A Testamentary Trust has a myriad of tax benefits, which can play an integral role in maximizing the net income that beneficiaries of the Trust receive.
It is important that all trustees, as well as trust creators (or grantors), are aware of these advantages in order to seek the greatest return for the beneficiaries, and to maximise after-tax net income.
What is a Testamentary Trust?
Testamentary Trusts are trusts created by a ‘testamentary’ instrument (usually a Will). This means that a Testamentary Trust comes into effect after the person who created it has died. Testamentary Trusts are usually created to benefit a person’s spouse, children or grandchildren. For more information please read: Testamentary Trusts in Estate Planning.
It is important to note that Testamentary Trusts require their own tax file numbers, separate from the tax file number of the deceased estate. Deceased estates are not subject to the Medicare Levy; Testamentary Trusts are.
Benefit #1 – Marginal Tax Rates for the Testamentary Trust
At the Commissioner’s discretion, a Testamentary Trust’s income can be assessed under s99 of the Income Tax Assessment Act 1936 (Cth) (“ITAA”). Other trusts, such as an Inter Vivos Trust (which comes into affect while the trust creator is alive), are assessed under s99A of the same Act.
What does this mean? Under s99A, an Inter Vivos Trust will be assessed at the highest marginal tax rate for undistributed income, that is, at 49% inclusive of Medicare and Budget Levies. Under a Testamentary Trust, however, the Commissioner may choose to apply s99 which taxes the trustee at what is essentially a standard adult marginal rate. This marginal rate also excludes the tax free threshold of $18,200.
- Any income between $670 and $37,000 is charged at a flat rate of 19%.
- Any income between $37,000 and $80,000 is charged at a marginal tax rate of approximately 32.5%.
- Any income between $80,000 and $180,000 is charged at a marginal tax rate of approximately 37%.
Benefit #2 – Discount on Capital Gains Tax for Disposal of Assets
Section 99, under which a Testamentary Trust can operate, allows trustees to access a 50% discount on Capital Gains Tax for assets that are sold off. This is provided they have been held for over 12 months. Most other types of trusts are subject to s99A which does not provide access to this discount.
Benefit #3 – Personal Income Benefits
A person will either be a “beneficiary” or a “beneficiary under a legal disability”. A beneficiary under a legal disability can include minors (under 18), bankrupts who have not been discharged and persons who are deemed “mentally impaired”. The beneficiaries will be assessed as follows:
- An ordinary beneficiary (not under a legal disability) will have their personal income assessed under s97 of the ITAA. This means their personal income tax will be assessed at marginal tax rates which are subject to the $18,200 tax-free threshold.
- A beneficiary under a legal disability (who is not a child) will be assessed under s98(1) of the ITAA. Here the trustee will be assessed by the ATO on the beneficiary’s behalf. The trustee will then issue a Beneficiary Tax Statement to the beneficiary. (Implications for this below).
- Further to the above, pursuant to s102AG(2)(a) of the ITAA, a child (who is a beneficiary with a legal disability) will have their income from a Testamentary Trust classified as “excepted trust income”. This means their income will be assessed at adult marginal rates, entitling them to the $18,200 tax-free threshold they otherwise would not have been able to access.
In addition to receiving marginal tax rates, beneficiaries under a Testamentary Trust are also entitled to “franking credits”.
A beneficiary to a Testamentary Trust will therefore be entitled to marginal tax rates when being assessed on income from the trust, while also receiving distributed franking credits. This maximises their overall net income.
While these are some of the nuances of taxation involved in a Testamentary Trust, if you are creating a trust, it is important to seek legal advice to help decide which trust structure is best for your personal circumstances. If you are a trustee of a Testamentary Trust legal advice can also assist in capitalising on the tax benefits available to you and the beneficiaries of the trust.