How a Testamentary Discretionary Trust can protect your clients' assets

When your clients are considering the inheritance they leave to their loved ones, the question of how assets will pass to their beneficiaries is just as important as what they leave them.

A Testamentary Discretionary Trust (TDT) can re assure your clients that their hard-earned assets won’t be wasted or attacked by creditors or ex-spouses. Using a TDT to pass on assets can often result in better outcomes than an outright gift.

A TDT can be an advantageous for beneficiaries by:

  • Providing significant flexibility
  • Minimising tax
  • Protecting assets

TDTs can have some downsides, and can involve administrative costs.

Before deciding to establish a TDT it’s important for your clients to receive advice from an experienced source, such as the team at Partners Legal.

A TDT is a special type of trust that is created as part of a will

Trusts have been around for centuries and have well-established rules designed to protect both the trustees and the beneficiaries. A trust is an ownership structure where the assets are owned by one person or organisation known as the trustee. However, those assets are held on trust for the benefit of other individuals known as the beneficiaries.

The TDT is not set up until your client passes away. Then, instead of their assets passing directly to their beneficiaries, they pass to the trustee of the TDT. Their assets are then held in the TDT on behalf of their beneficiaries according to the rules set out in their will. Their will becomes the TDT ‘deed’, which governs how the TDT is to be managed.

When creating a TDT under a will, your clients can choose which assets will be in their TDT. For example, they can choose certain assets, a specific portion of their estate, or the whole of their estate. Not only can they choose which assets are in the TDT, they can also create multiple TDTs under one will which each hold different assets. They can establish the rules of each TDT separately, so these rules will reflect their intentions and fit the circumstances of each beneficiary.

One of the key features of a TDT is that it is discretionary. Therefore, the trustee can be given as much or little discretion as your client wishes to choose how to distribute the capital and income to their chosen beneficiaries. 

Who are the key people involved in a TDT?
The Trustee

The trustee is the legal owner of the property, and has control over the assets of the TDT. The trustee is appointed by your client under their will, and it is often the executor of their will.

The trustee can be one or more individuals, or a company. If the trustee is a company, it is the directors of the company who will have day-to-day control of the assets and operate the TDT.

The trustee is able to make distributions to your client's beneficiaries from the TDT, and they have the discretion to determine how much each beneficiary receives. Therefore, it’s important that the trustee has the skills necessary to manage your client's assets in the TDT, as well as the appropriate personality to manage the beneficiaries’ expectations.

Appointor

Although the trustee is responsible for the day-to-day running of the TDT, many trusts also have an appointor (also commonly known as a principal, guardian or nominator).

The appointor can appoint and/or remove a trustee at any time, and their consent may be required to make any changes to the rules of the TDT.

Because of this, the appointor has the ultimate control of a TDT. Your client can nominate who the appointor of the TDT is in their will.

Beneficiaries

The TDT structure enables the capital, as well as income that is earned by that capital, to be distributed to (or withheld from) the beneficiaries of the trust in such proportions as the trustee decides.

Primary Beneficiaries: Typically, your client will nominate a small number of people in their will who can expect to receive distributions from the TDT. These people are commonly referred to as the primary beneficiaries, and are the people they wish to benefit from their estate.

Discretionary Beneficiaries: Your client might also specify a larger number of beneficiaries who are eligible to receive income from the TDT. They may be spouses, siblings or relatives of the primary beneficiaries, charities, or other trust or corporate entities in which a beneficiary holds an interest. These people and entities are often referred to as discretionary beneficiaries. 

The main reason for including many discretionary beneficiaries is to allow the trustee maximum flexibility when distributing income in the most commercially beneficial and tax-efficient way. Having a wide number of beneficiaries also provides protection by making it more difficult for a creditor to definitively state that any one beneficiary stands to receive the assets.

What are the advantages of a testamentary discretionary trust?
It’s all up to you

It’s important to understand that some of the advantages of a TDT come with corresponding disadvantages. The more discretion build in, the greater the chances that the decisions made by the trustee might differ from your client's decisions had they not passed away. Conversely, the more your clients limit the discretion of the trustee, they run a risk of limiting the best financial outcomes that could be achieved.

