CPD: Estate planning and tax

What are the tax consequences that flow from estate planning?

Estate planning is a fundamentally important aspect of financial (and legal) management – and has important tax consequences. This article, proudly sponsored by Allianz Retire+, examines some of the elements of estate planning and the tax consequences of each.

Estate planning is often viewed as a way to ensure that assets are distributed according to one’s wishes after death, but its significance extends beyond that. One of the most critical yet frequently overlooked aspects of estate planning is its role in effective tax management. Properly structured, an estate plan can help individuals and families navigate the complexities of wealth transfer, minimise tax payable by beneficiaries, consider any social security impact and ensure that a financial legacy is passed on efficiently.

To this end, estate planning is as relevant for a business as for individuals. For without thoughtful tax planning, a significant portion of an estate (business or personal) can be eroded by taxes, leaving beneficiaries with far less than intended.

When working with clients on estate planning, there are several important things to bear in mind.

Firstly, estate planning laws vary by state; therefore it’s important to understand the law as it pertains to your (and your client’s) locale.

Secondly, an estate lawyer is best placed to advise on and create relevant estate planning documents; this includes the Will and any Powers of Attorney.

Finally, your client’s circumstances may change, so the estate plan should be regularly reviewed to ensure that it’s up-to-date and reflects any changes to their personal situation. A marriage or divorce, the purchase or sale of a business, births and deaths…each of these events can necessitate a review of a client’s estate plan.

Ultimately, an effective estate plan will ensure that the ownership of assets passes to the correct beneficiaries, any payable tax is minimised, and the assets are protected if there is a legal dispute.

Key components of an estate plan

A comprehensive estate plan encompasses several elements to ensure your client’s wishes are honoured and their assets effectively managed:

• Will – the foundation of any estate plan, the Will details how your client’s assets should be distributed after death. It also designates an executor responsible for administering your client’s estate according to their specified wishes.
• Super – your client needs to make binding death nominations for super. The allocation of super is managed by the fund’s trustee and can’t be distributed via a client’s will. Binding and non-binding super beneficiaries will receive any unspent super money from the trustee.
• Power of Attorney – this allows your client to appoint a trusted individual to manage their financial and legal affairs in the event they become unable to do so themselves. An Enduring Power of Attorney is a specific type of POA that remains in effect if the client becomes incapacitated or unable to make decisions.
• Enduring Guardianship – in some jurisdictions, a medical Power of Attorney is granted, in others, an Enduring Guardianship grants a designated person the authority to make decisions regarding your client’s health and lifestyle if they become unable to do so.
• Advanced Care Directive – sometimes referred to as a Living Will, this document enables your client to outline their preferences for medical treatment and end-of-life care in situations they are unable to communicate their wishes.
• Trusts – a legal arrangement in which a trustee manages assets on behalf of beneficiaries, with distribution occurring at a predetermined time. Trusts can offer tax advantages and protect assets; an example is the establishment of a trust for a child that becomes accessible at a specific milestone birthday or other point in time.

All legal documents are best created by an estate lawyer. There are also a range of legal implications to consider:

• All estate planning documents must meet the legal requirements for validity. This includes compliance with relevant legislation, which varies by state or territory.
• Understanding the tax consequences of asset transfers is an essential part of estate planning. You need to consider capital gains tax, stamp duty and income tax, each of which can significantly impact the value of assets passed to beneficiaries.
• Legal capacity is important to avoid potential challenges to the Will in the future. Your clients need to create a Will at a time they have the legal capacity to do so. No-one expects to lose capacity, but steadily increasing dementia rates means that statistically, it’s likely it will affect some of your clients (note: it is estimated that more than 421,000 Australians are living with dementia in 2024, a figure likely to rise significantly without medical breakthrough)^[1].

The Will

The Will is the cornerstone of estate planning. It serves as the primary legal document that outlines how a client’s assets should be distributed upon death, or in some cases, permanent incapacitation.

A Will ensures that your client’s wishes are clearly stated and legally enforceable, helping to avoid potential disputes among beneficiaries.

The functions of a Will include:^[2]

1. Appointing someone to administer the estate after death
2. Recording how assets are to be distributed after death
3. Fulfilling financial responsibility after death – discharging debt and looking after dependents
4. Revoking/cancelling old wills
5. Establishing a trust for beneficiaries

A Will plays other important roles. It enables clients to appoint a guardian for minor children, name an executor to manage their estate and make specific bequests to individuals or charities. By formalising these decisions in a Will, your client takes control of their legacy.

