Mum dies, baby pays 66% tax

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Parent dies leaving children under 18 – use of Post-Death Testamentary Trust

In a perfect world, you build a 3-Generation Testamentary Trust in your Will. When you die, your Estate is tax-free for 80 years. A 3-Generation Testamentary Trust washes out the de-facto death duties: Capital Gains Tax, Stamp Duty and income tax. But this is not a perfect world. People die without tax effective Wills. Sadly, at times, a mother or father die with children under 18-years. This story is about those unfortunate souls.

There is no point reading this article if the dead person has no children under 18 years of age.

Mum’s car rolls over. She dies. Dad and the 6-month old baby don’t sleep much that night. Mum’s Will contains no 3-Generation Testamentary Trust. It leaves everything to Dad. With no 3-Generation Testamentary Trust, any income to the child is taxed up to 66%.

But the Government wants to help. Where the Estate goes into a 3-Generation Testamentary Trust, the child gets an adult tax rate threshold – just as if they were over 18. They, therefore pay little tax. Not here, however. All the Estate is going to dad – nothing to the 6-month old. There was no 3-Generation Testamentary Trust in the Will.

What can Dad do? Child Maintenance Trust

  1. Dad gets probate. The Will does not need to be varied. Dad does not need to renounce.
  2. Dad creates a Post-Death Testamentary Trust (also called Child Proceeds Trust and Child Maintenance Trust)
  • the trust is created for the benefit of the 6-month old
  • it is created within three years of Mum’s death: s 102 AG(2)(d)(ii) Income Tax Assessment Act 1936
  • he puts the maximum amount into the trust – the amount the child would have received had there been no Will
  • the trust finishes within 80 years of Mum’s death (earlier if the child dies)

The income distributed to the 6-month old is “unearned” income. Normally, this is taxed at 66%. However, because Dad is using a Post-Death Testamentary Trust, the tax rate is lower – being that of an adult marginal tax rate. Five years later, Dad goes bankrupt. His second wife spent all his money. She is divorcing him. The second wife wants the money in the child’s Post-Death Testamentary Trust.

Thankfully, the child is the sole capital beneficiary of the Post-Death Testamentary Trust. The money is safe. Dad’s creditors cannot touch the child’s trust money. Placing a 3-Generation Testamentary Trust in your Will automatically reduces tax. While a Post-Death Testamentary Trust is not as valuable, it is still useful for parents with children under 18 years.

What if the child’s Grandmother dies instead?

Sorry, the Post-Death Testamentary Trust only works if:

  1. a parent dies; and
  2. their child is under 18    Child Maintenance Trust

Of course, a 3-Generation Testamentary Trust does not suffer these restrictions.

 

Does the child control the trust at 18?

Control of the trust does not generally pass to the child when they turn 18. It depends on the drafting of the Post-Death Testamentary Trust. Dad usually keeps control for the next 80 years. If the child is mature and hardworking, Dad may decide to hand control over to the child earlier.

 

What about money not in Mum’s Will?

Dad also received Mum’s life insurance directly: the money went directly to him. The insurance was never part of Mum’s Estate. The money did not go to the Will. Dad cannot now put the insurance into the Post-Death Testamentary Trust. The Post-Death Testamentary Trust is only for the assets that automatically went into the Estate.

 

What About Joint Tenancy?

Mum and Dad owned their home as joint tenants. They jointly owned the house in equal shares. When one dies, their half of the house goes directly to the remaining person. This is the “Survivorship Rule.” Therefore, when Mum died, Dad received her half of the house directly. It did not become part of her Estate. It did not go into Mum’s Will. Her interest in the home, cannot be part of the child’s Post-Death Testamentary Trust.

 

What happens if the child dies?

The Post-Death Testamentary Trust assets go into the child’s deceased Estate. There cannot be a clause in the Post-Death Testamentary Trust Deed diverting the assets elsewhere.

 

Are there any de facto death duties?

Exemptions for stamp duty and capital gains tax by using Post-Death Testamentary Trusts are rare. In contrast, these taxes do not apply for 3-Generation Testamentary Trusts in a Will.

Why does the Government penalise ‘passive’ income to children?

Division 6AA ITAA 1936 taxes children at penalty tax rates. People over 18 (adults) pay a lower marginal tax rate than children. For children, the tax rate is 66% above $416. This penalty prevents parents using their children to get tax benefits.
“Passive income” is income you get without working – like rent from a property or interest that a bank pays you. If the child “earns” money through modelling or a paper-round, the child gets the benefit of paying tax at an ‘adult tax rate’. (This is the tax rate adults pay. It is lower than the penalty child tax rates.) However, a child is not so lucky for “unearned” income.

 

What is “unearned income”?Child Maintenance Trust

In Confidential Trust v FCT [2014] AATA 878, the trust had two beneficiaries – both were children under 18. The trust money was from a worker’s compensation claim. The income generated from the trust monies was “unearned income”. The “unearned” or “passive” income was paid to the children. Sadly, the children were under 18 and therefore didn’t gain the advantage of the adult marginal tax rates. The money was taxed at the penalty tax rate in the hands of the minors.

When can a child gain the advantage of paying tax on the adult tax rates?
There is an exemption to the above draconian rule. Division 6AA ITAA 1936 does not apply to an “excepted person”.

 

What is an “excepted person”?

An “excepted person” is a child under 18-years who:

• is a full-time employee (working at Hungry Jacks)
• is permanently disabled
• receives a disability pension or double orphan pension: section 102AC ITAA 1936
• derives income from a 3-Generation Testamentary Trust: Division 6AA ITAA 1936 (“excepted income”)

What is “excepted income”?

“Excepted income” is income taxed at the adult marginal tax rate. It Is not taxed at the penalty rate applied to minors.
Income received from a deceased estate, through a 3-Generation Testamentary Trust is “excepted income”. It is taxed at the adult tax rate: section 102AG ITAA 1936.
“Excepted income” also includes income from:

• employment
• taxable pensions, payments from Centrelink or the Department of Veterans’ Affairs compensation or superannuation
• a divorce
• damages from an injury
• an estate Child Maintenance Trust

Does the ATO check Post-Death Testamentary Trusts?

Yes, the ATO pays close attention to Post-Death Testamentary Trusts. We have found Post-Death Testamentary Trust often contain drafting errors. Legal Consolidated ensures that:

  1. Post-Death Testamentary Trusts comply with Division 6AA and Section 102AG Income Tax Assessment Act 1936 (Cth).
  2. the correct annual minutes of distribution are upheld
  3. proper tax considerations are met
  4. the capital only goes to the under 18-year old children  Child Maintenance Trust

A Post-Death Testamentary Trust is a poor man’s trust. While avoiding some death taxes, it lacks the flexibility of a 3-Generation Testamentary Trust.

Speak with your financial adviser and accountant. They know your situation and are able to advise whether a Post-Death Testamentary Trust is an option for you.

To avoid all these issues, your financial adviser and accountant can build a 3-Generation Testamentary Trust Will on our website. Child Maintenance Trust

Written by Adjunct Professor, Dr Brett Davies (Partner) and Madeleine Baxter (Solicitor) at Legal Consolidated Barristers & Solicitors

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