Testamentary Trusts Explained: When They May Improve an Estate Plan

A Will can leave assets directly to beneficiaries, but direct inheritance is not always the most suitable approach.

A beneficiary may be young, financially inexperienced, vulnerable to creditor claims or involved in a relationship breakdown. A family may also want inherited wealth managed over time rather than transferred outright in a single distribution.

A testamentary trust can provide a more structured way of passing wealth to the next generation. It may offer flexibility, asset-management benefits and potential taxation advantages, although it is not appropriate for every estate.

What is a testamentary trust?

A testamentary trust is a trust established under a Will. It generally begins after the will-maker dies and the estate assets allocated to the trust become available for transfer.

The Will contains the terms governing the trust, including:

• who will act as trustee;
• who may benefit;
• which assets may be held;
• how income and capital may be distributed;
• what powers the trustee has;
• when beneficiaries may receive assets directly; and
• when the trust ends.

Unlike an ordinary family trust created during a person’s lifetime, a testamentary trust does not usually operate while the will-maker is alive.

The executor first administers the deceased estate. Once debts, taxation, claims and administration expenses have been addressed, the relevant assets can be transferred into the testamentary trust in accordance with the Will.

Direct inheritance compared with a testamentary trust

Under a simple Will, a beneficiary may receive their inheritance directly.

Once distributed, those assets ordinarily become the beneficiary’s personal property. The beneficiary can use, invest, sell or give them away, subject to any applicable law.

Under a testamentary trust, the inheritance is instead held by the trustee under the terms of the Will. The trustee may distribute income or capital to eligible beneficiaries or retain and invest assets for future use.

This can provide greater flexibility where the beneficiary’s circumstances are uncertain or likely to change.

Parke Lawyers provides a detailed explanation of testamentary trusts and how they operate.

Who controls the trust?

The trustee is responsible for administering the testamentary trust.

Depending on the Will, the trustee may be:

• the primary beneficiary;
• another family member;
• more than one individual;
• a professional adviser;
• a trustee company; or
• a specially established corporate trustee.

The appropriate choice depends on the objectives of the estate plan.

Allowing the primary beneficiary to control the trust may provide autonomy and flexibility. However, independent or shared control may be preferable where the beneficiary is young, vulnerable, financially inexperienced or at risk of outside pressure.

The trustee must comply with the Will, trust law, taxation requirements and fiduciary duties. The role may involve maintaining accounts, lodging tax returns, investing assets and deciding when distributions should be made.

The Will should also appoint replacement trustees or provide a mechanism for changing trustees if the original appointee dies, loses capacity, becomes unsuitable or no longer wishes to act.

Which beneficiaries can be included?

A testamentary trust usually identifies a primary beneficiary and a wider class of potential beneficiaries.

The wider class may include:

• the primary beneficiary’s spouse;
• children and grandchildren;
• other relatives;
• companies;
• related trusts; and
• eligible charities.

The drafting must reflect the will-maker’s actual intentions. A very broad beneficiary class may offer flexibility, but it can also produce outcomes the will-maker did not anticipate.

Particular care is required where there are blended families, estranged relatives, vulnerable beneficiaries or concerns about a beneficiary’s partner.

Potential asset-protection benefits

A testamentary trust may provide a degree of separation between inherited assets and a beneficiary’s personal ownership.

That separation can be relevant where a beneficiary:

• operates a business;
• gives personal guarantees;
• works in a profession exposed to claims;
• has significant debts;
• is financially inexperienced;
• has addiction or gambling concerns; or
• is vulnerable to financial exploitation.

However, a testamentary trust does not create absolute protection.

The result depends on factors including:

• who controls the trust;
• whether distributions have already been made;
• the terms of the Will;
• the nature of any creditor claim;
• insolvency and bankruptcy laws; and
• whether the trust has been administered properly.

Once money or property is distributed outright to the beneficiary, it may become exposed in the same way as the beneficiary’s other personal assets.

Asset protection should therefore be treated as a possible benefit rather than a guarantee.

Relationship breakdown

Testamentary trusts are sometimes used where a will-maker is concerned about a beneficiary’s relationship stability.

Assets retained in a properly structured trust may be treated differently from assets inherited and held personally. However, family law courts have broad powers to examine a party’s interests, control, financial resources and actual benefit from a trust.

A trust controlled by a beneficiary may still be relevant in a property settlement. The practical treatment will depend on the trust terms, the history of distributions, the source of the assets and the beneficiary’s level of control.

A testamentary trust should not be promoted as a certain method of excluding inherited wealth from family law proceedings.

Beneficiaries with disability or vulnerability

A testamentary trust may be especially useful where a beneficiary cannot manage a substantial inheritance independently.

The trust can permit funds to be used for matters such as:

• accommodation;
• medical and dental expenses;
• education;
• personal support;
• transport;
• equipment;
• recreation; and
• general living costs.

The trustee can manage the inheritance over time rather than providing a single lump sum.

The drafting should address who controls the trust, how decisions are made and what happens after the beneficiary dies.

Where a beneficiary receives means-tested government support, specialist advice may be required. A standard testamentary trust is not necessarily the same as a special disability trust and may affect entitlements differently.

