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Why Your Parents Need Tax-Effective Wills: or how to pay 13% tax on $200,000 p.a.

Author: Stephen Gethin, Director, Fortuna Legal

Large tax savings through “full-family” income splitting

Most people look at wills solely from the perspective of the benefits to their family after they leave this world. While that remains a vital consideration, there are also substantial benefits if you can arrange for those who wish to leave assets to you to do so in the most tax-effective way.

Unlike a “standard” will, a “testamentary trust” will can enable the main beneficiaries to make substantial tax savings by distributing income earned on investing estate assets (and, in many cases, other income) to other family members in lower tax brackets. Most importantly, income from a testamentary trust paid to a minor child attracts the tax-free threshold of $18,200 p.a., and the normal, progressive tax rates on incomes above that amount. (This is unlike other trusts, where income paid to minor children is taxed at the top marginal rate.)

Instead of paying your children’s school fees and other expenses from your after-tax income, if you have a testamentary trust, you can make tax-free/low-tax trust distributions to them, and use that money to pay their expenses. And you can also distribute income to yourself and your spouse, as with a normal discretionary trust.

The benefits of full-family income splitting are best illustrated by an example. If you earned $200,000 p.a. income in your own name, you would pay around $68,000 tax. If, however, you could distribute that income around a family of 5, the total tax payable would be only around $27,000, or 13.5%![1]. (Under a normal discretionary trust, you could split that same income only with your spouse, which would only reduce the family’s tax bill to around $54,000*[2]).

Increase tax savings by moving non-inheritance assets into a testamentary trust

But I won’t earn anything near $200,000 p.a. from investing my inheritance – and most of my income comes from my business, so what’s the benefit?

Firstly, it is not uncommon to receive an inheritance which could be invested to earn between $20,000 and $35,000 per year. If that inheritance was left to you under a “standard” will, and you are on the top tax rate, you would lose half of that income to the Government. If the same inheritance was left to you under a testamentary trust, and you have two other family members with no other income, you would pay no tax on $35,000 of estate income per year.

Secondly, and often more importantly, there are many strategies for acquiring (or moving) non-estate, income-producing assets into a testamentary trust; such as a business, an investment property or a share portfolio, so that the income from these assets can be distributed in a tax effective way.

Case Study 1

Assume you are on the top marginal tax rate and you receive a $500,000 inheritance. You need to invest $500,000 in your business to expand it. If you received that inheritance under a “standard” will, you could still use it to grow your business.  But you would pay tax on all the additional business income you earned as a result, at your own marginal tax rate. (Of course you may already be distributing business income to a lower-income spouse through a discretionary trust.  They may already be on a relatively high tax bracket, or the extra income they will receive may push them into one.)

If you received the same inheritance under a testamentary trust will instead, the trust could contribute that amount to your business in return for say a half share.  That way half of your business income would now be earned through this tax-advantaged vehicle.  The testamentary trust could distribute its half share of your business income, not only to your spouse, but also to any minor children you have.  This has potential to cut your family’s total tax bill dramatically.

Case Study 2

You need to invest $500,000 to expand your business, but you receive an inheritance of only $10,000 under a testamentary trust.  You either have the $500,000 yourself, or assets which you could use as security to borrow it.  The testamentary trust borrows $500,000 – either from you if you have the spare cash, or from a third party – and invests it in your business in return for say a 50% share.  Again, half your business income would then be earned through this tax-advantaged vehicle.

Case Study 3

You do not need capital to expand your business, and you receive any amount as an inheritance under a testamentary trust will. If you do not have substantial unrealised capital gains in your business, or if you have capital losses against which you could offset any capital gain, and depending on the amount of stamp duty which will apply to the transfer, you may benefit from selling your business to your testamentary trust for market value. You would then begin earning all your business income through this tax-advantaged vehicle.

Case Study 4

You receive an inheritance of $300,000 under a testamentary trust will. You wish to buy an investment property for $600,000. Because you have a substantial deposit, the property will be positively geared, so there is no benefit in holding it in the name of an individual in a high tax bracket. The testamentary trust borrows $300,000 and buys the property. Net rental returns, and any capital gain on disposal, can be distributed among your family members through the tax-advantaged testamentary trust.

Case Study 5

You are an investor with a share portfolio worth $300,000. Of that, approximately $100,000 worth of shares have unrealised capital gains, $100,000 worth are at around “break even” and $100,000 worth have unrealised losses. You receive an inheritance of $100,000 under a testamentary trust will. You sell the $100,000 “breakeven” shares to the trust for market price. You lend the $100,000 back to the trust, which it uses to buy more shares. As you sell the “gain shares” and the “loss shares” held outside the trust, you lend the proceeds of sale to the trust on arms’-length terms. The trust uses the loan funds to buy replacement shares.

If you earn other income (e.g. salary) which you would otherwise use to buy more shares in your own name, you also lend these amounts to the trust (on arms’ length terms) for it to buy shares instead.  Over time you build a large share portfolio within this tax-advantaged vehicle.

Case Study 6

You come into any of the above categories, you have no family, but you plan to start one in the future. You presently have no opportunity to save tax by income splitting. You will be no worse off now by holding assets in a testamentary trust, and you will realise significant tax benefits when you start a family. Tax planning is a long-term activity. It is important that you acquire assets in the most tax-effective vehicle at the start, as buying them in the wrong structure and seeking to move them later may incur significant transaction costs, capital gains tax and stamp duty.

Conclusions on tax savings

As can be seen from the above examples, the amount you receive as an inheritance is not critical to whether you would benefit from assets being left to you under a testamentary trust will. Even $1 received on a testamentary trust could be worth tens, if not hundreds, of thousands of dollars of tax savings over your lifetime.

Note that income earned by a testamentary trust from investing assets transferred into the trust after the death of the deceased who made the will can only be distributed to minor children in a tax-effective way if the asset transfer was on arm’s-length terms.

Assets left to you on a testamentary trust are not “locked away”. If you need to access your entire inheritance at once (e.g. to pay off a mortgage) you are free to do so.

Asset protection

Another key benefit of a testamentary trust is asset protection. Many business people and investors avoid holding assets in their own name, to protect them from claims if they incur a major liability. If your parents leave you assets under a “standard” will while you are in financial difficulties, or they develop later, they can be taken by your creditors.  If you received the same assets under a testamentary trust will, however, while you still enjoy all the benefits of owning the asset, it is not legally “yours”, and is therefore safe from any legal claims against you.

What to do next

If you stand to receive:

  • a significant inheritance, or
  • any inheritance at all, but you could take advantage of a low-tax vehicle to hold a business or investments,

you may wish to discuss with your parents the possibility of leaving your inheritance to you under a testamentary trust will.

You should also consider the benefits of to your own dependents of including a testamentary trust in your will, particularly where you may leave behind a young family, or children who are raising families themselves or plan to do so.

[1] Assuming no family member has other income.
[2] See note 1.