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Testamentary Trusts & Gearing



Testamentary Trusts can:

a)    Distribute wealth to beneficiaries over time after the Testator’s death. Normally, the assets remain in trust with the distribution of income arising from those assets being paid to beneficiaries under a specified age or until they reach a nominated age with a final distribution of the assets occurring according to the terms of the trust. In this way, the Testator ensures the beneficiaries are mature enough to handle an inheritance.

b)    Protect the wasting of family assets by spendthrift beneficiaries. Testamentary Trusts can ensure assets do not end up in the name of a beneficiary who has exposure to claims by creditors or other claimants. Testamentary Trusts can provide a means to leave part of the estate to grandchildren in an efficient way instead of to financially vulnerable children.

c)    Leave parts of the estate to beneficiaries under 18 in a tax-efficient way. Income paid by Testamentary Trusts to children is taxable as ordinary adult income with the benefit of the standard tax-free threshold of $6000.00 for each beneficiary. This is significant as trust income of children, (“unearned income”), is subject to punitive taxes.  


Income paid to children from Testamentary Trusts is not subject to punitive taxes that apply to trust income (and other types of unearned income) paid to beneficiaries under 18 years. (The Income Tax Assessment Act, 1936, contains a special provision to discourage families from entering income-splitting arrangements to gain tax advantages by distributing income to children. A child’s income caught by this special punitive provision has a low tax-free threshold rather than the standard adult tax-free threshold.

The non-applicability of the punitive rates for children to income from testamentary trusts opens some excellent estate planning/tax planning strategies. A Testator with a testamentary trust in a Will might arrange for four grandchildren to each receive a tax-free annual income from a testamentary trust of $6000.00 (This is tax-free only if the children had no other income). In this example, the testamentary trust could distribute an annual total tax-free amount of $24,000.00 for many years.  


Trusts have become more popular in recent years because of the growing importance of asset protection. Much-publicized corporate collapses have emphasized the need for business people including company directors, executives and professionals to take sufficient action to protect their family wealth. This need for asset protection extends throughout the community.  


The owner of a small-to-medium business may have carefully taken steps to protect the family wealth during his lifetime against claims by creditors and other litigants. However, his painstaking asset-protection strategies could suddenly become largely undone if his wife were to predecease him and leave all her assets to him. Any litigants could immediately expose the assets inherited from his spouse to claims. An answer may have been for the wife to have a testamentary trust that would provide a regular income to their children.


Investors with concerns about the share and property markets should review their gearing strategies. Gearing is a way for an investor to gain a higher exposure to the share and property markets than would be possible without borrowing. This extra exposure multiplies capital growth when a market is rising, but multiplies losses when a market is falling. There are three fundamental levels of gearing, each with different levels of risk and different levels of tax benefits:  


This occurs when an investment’s borrowing costs and other non-capital costs exceed the investment’s income. The shortfall is tax deductible against an investor’s other income. Negative gearing has the highest level of risk for an investor because additional income from another source, typical from a salary, must meet all of the interest payments. However, the tax benefits of negative gearing are higher than for lower levels of gearing.  


This occurs when an investment’s borrowing costs and other non-capital expenses exactly equal its income. Although the investment’s income is taxable, the borrowing costs are tax deductible. Even on, an after-tax basis, the investor is in a neutral or balanced position. Many investors are willing to forgo the extra tax benefit of negative gearing to reduce their risks in uncertain times through neutral gearing.  


This occurs when an investment’s income exceeds its borrowing costs. The borrowing (and other non-capital expenses) costs are deductible with positive gearing. Investors using positive gearing have reduced tax benefits.

A neutral or positive gearing position is a delicate arrangement, meaning that the balance is easily upset if the income is less than expected. For example, many landlords of rental properties are now less confident of finding tenants in the present market conditions. A significant fact to keep in mind is that your normally tax deductible costs are still tax deductible even though your investment may not produce an income for a period.

Most investors who intentionally follow a negative gearing strategy expect to move to a neutral gearing position and then a positive gearing position as their investment matures. Their long-term aim, however, is to achieve their highest reward from a capital gain. Only half of the gain is taxable at the taxpayers’ marginal tax rate providing the investor holds the investment for at least 12 months, effectively halving capital gains tax.  


1    Neutral and positive gearing strategies are less risky than negative gearing.

2    Neutral and positive gearing strategies provide less tax benefits than negative gearing and can mean a lower exposure to share or property markets.

3    The gearing strategy should depend largely on personal circumstances and the prospects for the particular investment involved.


Behan Legal advises and assists on these important issues. For an appointment, call 03 9646 0344 .

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