Introduction

While the preparation of wills and estate planning advice is the responsibility of lawyers suitably qualified in those areas, it is important for lawyers and accountants to work together to ensure that the estate planning is in line with taxation and other business plans.

Often considerable effort is put into determining the best structure for a family group for both tax planning and asset protection purposes. However, if the reasons behind the structure are not taken into consideration, individuals may undo all of that effort leaving their estate to the “wrong” person.

A simple example of this is a husband and wide where the husband is a surgeon (high income and high risk of being sued) and the wife does not work (low income and low risk). In this case, the most basic structure will be to have all investments and other assets held in the name of the wife, where income will be taxed at lower marginal tax rates, and assets will not be at risk should the husband be sued. However, if the wife were to die, leaving her entire estate to the husband, any future income will be taxed at the highest marginal tax rate, and assets will be risk should he be sued. While it is possible to transfer any assets out of the husband’s name, there could be issues if the husband is being sued at the time of the wife’s death.

Even where investments and other assets are held in a trust, poor estate planning can undo the effectiveness of a structure, particularly where there are large unpaid present entitlements owed to beneficiaries.

Using the previous example, if we assume that the couple’s investments are held in a discretionary trust each year a declaration is prepared distributing the income to the wife, but as they do not need the cash, nothing is actually paid. In this situation, if the wife were to die, leaving her entire estate to the husband, there is still the possibility to distribute the trust’s income to other low income beneficiaries. However, as the unpaid distributions owning to the wide become an asset of the husband, they may be at risk should the husband be sued. The trustee may then be required to sell trust assets in order to meet any requirement to out this loan.

Estate planning options

There are several options available to prevent assets being passed to a high-income, high-risk individual. these options include:

  1. the creation of a testamentary trust within their will, with assets held for the benefit of one ore more beneficiaries;
  2. the creation of life interests within their will over one or more assets; and
  3. the forgiveness of unpaid present entitlements, either within their will or on a regular basis.

Each of these options is explored below.

Testamentary trust

A testamentary trust us simply a trust which comes into existence upon the death of an individual. A provision is made within an individual’s will that following their death, certain assets will be held on trust for more or more beneficiaries.

testamentary trusts are most commonly used when providing for minors, such as the deceased’s children or grandchildren, or for others that are subject to a legal disadvantage. However, they can be used for tax planning and asset protection purposes.

the greatest tax advantage of using a testamentary trust is that income distributed to minors will be taxed at normal marginal tax rates rather that the penalty rates which apply to unearned income of minors. there is no requirement that the beneficiary be related to the deceased to obtain this tax concession, provided that they are included in the provisions of the will. Depending on the number and age of minor beneficiaries, this concession can result in a significant reduction in tax playable during the life of the testamentary trust.

Where the trustee of the testamentary trust has discretion over distributions of income and capital, any beneficiary’s entitlement to the trust assets will be limited to any unpaid distributions to which they have been made presently entitled.

Where there is a single beneficiary of the testamentary trust, who is not under a legal disability, the beneficiary many be deemed to be presently entitled to the income and assets of the trust, making the trust ineffective. In this situation, it may be possible to provide the trustee discretion as to whether to make income or capital distributions.

Care should be taken where it is intended that a testamentary trust is to vest at a point in time, say when minor children reach 18. Where there is more than one potential beneficiary of the trust, CGT event E5 (beneficiary becoming entitled to a trust asset) occurs when the conditions for the passing of the interest to the beneficiary are satisfied.

CGT event E5 will not occur where there is a single beneficiary of a trust who becomes presently entitled to the assets as their is no charge in beneficial ownership. therefore, it there are significant asserts to be left to multiple minors, it may be beneficial to establish separate testamentary trusts to prevent the crystallisation of any capital gains or losses when each beneficiary becomes presently entitled. However, there may be additional compliance costs associated with maintaining testamentary trusts.

Continuing our previous examples, if the wife were to provide in her will that any investments held in her individual name are to be held in trust for the benefit of her husband and children, at the discretion of the trustee, and any income can be distributed to the children to be taxed at normal adult tax rates. The husband’s only asst will be any amounts to which the trustee has make him presently entitled.

