving $20k of trust income from a testamentary trust will not incur tax on that income. An adult on a higher wage might incur $9,400 in tax on the same $20k.
- Controlled Distributions: It allows for controlled and stipulated distribution of assets over time rather than a one-off distribution.
- Protection for Minors: For beneficiaries who are minors, a testamentary trust can safeguard their inheritance until they reach a predetermined age or maturity level.
When is it Worthwhile to Open a Testamentary Trust?
Simply having the option to use a testamentary trust does not mean you must open it. The following factors impact a beneficiary’s decision about when opening a testamentary trust is worthwhile.
- Presence of Significant Assets: A testamentary trust can ensure prudent management and distribution if the deceased’s estate contains significant assets.
Suppose the original capital of the testamentary trust is mainly used to fund the lifestyle of the new beneficiaries (like paying off the family mortgage). In that case, the low asset level of the testamentary trust might mean it is not worthwhile.
A testamentary trust is a classic asset protection strategy for family-owned businesses.
- Vulnerable Beneficiaries: If beneficiaries are minors, financially irresponsible, or have disabilities, a trust can protect and provide for their needs over time. There are other options in this instance, like using professional trustees of your testamentary trust.
- Complicated Family Situations: In blended families or when potential disputes between beneficiaries are foreseen, a trust can be a neutral mechanism to ensure fair distribution.
Costs in Operating a Testamentary Trust:
Operating a testamentary trust isn’t without its costs. These may include:
- Trustee Fees: A trustee may require compensation, whether a professional or a family member.
Ordinarily, a trustee of a testamentary trust doesn’t charge fees for the work they are doing. They will often be charging themselves money from their inheritance. However, the time cost for the unpaid trustee should still be considered.
- Accounting and Legal Fees: Annual tax filings, investment reporting, and potential legal challenges can incur costs.
- Investment costs: If the trust engages an investment advisor or real estate agent, the trust can incur costs in taking advice on those decisions. And if you are structuring your affairs for stock market investing, then the investment advisors’ positions and the cost of the advice on those positions is an essential factor.
- Administration Costs: Maintenance, record-keeping, and distribution tasks might necessitate expenses. At Westcourt, we use cloud software like BGL to track these items and reduce paperwork.
It’s essential to weigh these costs against the potential benefits when considering the establishment of a testamentary trust. While it is not directly comparable: the costs of operating a testamentary trust are roughly the same as operating an SMSF (excluding the audit fee or the ATO levy).
Dealing Overseas with a Testamentary Trust:
When a testamentary trust has overseas dealings, such as owning foreign assets or having international beneficiaries, complexities can arise:
- Tax Implications: Different jurisdictions might impose varying tax obligations on foreign-held assets or income distributions. And understanding how to deal with the ATO when you earn income overseas is vital. Ensure that your tax advisor can offer local and international tax advice for the one trust covering both jurisdictions.
- Legal Challenges: Understanding and adhering to overseas legal regulations concerning trusts can be challenging.
How Should You Operate a Testamentary Trust?
- Appoint a Reliable Trustee: This individual or entity will manage the trust’s assets and ensure the beneficiaries’ best interests. This person is usually identified in the will, which can often be changed later.
- Maintain Transparent Records: Keeping clear and thorough records is essential for legal, tax, and trust integrity reasons. Using appropriate cloud accounting software is essential to get the record-keeping of the trust streamlined and transparent.
- Regularly Review the Trust: Changes in tax laws, beneficiaries’ needs, or asset values may necessitate adjustments in the trust’s operation.
- Engage with your advisors: If your investment returns from your testamentary trust could be better, operating a testamentary trust might not be worthwhile. To create an investment benchmark and hold yourself accountable to the benchmark yearly.
Shutting Down a Testamentary Trust:
Closing a testamentary trust involves:
- Distributing All Assets: Before a trust can be terminated, all its assets must be appropriately distributed to the beneficiaries. If the value of the assets from the date of death to the closure date has increased, you might generate a capital gain on the distribution.
- Settling Liabilities: Any debts or obligations of the trust must be settled.
- Filing Final Tax Returns: The trust’s final tax obligations must be met. Often the bank account will need to be closed before you do the final tax return.
- Documenting the Termination: Proper legal documentation to end the trust officially is essential.
A testamentary trust can be valuable in estate planning, offering protection, controlled distributions, and potential tax advantages. However, its establishment and operation should be approached with a clear understanding of its purpose, costs, and responsibilities. Beneficiaries should seek expert advice to determine if it’s the right choice for their unique situation.