Clients may hold two types of assets: estate assets and non-estate assets. The former includes any asset the client owns in their own name. Non-estate assets include those owned as a joint tenant, in a trust or in superannuation. Life insurance is also generally disposed of according to specific rules and not distributed via the Will.

Without a Will, a client’s estate may be distributed according to state intestacy laws, which may not align with your client’s preferences. In the case of intestacy, there’s a risk that the undocumented intentions of the client in relation to their estate may not be acted on. Further, depending on the marginal tax rates of the beneficiaries, intestacy can lead to an imbalance in the distribution of an estate due to higher rates of tax payable by some beneficiaries.

Intestacy can also reduce the size of your client’s estate thanks to other charges; administering an estate is more expensive when outside parties must be involved and compensated for their services. The family can generally expect to pay the government more revenue, in the form of legal and other fees, capital gains tax and income tax.

Powers of Attorney

While a Power of Attorney (POA) won’t impact the tax implications of estate planning, it’s good form for clients to nominate a power of attorney while they are preparing their Will. As with Wills, each state has its own legislation in respect to POAs.

A POA is a separate legal document which enables your client to appoint one or more people to manage their financial and legal decisions on their behalf while they are alive. A POA ceases upon death.

An Enduring Power of Attorney (EPA) can be used to make decisions for your client in the situation they are unable to do so, if for example, they lose capacity. An attorney is legally required to act in your client’s best interests; therefore, the appointment of a trusted person to as POA can ensure your client’s affairs are managed as they would like them to be in the event they become incapacitated before death.

An EPA is of particular importance to clients with a self-managed super fund. Regulations require all members of an SMSF to be trustees, but a person without capacity is prohibited from being a trustee. In the situation where a trustee of an SMSF loses capacity – whether your client or a non-client member of a client’s SMSF – decisions about the SMSF would have to be made by a tribunal if there is no EPA in place for that member. It’s good form to ensure that all SMSF clients have EPAs in place – and that all members of their SMSFs do too.

Superannuation

As a non-estate asset, superannuation is treated differently to other investments. Because it’s managed by the trustee of your client’s fund, it can’t be incorporated into or distributed by their will.

There are four important considerations when estate planning for client’s superannuation^[3].

1. When a super fund’s member dies, the money is paid out of the fund
2. Only certain people (i.e. nominated beneficiaries) are eligible to directly receive a superannuation death benefit
3. Insurance proceeds inside a super fund may be heavily taxed on the member’s death
4. In some circumstances, there can be a death tax on super; there are strategies to minimise this or for beneficiaries to avoid becoming eligible to pay it.

Your client needs to nominate superannuation beneficiaries who will receive any remaining super once your client passes away. There are two types of beneficiaries: binding and non-binding beneficiaries.

A binding death benefit nomination is a written declaration your client provides to their fund. This provides a legal obligation for the trustee to distribute your super to those people nominated by the client. Binding nominations are generally required to be validated every three years to remain binding.

A non-binding nomination is the preferred choice of beneficiary that your client selects, the difference being that the super trustee is not obligated to follow it. When distributing your remaining super, the trustee will take your non-binding nomination into account, along with the claims of other dependants.

In both cases, trustees must follow the relevant super laws. Beneficiary nominations are made available so clients have the opportunity to legally ensure their chosen beneficiaries receive payment, even where there may be claims over your client’s estate after their death.

When it comes to super and tax, there’s a difference between SIS-dependent beneficiaries and tax-dependent beneficiaries; in super law it defines who can receive death benefits, in tax law, if and how a recipient will be taxed.

A SIS-dependent beneficiary indicates the beneficiary meets the rules to receive the death benefit under the SIS Act 1993.

A tax-dependent beneficiary includes a former spouse and children under 18. They can generally receive death benefits tax-free. Non tax-dependents, including adult children, pay tax on the taxable component of any death benefit received from their parents’ super.

A client can nominate an eligible dependant, such as their spouse, to continue receiving an income stream rather than a lump sum payment. This is called a reversionary pension and only applies to super savings already in pension mode.

