What is a testamentary trust?

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This week, we want to discuss a potentially sensitive issue for many people – what to do with your assets after you die. In order not to breach our client’s privacy, we thought we would use a recent ‘ask the expert’ scenario from the Fairfax press, which read in part:

We are aged 80 and 79, respectively, and together have more savings than we will ever spend. Our estate is to be divided between our daughter in the US and son in the UK. He is addicted to the card game machines found in almost every NSW pub. I thought of boosting his superannuation, which he cannot access until retirement, but what then? We could set up a testamentary trust, but who could act as trustee?

We have edited the scenario a little bit, and we need to also point out that we would want more information from this couple before offering definitive solutions. This is simply too complex a situation for people to be relying on a newspaper advice column (as the columnist rightly pointed out in his response). Amongst much else, we would want to know what the total assets would be and then how those assets are currently held. The answer to those questions would be very important to our answer.

This scenario caught our eye due to the mention of a testamentary trust. Testamentary trusts are special types of trust that are created according to the Will of someone who dies. To understand them, it helps to understand what a trust is in the first place.

A trust is a complex legal device that generally tries to achieve quite a straightforward outcome: to create a situation where one person manages – and legally owns – assets on behalf of another person. A trust describes a unique situation in which legal ownership is separated from beneficial ownership. The legal owner of the assets is called the trustee, and the person who benefits from the assets is called beneficiary.

An example of a trust that you might be familiar with is superannuation. Most managed super funds are trusts, with a trustee company legally owning the assets and managing those assets on behalf of beneficiaries, usually referred to as members of the fund.

In the case of the couple above, the beneficiary of the proposed trust would be the son, with some other person legally owning and managing the assets in the trust for the son’s benefit of the son as his trustee. Managing the assets can mean different things. It may involve for example, the trustee giving the son a small regular allowance from the trust’s assets for him to live on. Alternatively, the trustee might use the trust to buy a house for the son to live in for the rest of his life. The key point would be that, while the rules of the trust require that the assets be used for the son’s benefit, the son himself does not own the assets. In this simple case, this prevents him from using the assets to pay for gambling. If you do not own an asset, you cannot lose the asset.

testamentary trust is a trust that only comes into existence when the person who wants to create the trust dies. Often, the person’s Will states that, when they die, the executor should sell all the assets and place the proceeds into one or more trusts for the benefit of one or more beneficiaries.

Commonly, the Wills of parents of young children provide for a testamentary trust to be created for the benefit of the kids until they reach a certain age, at which point the trust dissolves and the kids can start to manage the assets for themselves. The reason for this is obvious: if Mum and Dad die while the kids are still minors, the kids cannot legally own certain assets. However, even after the kids have turned 18, they may not be able to manage substantial assets for their own benefit – it can be hard to put an old head on young shoulders.

The reason that testamentary trusts only come into existence when a person dies is usually that they do not need a trust before they die (and in the case of Mum and Dad, they usually do not need a trust until they both die – which is very uncommon for parents of young children). If Mum or Dad remain alive until their kids reach a certain point of maturity, for example age 25, then no trust is usually needed when they eventually die.

In the scenario above, however, this is not the case.  Mum and Dad are worried that their son would not be able to manage money that he inherits directly. That is why they are contemplating a testamentary trust.

Whether a testamentary trust is the best way to proceed depends on many factors that the scenario does not identify. The most important one is whether there would be a person/s who can act as the trustee. While the daughter may be one option, there might be some issues here: she might be several years older than her brother, in bad health, or simply unwilling to manage her brother’s affairs.

This is where the work of a good financial adviser comes in. In a scenario like this, the most important rule is not to rush. The situation is complicated and the solution needs to be a sensitive one. That said, obtaining the best outcome in a situation like this is one of the real joys of our work, as it allows Mum and Dad to have real peace of mind about their much-loved children. After all, you never really stop loving your loved ones and wanting the very best for them.

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