CPD: Deceased estates and tax

Testamentary trusts offer a powerful tool for estate planning, particularly for families looking to protect assets, provide for future generations and optimise tax outcomes.

Despite a perception that the use of trusts is the domain of the extremely wealthy, trusts can be used by a broad spectrum of clients to achieve a range of objectives, including effective tax management. This article, proudly sponsored by Allianz Retire+, examines trusts and tax.

A trust is a legal arrangement in which a person or entity (the trustee) holds and manages property or assets for the benefit of one or more beneficiaries. It is a versatile tool used to manage and protect assets and offers benefits in estate planning and tax optimisation.

While trusts are generally not considered legal entities, they are treated as taxpayer entities for tax administration purposes. Trusts are commonly used for investment, estate planning and business because they provide flexibility and control over how assets are managed and distributed.

Trusts – an overview

A trust is an obligation imposed on a person or other entity to hold property for the benefit of beneficiaries. It should have its own tax file number, which the trustee uses when it lodges income tax returns for the trust. A trust is also entitled to an Australian business number if the trust is carrying on an enterprise.

There are two main parties in a trust, the trustee/s and the beneficiaries. You may also see reference to the settlor, who is the person who creates the trust and transfers property or assets into it.

Key parties and obligations

Trustees can be an individual or a company – known as a corporate trustee – which are responsible for managing the trust’s assets. The trustee must act in accordance with the trust deed and relevant laws, including tax laws. Where the trust is established by a trust deed, the trustee must deal with trust property in line with the intentions of the settlor as detailed in the trust deed.

Under trust law, which is administered by states and territories, trustees are personally liable for the debts of the trusts they administer. They are generally entitled to be indemnified out of the trust property for liabilities incurred in the proper exercise of their powers, except in the situation where a breach of the trust has occurred.

Under tax law, the trustee is responsible for managing the trust’s tax affairs, including registering the trust in the tax system, lodging trust tax returns and paying some tax liabilities.

Beneficiaries are the people or entities entitled to receive the benefits of the trust, such as income or capital. Beneficiaries can be individuals, companies, or even other trusts. The trustee may also be a beneficiary but cannot be the sole beneficiary unless there are multiple trustees.

Tax treatment of trust earnings

For tax purposes, trusts are treated as distinct taxpayer entities. However, the way income is taxed depends on the beneficiaries’ entitlements to that income. Trusts generally distribute their earnings to beneficiaries, and the beneficiaries are taxed on their share of the trust’s net income, regardless of whether they have actually received the income.

The net income of a trust is its assessable income for the year, minus allowable deductions, and it is worked out on the assumption that the trustee is a resident, even if they are not. Because the income of a trust is determined in accordance with the trust deed and the net income is determined in accordance with tax law, the two amounts may differ.

The trustee is responsible for lodging the trust’s tax return and ensuring that the trust complies with tax laws. Special rules apply to certain types of income, such as capital gains and franked distributions.

The beneficiaries are taxed on their share of the trust’s net income. For example, if a beneficiary is entitled to 50 percent of the trust’s income, they will be taxed on 50 percent of the net income of the trust. Beneficiaries may also be entitled to receive franked distributions from the trust. If allowed by the trust deed, franked dividends can be streamed to particular beneficiaries for tax management purposes. For example, franked dividends may be allocated to those beneficiaries with the highest marginal tax rate.

The trustee pays tax on behalf of non-resident beneficiaries and minors. If there is no beneficiary entitled to the income, the trust is taxed at the highest marginal rate applicable to individuals.

Capital gains tax

Trusts also have specific rules related to capital gains tax (CGT). For example, if a trust disposes of an asset and generates a capital gain, that gain is included in the trust’s net income and distributed to the beneficiaries in proportion to their entitlements. In some cases, a trustee can choose to pay tax on a capital gain rather than distribute it immediately to a beneficiary. A net capital loss is carried forward and offset against the trust’s future capital gains.

If there is no beneficiary entitled to income (or specifically entitled to the capital gain) the trustee is taxed on the capital gain. In the situation where the trustee is taxed on trust net income at the top marginal rate, they are not entitled to the CGT discount on the gain.

Important to CGT is the notion of ‘absolute entitlement’. A beneficiary is ‘absolutely entitled’ to an asset of a trust if they have a ‘vested and indefeasible’ interest in the entire trust asset – in other words, they can direct the trustee to immediately transfer the asset to themselves or to someone else.

