Testamentary Trusts Explained: Protecting Family Wealth for the Future

by Wadia Mansour – Solicitor

Key Takeaways

• Creation under a Will: Unlike a family discretionary trust established during a person’s lifetime, often called an inter vivos trust, a testamentary discretionary trust is created under a Will and begins operating after the will-maker’s death.
• Potential asset protection: Because trust assets are generally held by the trustee rather than owned personally by a beneficiary, a properly structured testamentary trust may provide protection against a beneficiary’s creditors, bankruptcy and professional liability risks. The level of protection depends on the trust terms, control arrangements and individual circumstances.
• Family law considerations: Holding an inheritance in a discretionary testamentary trust may reduce the risk of it being treated in the same way as an asset owned personally by a beneficiary. However, the Federal Circuit and Family Court of Australia has broad powers and may treat the trust as property or as a financial resource, depending on its structure and operation.
• Tax treatment for minors: Certain income derived from property transferred from a deceased estate may qualify as “excepted trust income”. Eligible distributions to beneficiaries under 18 may then be taxed at ordinary individual rates rather than the higher rates that usually apply to minors’ unearned income.
• Protection for vulnerable beneficiaries: A testamentary trust can preserve and manage capital for beneficiaries with disability, dependency, financial management difficulties or other vulnerabilities while permitting funds to be applied for their ongoing benefit.

When planning an estate, passing wealth to the next generation is not always as simple as making an outright gift. Beneficiaries may face business liabilities, professional exposure, financial difficulties, relationship breakdowns and significant taxation liabilities. Without an appropriate structure, an inheritance may be exposed to those risks.

For families across Parramatta and Greater Western Sydney, a testamentary discretionary trust can be an effective estate planning tool. It may provide flexible wealth management, taxation advantages and a degree of asset protection that is not available where an inheritance passes directly to a beneficiary.

What Is a Testamentary Discretionary Trust?

A testamentary discretionary trust is established under the terms of a Will. Although the relevant provisions are drafted while the will-maker is alive, the trust does not begin operating until after the will-maker’s death and the administration of the estate permits assets to be transferred to the trustee.

Unlike a simple Will under which assets are transferred directly to beneficiaries in their personal names, a testamentary trust separates legal ownership from beneficial enjoyment:

• The trustee: The trustee holds legal title to the trust assets and administers them in accordance with the Will’s trust provisions. The trustee may be one or more individuals or a company acting as corporate trustee.
• The appointor or principal, if applicable: Some testamentary trusts provide for a person with power to appoint and remove the trustee. This role is not essential to every testamentary trust and its powers must be carefully defined in the Will.
• The beneficiaries: The beneficiaries are the people or entities who may receive income or capital from the trust. They may include a primary beneficiary, that beneficiary’s spouse, children and descendants, as well as eligible charities or other specified beneficiaries.

In a discretionary trust, beneficiaries generally do not have a fixed entitlement to any particular trust asset unless and until the trustee exercises its discretion or the trust otherwise vests an entitlement in them. This distinction can support asset protection and taxation flexibility, but neither outcome is automatic.

1. Protecting Inheritances from Creditors and Bankruptcy

If a beneficiary receives an inheritance outright under a standard Will, the inherited property generally becomes the beneficiary’s personal asset. It may therefore be available to creditors or a trustee in bankruptcy if the beneficiary operates a business, works in a high-liability profession or experiences financial distress.

Where an inheritance is held in a testamentary discretionary trust:

• No direct ownership: A beneficiary generally does not personally own the trust assets merely because they are an eligible discretionary beneficiary.
• Potential creditor protection: Creditors and a trustee in bankruptcy may have greater difficulty accessing trust assets than assets owned outright by the beneficiary.
• Intergenerational preservation: The trustee can retain capital and apply income or capital for the benefit of the beneficiary and their family over time.

This protection is not absolute. A court or bankruptcy trustee may closely examine the trust if the beneficiary exercises effective control over it, has a fixed or vested interest, transfers personal assets into it, or uses the structure to defeat creditors.

Trustee selection, succession of control and the practical administration of the trust are therefore critical.

2. Family Law and Relationship Breakdown

Many parents wish to reduce the risk that an inheritance will be divided following the breakdown of a child’s marriage or de facto relationship.

A testamentary trust can assist by keeping inherited assets separate from assets owned personally by the beneficiary. Relevant protective features may include:

• appointing an independent or joint trustee;
• ensuring the beneficiary does not have unrestricted control over the trustee;
• carefully structuring any power to appoint or remove trustees;
• maintaining separate trust accounts and records; and
• avoiding the use of trust assets as though they were the beneficiary’s personal property.

However, a testamentary trust does not guarantee that inherited wealth will be excluded from family law proceedings. The Federal Circuit and Family Court of Australia may treat a trust interest as:

• property available for division;
• a financial resource of a party;
• relevant to a party’s future financial circumstances; or
• evidence of that party’s effective control over trust assets.

The outcome depends on matters including the trust terms, the identity and independence of the trustee, the beneficiary’s degree of control, the history of distributions and the way the trust has been administered.

A properly designed and genuinely administered trust may nevertheless place an inheritance in a stronger protective position than an outright gift.

3. Tax Treatment of Minor Beneficiaries

The taxation treatment of testamentary trusts can be advantageous, particularly where income is distributed for the benefit of beneficiaries under 18.

