Trying to ‘rule from the grave’? The trouble with testamentary trusts

When it comes to divvying up your estate after death, testamentary trusts are often touted as an option. They can be a way to ‘rule from the grave’, giving you more control over the way your assets are distributed – placing them in a trust, rather than having them given directly to your beneficiaries.

However, it’s important to consider that all the power lies with the trustee, not the person you want to provide for. And though the trustee has a fiduciary duty to the beneficiaries, that may require a significant level of foresight and wisdom. Let’s look at some of the ways testamentary trusts can go south.

Locking your money away in a testamentary trust can cause problems for your beneficiaries.Credit: Simon Letch

There are many ways to structure a testamentary trust. The trustee could be a friend, relative or professional organisation. The income beneficiary may be your spouse, who may end up without actual ownership of the trust assets, just the earnings.

Remaindermen are the beneficiaries who will receive the assets on the death of the income beneficiary, maybe your children from an earlier marriage. Whatever is not paid to the beneficiary eventually becomes the property of the remaindermen.

However, in some cases, the trustee may be one of the remaindermen, or might just feel a lot of pressure from the remaindermen to protect their interests, causing the elderly spouse a lot of worry in their old age.

Even defining income is a problem. This should be addressed in the trust deed. If not, then the trust law definition of income applies. Income in accordance with Australian Accounting Standards includes capital gains, trust law income does not.

Testamentary trusts are rarely a solution and likely to be very costly to the estate.

Taxable income is different again; for example, it includes franking credits and capital gains. Dividend reinvestment may leave the beneficiary with nothing. Regardless of what the beneficiary receives, they will be required to pay tax on all the taxable income of the trust.

Let’s look at a trust with just shares and the like, as it is a much bigger problem if the trust contains the family home.

To avoid income manipulation you might consider giving the trustee the discretion to use capital to provide a comfortable lifestyle for the spouse. However, how do you define a ‘comfortable’ lifestyle?

I have seen the sole income beneficiary of a professionally managed trust receive just $200 per week, and no payments for six months at a time, and yet they are not entitled to the pension because the assets of the trust excluded them under the asset test.

Giving the trustee discretion puts the spouse at their mercy. Furthermore, it can jeopardise their entitlement to franking credits, an important income stream for many retirees. A trust with any discretionary powers is not a fixed trust, so the beneficiary cannot say they have owned the shares that generated the income for more than 45 days.

Accordingly, unless the beneficiary is only entitled to less than $5000 in franking credits they will not be able to use any franking credits to reduce the tax on their distribution.

The spouse can wind up destitute because Centrelink will look at the assets of the trust and the deed and decide that the spouse is the sole income beneficiary so has control, and declare they are not entitled to any pension. A trustee prioritising protecting the purchasing power of the assets will invest for capital growth, leaving the spouse with no pension and very little income.

You might say this is not right, but the only way of getting more income is to take the trustee to court – apparently common practice, and it quickly erodes the estate via legal fees.

Finally, to avoid this, you might consider using a professional organisation hoping for more equitable management. But the more assets these organisations have under management, the more they earn in fees.

They can sell up all your assets and put them into their managed funds of “prudent investments” that, after fees, return 2 per cent, and then charge fees on top of that for managing your trust.

This is only a small sample of the problems you could be leaving behind. Testamentary trusts are rarely a solution and likely to be very costly to the estate.

Julia Hartman founded BAN TACS Accountants more than 30 years ago and is still passionate about all things tax.

• Advice given in this article is general in nature and is not intended to influence readers’ decisions about investing or financial products. They should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.

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