In the situation where a beneficiary is absolutely entitled to a trust asset, the asset is treated for CGT purposes as if it is owned directly by the beneficiary and not the trustee. Any actions taken by the trustee in relation to the asset are taken to have been done by the beneficiary directly. This means that if a capital gains tax (CGT) event happens in relation to the asset, any capital gain or loss will be made directly by the beneficiary and doesn’t form part of the trust’s net income.

There is also the notion of ‘specific entitlement’. In this situation, a capital gain can be streamed to a particular beneficiary by making them specifically entitled to the gain. In such cases, the capital gain is calculated for the income year with the benefit of any discounts or concessions to which they are entitled.

Tax returns and tax payments

The trustee is required to lodge a trust income tax return, irrespective of the amount of net income involved, unless advised otherwise by the ATO. If the trustee is liable for tax, they will receive an income tax assessment as trustee; this is separate to their own assessment as an individual or corporate tax entity.

The beneficiaries (or the trustee when assessed on their behalf) may have to pay regular tax instalments based on their share of the trust’s instalment income.

Advantages and disadvantages of trusts

The following details some of the advantages and disadvantages of the trust structure but is not an exhaustive list. Specific client circumstances could impact whether certain trust features are advantageous or disadvantageous.

Family trusts

A family trust is a popular legal structure primarily used to manage and protect family wealth, distribute income and for tax planning. When a trust makes a ‘family trust election’, it is recognised as a family trust; this confers certain tax advantages but also specific tax obligations.

How a family trust works

A family trust is typically discretionary, meaning the trustee has the power to decide how to distribute income and capital among the beneficiaries. The beneficiaries are often members of the same family, and their entitlement to distributions is at the trustee’s discretion. This flexibility allows for strategic financial planning, especially in terms of managing tax liabilities.

To establish a family trust, the trustee can be an individual or a corporate entity. Many families prefer appointing a corporate trustee for reasons such as asset protection, limited liability and succession planning. The trust itself is governed by a trust deed, which outlines how the trust will be managed, who the beneficiaries are and how distributions will be made.

The family trust election is a key aspect of this structure. It is a formal declaration made to the ATO that qualifies the trust for specific tax concessions, particularly related to the trust loss provisions. However, this election also means that any distribution made to individuals or entities outside the ‘family group’ may trigger the Family Trust Distribution Tax (FTDT). This tax is levied at the highest marginal rate plus the Medicare levy, making it a significant cost if the trust does not stay within its family group for distributions.

Why use a family trust?

The most common reasons for setting up a family trust include:

• Asset protection: by holding assets in a trust, families can protect them from potential creditors or legal claims against individual family members. If a family member faces financial difficulties, the assets held by the trust are not considered part of their personal estate which provides a level of legal insulation.
• Tax planning: family trusts offer considerable flexibility when it comes to tax planning. By distributing income to beneficiaries with lower marginal tax rates, families can minimise the overall tax burden. For example, a trustee might allocate more income to a beneficiary who earns less or is not employed.
• Investment and business planning: many families use trusts to hold investments or business assets. For instance, if a family trust owns a commercial property, the rental income can be distributed in a tax-efficient way. Family businesses are often structured as trusts, offering both asset protection and tax benefits.
• Succession planning: a family trust can be an effective tool for estate and succession planning. Rather than transferring assets directly to heirs, which could trigger capital gains tax (CGT) or stamp duty, the assets remain in the trust, allowing beneficiaries to continue to enjoy the benefits, such as income from shares or property investments.

Advantages and disadvantages of family trusts

As with trusts more generally, specific client circumstances could impact how advantageous or disadvantageous certain family trust features are

Family trusts are an effective tool for tax planning, asset protection and succession planning. They give trustees the flexibility to manage income distributions in a tax-efficient manner and offer advantages that other structures may not. However, family trusts can also present challenges, particularly when it comes to tax obligations, potential family conflicts and handling undistributed income. To ensure the trust meets its objectives and adheres to legal regulations and tax obligations, careful planning and management are crucial.

Testamentary trusts

A testamentary trust is established through a will and only comes into effect after the will-maker, or testator, has passed away. Its main function is to control how assets from the deceased’s estate are distributed to beneficiaries.

