What is a testamentary trust and when may one be appropriate?

A testamentary trust is a trust created by a will that only comes into existence when the will-maker dies. Instead of leaving assets directly to a beneficiary, the will directs those assets into a trust of which the beneficiary is typically a primary or controlling beneficiary. The trust is administered by a trustee (often the beneficiary or someone the beneficiary controls) and is governed by the terms set out in the will.

Why use a testamentary trust

There are three main reasons a testamentary trust is worth considering:

1. Asset protection. Assets held in a properly structured testamentary trust are not, in general, treated as personally owned by the beneficiary. That can be significant where the beneficiary is in a high-risk profession, is vulnerable to relationship breakdown, or has creditor exposure.
2. Tax treatment of income for minors. Income distributed to minor beneficiaries from a testamentary trust is, under current law, taxed at ordinary adult marginal rates rather than the punitive minor tax rates that apply to trust distributions generally. For families with young children or grandchildren, this can be materially valuable.
3. Control and continuity. A testamentary trust allows the will-maker to influence how assets are used across a longer period than a direct gift would. It can direct income to a spouse for life with capital preserved for children, protect a beneficiary with a disability, or provide staged distributions to young adult beneficiaries.

How a testamentary trust works in practice

The will typically contains one or more testamentary trust structures. On death, instead of assets being transferred directly to a beneficiary, they are transferred to the trustee to hold on the terms of the trust. The trustee then applies income and capital in accordance with those terms.

Common structures include:

• Discretionary testamentary trust. A wide class of potential beneficiaries — the primary beneficiary and their descendants, spouse and related entities — with the trustee having discretion over distributions. Provides the greatest flexibility.
• Fixed testamentary trust. Defined beneficiaries with defined entitlements. Less flexible but simpler.
• Protective trust. Used where a beneficiary is vulnerable — a disability, addiction, spendthrift habits — so that assets are managed for their benefit but not put in their hands.
• Life-interest trust. A beneficiary receives income (and often the right to occupy a home) for life; capital passes to the ultimate beneficiaries afterwards. Common in blended families.

When a testamentary trust is not the right choice

• Small estates. The cost of running a trust — separate tax return, trustee decisions, distribution paperwork — may outweigh the benefits.
• Straightforward beneficiaries. Where all beneficiaries are adults, financially independent, in stable relationships and comfortable managing their own affairs, the added complexity may not be worthwhile.
• Beneficiaries who will not use the structure. A trust that is set up but ignored — the trustee simply distributes everything immediately — gives up the benefits while keeping the costs.

Superannuation and testamentary trusts

Superannuation death benefits do not automatically pass through the will. They are paid by the trustee of the superannuation fund under the fund's rules and any binding death benefit nomination the member has made. A binding nomination can be made to the legal personal representative, in which case the superannuation proceeds pass into the estate and can then flow into a testamentary trust. Whether this is worth doing depends on the tax profile of the intended recipients — particularly whether they are dependants for superannuation tax purposes.

Family provision claims

A testamentary trust does not shield an estate from family provision claims under the Administration and Probate Act 1958 (Vic). A person eligible to bring a claim can still do so. The trust structure sits within the estate, not outside it.

Setting up a testamentary trust well

A testamentary trust is only as good as the drafting and the follow-through. Key things to get right include:

• Precise identification of the primary beneficiary and the trustee.
• A workable trustee succession mechanism.
• Clear provisions on income and capital distributions.
• Appropriate powers — investment, borrowing, use of assets in specie.
• Sensible perpetuity period and vesting provisions.
• Coordination with superannuation binding nominations and any relevant company or trust structures.

For advice on whether a testamentary trust is right for your circumstances, see our testamentary trusts service or the broader wills and estate planning area.

How the trust comes into existence

A testamentary trust is created by the will and takes effect on the death of the will-maker. The will contains the trust deed, which sets out the trustee, the beneficiaries, and the powers of the trustee. When the executor completes administration and is ready to distribute, the beneficiary's share is transferred to the trustee of the testamentary trust rather than to the beneficiary directly.

Discretionary versus fixed structures

Discretionary testamentary trusts give the trustee power to decide, from year to year, which of the defined beneficiaries receives income and capital. This flexibility can be valuable where family circumstances change over time and is one of the reasons discretionary structures are widely used. Fixed structures give named beneficiaries defined shares and are more appropriate where the will-maker wishes to lock in a particular outcome.

Control and the appointor role

Testamentary trusts frequently include an appointor — a person with power to remove and replace the trustee. The choice of appointor is important because it effectively determines who controls the trust. Common structures include the primary beneficiary as appointor once they reach a defined age, joint appointors from among the children, or an independent appointor for a defined period.

Not for every estate

Testamentary trusts require ongoing administration — a trustee willing to act, an accountant to prepare annual financials and tax returns, and beneficiaries who understand the arrangement. For smaller estates or beneficiaries who would prefer to receive a straight inheritance, the ongoing cost may outweigh the benefit. Structuring should be considered on its merits for each estate rather than adopted by default.

Taxation and separate advice

The tax treatment of income distributed by a testamentary trust, the concessions available for distributions to minor beneficiaries, and the capital gains tax consequences of transfers into and out of the trust are set by taxation legislation and should be confirmed by the client's accountant before the will is signed.