Under Division 6AA of the Income Tax Assessment Act 1936 (Cth), minors are generally taxed at higher rates on unearned income. However, income that qualifies as “excepted trust income” under section 102AG may be taxed at ordinary individual rates.

Since 1 July 2019, the concession is broadly restricted to income derived from assets transferred to the trust from the deceased estate, or from permitted accumulations or substitutions connected with those assets. Income generated from unrelated assets later injected into the trust may not qualify for the concessional treatment.

Standard Discretionary Trust Compared with a Testamentary Trust

In a family discretionary trust established during a person’s lifetime, distributions of unearned income to minors are ordinarily subject to the special higher tax rates once the relevant low-income threshold is exceeded.

By contrast, eligible excepted trust income distributed to a minor beneficiary from a testamentary trust may be taxed at ordinary individual rates. A resident minor with no other taxable income may therefore benefit from the ordinary individual tax-free threshold, currently $18,200. The precise liability depends on the beneficiary’s other income, residency, available offsets and the tax law applying in the relevant financial year.

Practical Example

Suppose a testamentary trust derives $50,000 of net investment income from assets transferred from a deceased estate. The principal adult beneficiary has three school-aged children.

• Outright inheritance: If the adult beneficiary receives the estate assets personally, all investment income will be included in that beneficiary’s assessable income. The tax payable will depend on the beneficiary’s total taxable income and marginal tax rate.
• Testamentary trust: Subject to the Will, the trustee may resolve to distribute approximately $16,666 to each of the three minor beneficiaries. If the distributions qualify as excepted trust income and each child is an Australian resident with no other taxable income, the distributions may fall below the ordinary $18,200 tax-free threshold.

The actual taxation outcome may also be affected by the trustee assessment provisions, capital gains, franking credits, Medicare levy rules and anti-avoidance provisions, including section 100A of the Income Tax Assessment Act 1936 (Cth). Distributions must represent genuine beneficiary entitlements and must not form part of an arrangement under which another person improperly receives the benefit.

Trust funds may be applied for a minor’s education, medical care and living expenses where permitted by the Will and trust law. Appropriate trustee resolutions, accounts and records should be maintained.

4. Safeguarding Vulnerable or At-Risk Beneficiaries

An outright inheritance may create risks where a beneficiary experiences:

• gambling, drug or alcohol dependency;
• intellectual disability or significant mental illness;
• impaired decision-making capacity;
• vulnerability to financial exploitation;
• poor financial management; or
• eligibility concerns relating to means-tested government benefits.

A testamentary trust can provide long-term financial support without giving the beneficiary immediate control of the capital. An independent family member, joint trustees or a professional trustee may be appointed to manage the funds and apply income or capital for housing, healthcare, education and ordinary living expenses.

Where a beneficiary has a severe disability, a special disability trust may also be relevant. That structure is subject to specific statutory eligibility, trust deed and expenditure requirements and differs from a general testamentary discretionary trust.

How to Establish a Testamentary Trust in NSW

Because a testamentary trust is created under a Will, its effectiveness depends on careful drafting and proper estate administration. Generic Will kits and online templates may not address the required trustee powers, taxation provisions, control mechanisms and succession arrangements.

Establishing an appropriate testamentary trust commonly involves the following decisions:

1. Selecting the trustee structure: Determining whether the trustee should be an individual, joint trustees or a corporate trustee. If a company is to act as trustee, the relevant arrangements may be implemented after death in accordance with the Will.
2. Structuring control and succession: Defining who may appoint or remove trustees and who assumes control if the original trustee or appointor dies, loses capacity or becomes unsuitable.
3. Defining beneficiary classes: Identifying primary and secondary beneficiaries with sufficient clarity and flexibility while avoiding unintended beneficiaries.
4. Determining distribution powers: Specifying the trustee’s powers to distribute or accumulate income and capital and to apply funds for beneficiaries who are minors or lack capacity.
5. Managing vesting and perpetuity requirements: Setting an appropriate vesting date and ensuring the trust complies with applicable NSW law, including the rule against perpetuities.
6. Coordinating non-estate assets: Reviewing superannuation death benefit nominations, jointly owned property, life insurance, company interests and existing trusts. These assets do not necessarily pass under the Will.
7. Addressing taxation and administration: Ensuring that the trustee has appropriate accounting, investment and taxation powers and that the trust can be administered in a manner consistent with Commonwealth tax law.

Final Thoughts

A testamentary discretionary trust can be more than a mechanism for distributing an estate. When appropriately drafted, controlled and administered, it may provide meaningful asset protection, taxation flexibility and long-term financial management for children, grandchildren and vulnerable beneficiaries.

The benefits are not automatic. Bankruptcy protection, family law treatment and taxation outcomes depend on the trust terms, the source of its assets, the identity and independence of those controlling it, and the way it operates in practice.

Led by Wadia Mansour since 2001, the estate planning team at CK Lawyers has extensive experience in structuring Wills and testamentary trusts for clients in Parramatta and Greater Western Sydney. The team works with clients’ financial advisers and accountants to develop estate plans designed to preserve family wealth and address taxation, control and succession risks.

To discuss protecting family wealth through a testamentary trust, contact the estate planning solicitors at CK Lawyers to arrange a consultation.

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