Unlike a standard bequest where assets are handed directly to the heirs, a testamentary trust holds these assets in trust, with the trustee responsible for managing and distributing them according to the terms of the will. This structure provides certain legal, financial and tax advantages that make it an attractive option for estate planning.

How does a testamentary trust work?

The creation of a testamentary trust occurs upon the death of the testator and after the estate administration has been completed. Assets from the estate are transferred into the trust, and the trustee manages them for the benefit of designated beneficiaries. These beneficiaries can include minor children, family members with specific needs, or even individuals who require financial protection.

Testamentary trusts can be either fixed or discretionary. In a fixed trust, the amount each beneficiary receives is predetermined. A discretionary testamentary trust more commonly used because it provides the trustee with the flexibility to distribute income and capital among beneficiaries based on their needs and tax circumstances. This flexibility makes discretionary trusts particularly useful for tax planning purposes.

Why use a testamentary trust?

Testamentary trusts are primarily used to manage how assets are distributed to beneficiaries after death, but they serve several key purposes:

• Tax efficiency: testamentary trusts can provide significant tax advantages, particularly when distributing income to minors. Normally, income distributed to children under the age of 18 is taxed at penalty rates to prevent parents from diverting income to lower-tax-rate children. However, testamentary trusts are an exception to this rule and minors who receive income from a testamentary trust are taxed at adult tax rates, which are typically much lower, and use can be made of the tax free threshold. This provision allows families to reduce the overall tax burden on estate income and improve tax efficiency across family members.
• Asset protection: a testamentary trust can protect estate assets from creditors, legal disputes and family law claims. Because the beneficiaries do not have direct ownership of the trust’s assets – only an entitlement to income and distributions determined by the trustee –those assets are often shielded from legal action taken against the beneficiaries, such as bankruptcy or divorce settlements.
• Control over asset distribution: testamentary trusts allow the testator to retain control over how and when assets are distributed to beneficiaries. This is particularly useful for ensuring that minors or financially irresponsible heirs do not receive large sums of money all at once. The trust can specify conditions for when beneficiaries can access their inheritance, such as reaching a certain age or meeting particular milestones, such as completing tertiary education.
• Long-term estate management: where the estate includes significant assets that require ongoing management, such as investments or property, a testamentary trust can ensure these assets are managed professionally and in the best interests of the beneficiaries. The trustee – who may be a family member, professional adviser or financial institution – oversees the investment and distribution of trust assets in accordance with the testator’s wishes.

Tax effectiveness

One of the most compelling reasons to establish a testamentary trust is the tax efficiency it can offer. Testamentary trusts allow for income splitting among beneficiaries, particularly those in lower tax brackets, thereby minimising the overall tax paid on estate income. By distributing income to beneficiaries based on their personal tax rates, the trustee can reduce the tax burden on the estate.

As indicated above, a notable tax advantage of a testamentary trust is the concessional treatment of income distributed to minors. Normally, income received by minors from trusts is taxed at penalty rates; however, income distributed to minors from a testamentary trust is taxed at the same rates as adults, which allows families to make use of lower marginal tax rates to their advantage. This can significantly reduce the tax on income derived from assets within the trust, such as rental income or investment returns.

However, it’s important to note that tax concessions are limited to income generated by assets directly transferred into the trust from the deceased’s estate. Income from assets introduced to the trust from external sources, such as gifts or loans, does not qualify for these tax benefits and will be taxed at the higher penalty rates for minors.

Advantages and disadvantages of testamentary trusts

As with trusts more generally, specific client circumstances could impact how advantageous or disadvantageous certain testamentary trust features are.

Testamentary trusts offer a powerful tool for estate planning, particularly for families looking to protect assets, provide for future generations and optimise tax outcomes. However, they require careful planning and consideration to ensure that they are the right solution for each particular family’s needs.

All trusts come with significant legal and tax obligations that must be carefully managed. Trustees have a fiduciary duty to act in the best interests of the beneficiaries, while beneficiaries have an obligation to report their share of the trust’s income for tax purposes. In the event a client wishes to establish a family or testamentary trust, the decision should always be guided by your professional advice – or that of other specialists you may call on – to navigate the complexities and ensure compliance with legal and tax requirements.

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Notes:
[1]  ATO, Deceased Estates
[2] ATO, Inherited Property and CGT