SMSF vs 3-Generation Testamentary Trust

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Adjunct Professor, Dr Brett Davies
Founder, Legal Consolidated

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SMSF vs 3-Generation Testamentary Trust
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SMSF vs Testamentary Trust
‘No longer is Super a tax haven or an Estate Planning tool – it is only for your retirement.’ Canberra speaks
Super ‘loop-holes’ closed

On 1 July 2016, the Liberals successfully passed legislation to make it harder to get wealth into Super – and then harder to get it out! This attacks both the tax breaks and Super as an Estate Planning tool. This is the SMSF vs Testamentary Trust debate.

What is the ‘Deal’ with superannuation? What is the covenant?

This is the deal:

  1. the government gives you massive tax discounts when you put your money into Superannuation
  2. but, you can’t touch it until you reach the retirement age – it is locked away

This is a fair exchange, some would have thought, but not the Government. Now:

  • $1.6m superannuation transfer balance cap
  • taxation of concessional superannuation contributions reduced to $250k
  • annual non–concessional contributions cap reduced to $100k
  • anti–detriment rule abolished

Is Super still useful for wealthy people?
What about 3-Generation Testamentary Trusts? SMSF vs Testamentary Trust

For those people (I won’t call them wealthy, because often the are not, they are just hard working)  who have already loaded up their Super with $1.6m they need to look at:

  1. Wills with 3-Generation Testamentary Trusts (comes into effect when you die – children taxed at low adult tax rate)
  2. Family Trusts (come into effect when you set them up – before you die – but children taxed at 66%)

SMSF vs Testamentary Trust – the debate

Contrary to popular opinion 3-Generation Testamentary Trusts (and the common garden variety Testamentary Trust) only do only one job – reduce tax. The characteristics of a 3-Generation Testamentary Trust are:

  1. Each child can set up none, one or more 3-G Testamentary Trusts for their interest in your estate. For example, one child can set up 4 Testamentary Trusts for his half. The other child can choose to set up none.
  2. Cherry pick which assets you want. Eg. provided the two children end up with 50/50 by value, one child can take the shares and the other child can take the real-estate
  3. Operates for 3 generations – mum, then the children and then the grandchildren – up to 80 years from the date of your death
  4. Comes into effect when the Will comes into effect – that is when you die
  5. All minor beneficiaries including grandchildren, great-grandchildren and your 17-year-old mistress benefit from the lower adult tax rate (in contrast minors after receiving $416 pay 66% tax)
  6. Not means tested for Centrelink
  7. Automatically activated Bankruptcy Trust if a beneficiary is bankrupt at the date of your death
  8. If required, ‘Spendthrift trusts’ – with extensive maintenance clauses to allow for food, shelter and quality of life
  9. Superannuation Testamentary Trust – to stop your adult children over 18 paying 32% tax on your Superannuation

Can my wife and then children do whatever they want with my estate?

Yes, they can. As stated above, your 3-G Testamentary Trust only does one thing: it reduces tax. Your spouse has full control of your assets. She can do whatever she wants; buy a boat, travel, give money to the children or whatever she feels like. Your wife can even choose to not set up a Testamentary Trust. It is her money, the 3-G Testamentary Trust is only to reduce tax. It does not control her. After you both have died, likewise your children can do whatever they wish to do with ‘their’ money. They can buy another home, a car or go on a holiday.

What about vulnerable children?

If you are not happy with the above then Mum and Dad can build Wills with ‘Spend Thrift Trusts’. In that instance, the child now suffers the indignity of having to go hat in hand to ask the Trustees for money. This is useful if the child is drug or mentally affected, but otherwise a little harsh.

A Spendthrift trust is useful for a vulnerable beneficiary:

  1. child under 18 or young (make the Age of Majority, for example, 25 years of age)
  2. drug affected
  3. gambling addiction (casinos, Pokemon cards or fast cars)
  4. mentally disabled, including Bipolar Disorder and Manic Depressive.

What if my child gets divorced?

The Family Court ignores any protection afforded by a Testamentary Trust. The Family Court even ignores the superior 3-G Testamentary Trust. After you die, if it smells like some money is ear-marked for your son, then the Family Court will put it in the pot. To the Family Court, all trusts are mere alter egos. Irrespective of how tied up, Trust assets are marital property available for dividing between the couple.