From a tax perspective, there are several benefits:

• A super pension is generally tax free or in some cases, concessionally taxed, depending on your client’s age and the age of their beneficiary. Consequently, there may be tax benefits for the reversionary beneficiary.
• Because the assets supporting the pension payments remain within the super system, they continue to benefit from super’s lower tax environment.
• When the reversionary pension reverts to the beneficiary, the taxable and tax-free components that were calculated when the pension first started are preserved.

Where life insurance is held within super, any proceeds are paid as part of the superannuation death benefit to beneficiaries. As such, tax will be payable by those beneficiaries who are not tax-dependents.

Testamentary Trusts

A testamentary trust can play a major role in the estate planning process and is usually created when your client drafts their Will. It is written into the client’s Will and is dormant until the client’s death.

Administered by a trustee, a testamentary trust enables your client to leave money to beneficiaries who have use of that money – often subject to certain conditions – but it’s not their own property. This is a strategy commonly used to provide protection against relationship breakdowns, creditors, poor decision making and potential legal issues.

Clients may consider a testamentary trust in circumstances such as:

• They wish to protect their assets for future generations. For example, your client’s beneficiaries can benefit from assets such as an investment portfolio or family business, while the trustee controls how they’re managed. In this scenario, the assets are protected from potential legal action or actions of individual beneficiaries that could otherwise impact them.
• A client has a blended or complex family structure. Numerous scenarios can be modelled by the trustee to preserve assets or to ensure the relevant beneficiaries can access assets in the trust if others pass away.
• Your client needs to protect vulnerable beneficiaries, such as a disabled child. A trust can ensure they don’t lose this inheritance to creditors or that funds are used in their best interests. For those with young children, a trust can hold assets and/or manage assets until the children are old enough to do so themselves.
• Depending on assets held, a testamentary trust can provide tax benefits for your beneficiaries.

From a tax perspective, income generated by a testamentary trust is taxed at the marginal tax rate of the beneficiary of that trust. A testamentary trust also facilitates income splitting, where a beneficiary can allocate trust income to other beneficiaries. This strategy enables beneficiaries with lower marginal tax rates to receive income and pay tax at their lower rate.

Further, minors (children under 18) who receive ‘unearned income’ are generally taxed at the highest marginal tax rate (although the first $416 is tax free). This is not the case with income received from a testamentary trust. Tax law provides that income and capital gains derived by children under age 18 from assets received from a testamentary trust are ‘excepted trust income’ and taxed at normal adult marginal rates.

This means a minor receiving income from a testamentary trust has a tax-free threshold of $18,200 before being taxed at the usual adult marginal rate, depending on the level of income. Imputation credits relating to franked dividends received can be used by the minor.

One of the main advantage of using a testamentary trust for bequeathed assets is that income, capital gains and franked dividends can be distributed among your client’s family beneficiaries each year in the most tax-efficient way.

A major part of estate planning is considering the tax implications for client’s beneficiaries and minimising the tax on their estate. Capital gains is triggered when an asset is sold or gifted. The ATO deems any gift your client makes as a sale at the current market value.

Therefore, good record keeping is essential. For example:

• Knowing what assets were acquired pre-CGT and which may attract capital gains tax.
• Is the family home a pre or post-CGT asset and would it be wholly or partly covered by the main residence CGT exemption?
• Most clients can reduce taxable capital gains by claiming expenses but require records to substantiate any such claims.
• Assets acquired pre-CGT (prior to 20 September 1985) may not be subject to capital gains, however your client needs records to prove the asset is a pre-CGT asset.
• Changes to holdings in shares and managed funds that might arise because of dividend reinvestment, merger and acquisition activity, bonus issues and so on. Again, knowing which are pre and post-CGT holdings is important.

Estate planning is a vital process that goes beyond simply dictating the distribution of assets after death; it plays a critical role in tax management, asset protection and ensures that your clients’ wishes are fully honoured. By carefully considering the various components of an estate plan, your clients can ensure that their financial legacy is preserved, tax liabilities are minimised, and their loved ones provided for according to their intentions.

As personal circumstances evolve, it’s crucial to regularly review and update your clients’ estate plans to reflect any changes. By doing so, your clients can mitigate risks such as disputes, unnecessary taxes or the unintended consequences of intestacy. Estate planning is not a one-time task but an ongoing process that ensures peace of mind for your clients and their families, securing their financial legacy for generations to come.

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Notes:
[1] https://www.dementia.org.au/about-dementia/dementia-facts-and-figures
[2] Wills, death and taxes made simple, Noel Whittaker, 2024
[3] Ibid