If the idiom is true that “nothing can be said to be certain, except death and taxes” then it would make a lot of sense to think about tax-effective estate planning, wouldn’t it?
While we all breathed a sigh of relief when Death Duty or Probate Duty was abolished, Capital Gains Tax on assets passing on death now earns the Government much more revenue than duties ever did.
Worse yet, the inheritance of income-earning assets can attract huge tax liability at the individual income tax level as well.
A Testamentary Trust can be a very effective mechanism to help minimise tax liabilities on estate assets. As explained by GSR Lawyers, this is a trust created in your will, usually discretionary in nature and funded by assets of your estate on death or by payments to the estate in consequence of your death.
The primary benefit of setting up a Testamentary Trust is the capacity to ‘spread’ income between members. Ordinarily, where an income-earning asset is left to an individual, the income produced from that asset forms part of that individual’s assessable income.
Similarly, if a beneficiary decides to sell an asset they have inherited, this event is likely to attract Capital Gains Tax. In this instance, the ATO will generally make an assessment as to the market value of that asset when passed down upon death to a beneficiary and compare this to the price received for its sale down the track. The difference between these values minus any expenses incurred in improving the asset is deemed a capital gain and will form part of the beneficiary’s assessable income during the financial year of sale.
Note: this is a blanket approach and there are a number of exceptions, concessions and other variables worth considering when it comes to CGT – a discussion for another time.
To help highlight just how tax- effective a Testamentary Trust can be, we’ve created a scenario below:
Say Paul is left a residential block of units from his father, valued at $1,500,000 at the time of transfer. The units return $60,000 in rental income per year. Paul is a successful executive earning a salary of $190,000 per annum. Ignoring other relevant factors for the purposes of this example, Paul’s assessable income is now $250,000 per annum. This means Paul will need to pay $85,597 per year in tax.
In 10 years’ time, Paul decides to sell the block of units. He spent $200,000 giving the units a facelift and renovating the bathroom in each unit. He sells the block for $2,500,000. The ATO will deem Paul has made a capital gain of $800,000 in the financial year he sells the units (see below):
This capital gain of $800,000 now forms part of Paul’s assessable income, which now totals $1,050,000 for the financial year and is taxed a whopping $445,597!
Now imagine what would happen if Paul’s father had established a testamentary trust with his three children aged 3,4 and 6 as beneficiaries and himself and his wife as trustees?
GSR Lawyers explains:
“A major income tax advantage occurs when income from a Testamentary Trust is distributed to benefit a child, grandchild or great-grandchild under the age of 18. This is because this income is ‘excepted’ under Section 102AG of the Income Tax Assessment Act from the normally higher rates of tax that children otherwise pay. (Children normally earn $416 tax free but after that they tax at the highest marginal rate). However, under a Testamentary Trust children get the same tax treatment as adults. That means the first $18,200 of income tax is free, $18,200 to $37,000 is taxed at 20.75% and so on.”
So applying this, using a Testamentary Trust John could have evenly distributed the $60,000 in rental income from the block of units to his three children ($20,000 each) and they could pay tax at adult rates which means they could earn up to $20,542 after low income tax offset and pay NO tax.
This means John is now paying $58,597 in tax assessed on his salary of $190,000 rather than $85,597 had the rental income formed part of his assessable income. By creating a Testamentary Trust, John has saved $27,000 in tax per annum and as much as $270,000 in tax during the time he holds the block of units!
But the benefits of a Testamentary Trust don’t stop there. As mentioned, Paul was up for $445,597 in tax when he sold the block of units. Using the same strategy outlined above, Paul could distribute the capital gain derived from the sale of the block of units between his 3 children through the Testamentary Trust.
In this case, the Testamentary Trust has made $60,000 in rental income throughout the year plus $800,000 in capital gains. The total assessable income of $860,000 can be distributed between the beneficiaries of the trust. In this case, each child will have an assessable income of $286,666 and be taxed $102,096.70 respectively. This means the total tax paid will comprise of the three children’s combined assessable income $306,290 plus Paul’s assessable income tax on his salary which is $58,597.
The total tax paid during this financial year with the help of a Testamentary Trust is therefore $364,887.10. This is a total tax saving of $80,710 or 19%!
Testamentary Trusts are fairly straight forward to set up for a solicitor and are not very expensive, especially when you consider the potential tax savings and asset protection strategies they can create.
When you take a step back and think about just how much a Testamentary Trust can do for you, it’s hard to ignore.
Estate Planning plays a significant part of our service here at Wealth Depot and we believe just a little bit of attention now to the legacy you leave in the future can have a massive impact on your loved ones.
And don’t forget to review how your superannuation and life insurance benefits would be distributed!