It’s a balancing act, and Partners Legal can help your clients work through the pros and cons to draft a will in a way that best suits their intentions.

Flexibility for your beneficiaries

A TDT can give the beneficiaries flexibility and control over when and how they receive their inheritance. The trustee can decide the appropriate amounts to distribute from the TDT to any of the beneficiaries, having regard to the needs of each beneficiary and what is most tax-effective in any given year.

A will can also allow the TDT to be wound up at a certain point (up to a maximum of 80 years).

Protection of assets

The TDT structure legally separates the inherited assets from the beneficiaries’ own personal assets.

The assets in a TDT are not legally owned by the beneficiaries, and they do not have a fixed and certain right to any of assets in the TDT until the trustee decides to distribute.

This means a TDT will provide the inheritance with a far greater level of protection from situations where those assets could be taken by third parties, such as legal proceedings arising from a broken marriage, relationship breakdown, or bankruptcy.

A TDT can also be used to protect assets if your client is concerned that their assets might otherwise be squandered by a beneficiary.

Taxation advantages

Taxation laws are continually changing, and it’s likely that the tax laws that exist at the time a client draws up their will almost certainly be different at the time of their death.

A significant advantage of The TDT is that it provides for flexible tax outcomes due to the discretionary powers given to the trustee under the will. This allows the taxable income or capital gains generated by the assets of the TDT to be allocated to the beneficiaries in the most tax-effective manner.

Another important advantage of a TDT relates to beneficiaries under 18 years of age. The potential for tax savings when trust income is allocated to children may be substantial. This is because rather than being taxed at the higher penalty tax rates which normally apply on ‘unearned income’ of minors, they will be taxed at normal adult rates.

Effectively, this allows every beneficiary under 18 to receive up to $18,200 tax-free from a TDT each year. As a result, the potential for tax savings when trust income is allocated to children may be substantial.

Example[1]

Here is an example that shows the power of a TDT. Let’s suppose that your client has an adult beneficiary with a spouse whose incomes are taxed at the top marginal rate of 45%. They have two children under the age of 18 who have no income.

The inheritance left to the beneficiary consists of assets worth about $500,000, comprising a mix of property, shares and securities, the anticipated annual income from this inheritance is:

Property Income (net)

$12,500

Interest

$1,000

Dividends

$10,000

Imputation credits

$4,200

Total taxable income

$27,700

 
Option 1: The beneficiary receives and holds inheritance directly

Tax payable:

Tax on $27,700 @ 45%

$12,465

Less imputation credits

$4,200

Tax payable

$8,265

Net cash received ($23,500 - $8,265)

$15,235

 
Option 2: The beneficiary receives inheritance as trustee of a TDT

The beneficiary can choose to distribute the TDT’s income to their children (both of whom would also be general beneficiaries of the TDT) in equal shares.

Taxable income

Distribution per child

$11,750

Imputation credits

$4,200

 

Tax payable

Tax on $11,750 (x2) @ 0%

Nil

Less imputation credits

$4,200

Tax refund

$4,200

Net cash received

27,700

 

If the beneficiary received the inheritance directly, the income they would receive from the inheritance is $15,235 per year.

If they receive the inheritance through a TDT, allowing income to be streamed to their minor children, the income from the inheritance is $27,700 per year.

This represents an after-tax cash saving of $12,465 each year (over $1,000 per month!) for your client's loved ones.

Partners Legal can help

As part of Partners Wealth Group, Partners Legal is uniquely placed to assist your clients with their estate planning needs. Our team is experienced in the planning, structuring and establishment of testamentary discretionary trusts and can help bring the peace of mind that comes from knowing that your clients' assets will be safe and their intentions for their loved ones fulfilled.

If any of this resonates with you, or if your clients would like to explore their options, please contact:

Patrick Robertson
Partners Legal
Level 13, 636 St Kilda Road
Melbourne VIC 3004

T 0437 544 052
E probertson@pwg.com.au

[1] This example is general. It may not apply in all cases and individually-tailored financial and taxation advice should be sought before relying on this.

Related News