Life interest

A life interest is created when the ownership of an asset is left to one or more beneficiaries (the remainder beneficiaries) but another beneficiary is granted the use and enjoyment of the asset during their lifetime (the lifetime beneficiary).

A life interest is often used in blended families where the owner of the family home wishes to leave the house to the children from a previous marriage, bot allow their current spouse to live there for the reminder of their life. It can also be used to provide an income stream for a particular beneficiary, by leaving income-producing assets to one beneficiary, but providing that the income be used for the benefit of another.

the principles which apply to pass ownership of an asset to one beneficiary, but the usage to another can also be used for asset protection purposes.

Continuing our earlier example, let us assume that the family home is owned solely in the wife’s name, protecting it from claims against the husband. In the wife’s will she can provide that the house is to be left to their children (held in trust if under 18), but grant the husband a life interest to live in the house for the remainder of his life.

From a capital gains tax perspective, the asset will be deemed to be owned by the reminder interest holders during the entire period which the life interest exists, with the normal inheritance rules applying to deem the purchase date and cost base, depending on when the deceased purchased the asset. If the asset is sold at some point in the future, the capital gain will be realised in the hands of the remainder interest holders.

Where a life interest is created over a dwelling which was the main residence of the deceased, s 118-195 of the Income Tax Assessment Act 1997 (Cth) (ITAA97) can apply to extend the exemption for the period in which an individual with the right to occupy the dwelling under the deceased’s will uses it as their main residence. Therefore, the benefits of the main residence exemption will be lost.

It is worth noting that a life interest is an asset of the life beneficiary, and if they choose to give it up, or deal with it in some other way during their lifetime, it will be necessary to consider the capital gains tax issues that may arise. Depending on the nature of the asset in which it is located, transfer duties may also apply on this dealing with the life interest during the holder’s lifetime.

Forgiveness of unpaid present entitlement

While the forgiveness of the liability to pay any unpaid distributions is not technically an estate planning exercise, there is a flow-on effect on what is included in an individual’s will.

Any unpaid distributions owned by a trust to an individual will be an asset of the individual, and will be included in their estate upon their death. This asset will then have to be dealt with according to the individual’s will. However, if the debt were forgiven prior to their death, there would be no asset to be included in the individual’s estate and therefore no possibility that it will be left to the “wrong” person from an asset protection perspective.

As a general rile, the commercial debt forgiveness rules contained in Dev 245 ITAA97 will apply to the forgiveness of a debt where interest paid on that debt is deductible. These provisions can have quite significant tax implications on the debtor. However, s 245-40(e) ITAA97 provides that the commercial debt forgiveness rules will not apply to debts forgiven for reasons of natural love and affection.

There is no definition provided for “natural love and affection.” However the ATO has issued imperative decisions which give a wide interpretation of this term.

ID 2003/582 provided that the love and affection does not need to be between the creditor and debtor for s 245-40(e) to apply.

It should be noted that this interpretive decision was withdrawn on 5 April 2012. However, we have had confirmation from the ATO that this view is still current.

Similarly, ID 2003/589 states that the creditor does not need to be a natural person for the debt to be forgiven for reasons of natural love and affection. This principle can apply equally to conclude that the debtor also does not need to be a natural person.

Applying these principles to an unpaid present entitlement owning by a trust to an individual beneficiary, the beneficiary can choose to forgive the debt as a result of the natural love and affection that they have for the other beneficiaries of the trust.

The forgiven debt would form part of the capital of the trust, and can be used to make capital distributions to beneficiaries should the need arise.

Conclusion

Estate planning should not occur independently of any other planning exercise, whether that is taxation planning or structuring planing for asset protection purposes, but should form part of the holistic planning process. By considering the intentions behind the other plans, an individual’s will should not leave any nasty surprises for their beneficiaries.

This is an area where accountants, lawyers and other advisers should work together to ensure that the best outcome is achieved for their clients.

This article was first published in Taxation in Australia VOL 50(5)