Taxation considerations

Testamentary trusts can have taxation advantages in some circumstances, particularly where income is distributed to beneficiaries under 18.

Ordinarily, unearned income distributed to minors may be taxed at penalty rates. Certain income derived from property transferred through a deceased estate may qualify as excepted trust income and be taxed at ordinary individual rates, subject to the legislation and the circumstances.

The relevant rules are technical. The concessional treatment does not automatically apply to every dollar earned by every testamentary trust.

Factors that may affect the result include:

• the source of the trust assets;
• later contributions to the trust;
• borrowings;
• transactions with related entities;
• the type of income earned;
• the identity and residency of beneficiaries; and
• whether the income satisfies the statutory requirements.

A testamentary trust is a separate trust that may continue after the deceased estate has been finalised and may require its own tax returns and ongoing accounting records.

Taxation should not be the sole reason for establishing the trust. Legal and taxation advice should be coordinated before the Will is finalised and during the administration of the trust.

What assets can be placed in the trust?

A testamentary trust may hold assets such as:

• cash;
• shares;
• managed investments;
• real estate;
• business interests;
• loans;
• insurance proceeds paid to the estate; and
• other estate property.

Not every asset owned or controlled by the deceased necessarily passes under the Will.

Superannuation death benefits, jointly owned assets, family trusts, company assets and life insurance may pass under separate rules or arrangements. The estate plan must therefore identify which assets can actually fund the testamentary trust.

For example, an existing family trust is not itself distributed under a Will merely because the deceased was involved in it. The succession of control may instead depend on the trust deed, trustee arrangements, appointor provisions and company records.

Discretionary and protective structures

Many testamentary trusts are discretionary trusts. This means the trustee has discretion about which beneficiaries receive income or capital and in what proportions.

Other trusts may impose tighter controls.

A protective trust might provide that:

• an independent trustee controls distributions;
• the beneficiary cannot demand the capital;
• funds may be applied only for specified purposes;
• assets are released at particular ages;
• distributions depend on specified conditions; or
• the trust continues for the beneficiary’s lifetime.

The right structure depends on the reason for using the trust.

A trust intended for an adult child who is financially capable may be drafted very differently from one designed for a beneficiary with disability, addiction or impaired decision-making capacity.

Costs and administration

A testamentary trust creates ongoing obligations.

Potential costs include:

• specialised Will drafting;
• legal advice;
• accounting fees;
• tax returns;
• investment management;
• trustee expenses;
• financial advice; and
• corporate trustee costs.

The trustee must also maintain adequate records and keep trust assets separate from personal assets.

For a small inheritance, the expense and complexity may outweigh the potential benefits. A testamentary trust is generally more useful where the estate has sufficient assets, there is a genuine risk to address or the family requires long-term management flexibility.

Multiple trusts for different beneficiaries

A Will can establish separate testamentary trusts for different beneficiaries.

For example, each adult child might receive their inheritance through a separate trust. This can prevent one beneficiary’s financial circumstances from affecting another beneficiary’s share and allow each trust to be managed according to that beneficiary’s needs.

Separate trusts may also be appropriate where:

• beneficiaries have different levels of financial capacity;
• one beneficiary is vulnerable;
• different trustees are preferred;
• there is a blended family;
• assets are to be managed differently; or
• one beneficiary wishes to retain investments while another prefers cash.

The Will should explain clearly how assets are divided and how liabilities and administration expenses are allocated.

When a testamentary trust may not be suitable

A testamentary trust is not automatically better than a conventional Will.

It may be unnecessary where:

• the estate is modest;
• the beneficiaries are financially secure;
• there are no material asset-protection concerns;
• the expected administration cost is disproportionate;
• the beneficiary wants immediate and unrestricted ownership; or
• there is no suitable trustee.

An overly complex Will can create costs and disputes without producing a meaningful benefit.

The decision should be based on the estate’s value, the beneficiaries’ circumstances and the objectives the will-maker wants to achieve.

Review the structure over time

A testamentary trust Will should be reviewed as circumstances change.

A review may be needed after:

• marriage, separation or divorce;
• the birth of children or grandchildren;
• acquisition or sale of a business;
• significant changes in wealth;
• a beneficiary developing a disability;
• a trustee becoming unsuitable;
• changes to superannuation nominations;
• establishment or restructuring of a family trust; or
• changes in taxation or succession law.

A structure designed many years earlier may no longer reflect the family, assets or risks that exist when the will-maker dies.

Parke Lawyers assists clients through its wills and estate planning practice with Wills, testamentary trusts, enduring powers of attorney and broader succession planning.

The trust must serve a clear purpose

A testamentary trust should not be included merely because it sounds sophisticated.

It should address a defined objective, such as protecting a vulnerable beneficiary, managing wealth over time, providing flexibility between family members or responding to particular taxation and asset-management considerations.

Careful drafting is essential. The Will must identify who controls the trust, who can benefit, what powers apply and what happens when circumstances change.

When properly designed and administered, a testamentary trust can provide a flexible framework for preserving and managing inherited wealth. When poorly matched to the estate, it can create unnecessary cost and complexity.

This article provides general information only and is not legal, taxation or financial advice. Anyone considering a testamentary trust should obtain advice based on their assets, family circumstances and estate-planning objectives.