Challenges after you die

a) Who can challenge where the Super goes? 

If you have a binding non-lapsing death benefit nomination (Binding Nomination) then your Super can’t be challenged at death. Build Binding Nominations here. With Binding Nominations your Super goes where you want it to go. You have only two choices where your Super goes: 1. directly to dependants or 2. to your estate (Will).

If your Binding Nomination is to your estate then your Super goes into your Will. Your Super stops being Super and is now just another asset of your estate. Since your Will can be challenged the Super in your Will can be challenged.

b) Who can challenge my Will? 

Sadly, unlike Superannuation that can be structured so that it can’t be challenged, there is no such certainty in a Will. A Will is a grubby little document that the Court can rewrite if it feels you haven’t been fair to all your ‘loved ones and family’. This is a family provision claims. ‘Eligible persons’ can claim that they had inadequate provision for their ‘proper maintenance, education or advancement’ in life. These eligible persons are:

  1. parents
  2. people you sleep with such as a wife, husband, mistress, de facto and same sex partner (you can have more than one – if you can afford it)
  3. step-children living with you that you maintain, children, children you adopt and
  4. grandchildren if parent dead
  5. grandchildren if they are living with you
  6. in NSW, a person ordinarily resident in the household and dependent upon you (sexual involvement is not required)

Testamentary Trusts don’t protect your assets from challenges from your family. This is because the Will itself is challenged. Testamentary Trusts and 3-G Testamentary Trusts are merely trusts sitting in the Will.

Tax advantages of 3-G Testamentary Trust

Only ‘legal entities’, being humans and companies, pay tax. A trust is not a legal entity. A trust, itself, doesn’t pay tax. Instead, the beneficiaries of the trust pay the tax. The trust’s beneficiaries are humans and companies. Trusts are taxed under:

  1. Division 6 Part III Income Tax Assessment Act, 1936 (ITAA 1936); and
  2. Chapters 3-1 and 3-3 Income Tax Assessment Act 1997 (ITAA 1997).

In summary:

  1. Prepare the annual 3-Generation Testamentary Trust Distribution Statement
  2. Calculate the 3-G Testamentary Trust’s ‘net income’
  3. Trustee distributes the income to the lucky beneficiaries on the lowest marginal tax rate (‘presently entitled’) according to the Distribution Statement  (these are journal entries, actual money rarely changes hands)
  4. Income not distributed is taxed in the Trustee’s hands at the highest marginal tax rate (no beneficiaries presently entitled)
  5. While in a Family Trust children are taxed at 66% above $614; in the 3-G Testamentary Trust the minor gets the benefit of the adult tax rate thresholds
  6. Anytime during the 80-year life of the 3-G T/T, assets can be transferred from the 3-G T/T to a beneficiary for no Capital Gains Tax. No CGT is triggered by the transfer. The transfer to the beneficiary does not trigger a CGT. In fact, there is no CGT liability on that asset until the beneficiary disposes of the asset.
The costs base:

(a) for pre-1985 CGT assets – as at the date of your death. Eg. you purchased the land for $50k in 1982. You died today and the land was worth $2.3m. Your beneficiaries’ cost base is $2.3m. If your beneficiary sells the land for $2.3m no CGT is payable.

(b) for post-1985 CGT assets – the beneficiary ‘stands in your shoes’. Your beneficiary inherits whatever cost base you had. Eg. you acquired the land for $400k. By the time you died the land was worth $900k. Your cost base as at date of death is $900k. So to your beneficiaries cost base is the same amount: $900k. If your beneficiary sells the land for $900k then they made a $500k capital gain.

(c) your family home retains its tax-free status for 2 years after death if it remains in the Executor’s name. Eg. at death your home is worth $6m. It increases in price to $8m within 2 years. Your children quickly sell the home within 2 years from your date of death. The whole $8m is tax-free. But say, by mistake, they sell it 2 years and one day after your death – then they will have to pay tax on the $2m capital gain.

So which is best: SMSF vs Testamentary Trust?

If it is not possible to put any more money in Superannuation then a 3-Generation Testamentary Trust is a viable alternative tax saving strategy. If you have to narrow Estate Planning to one word it is ‘flexibility’. You don’t know when you will die, what you will own at death and the tax law. The 3-G T/T:

(a) allows income to go to low tax payers for that financial year

(b) change the distribution the following year to another beneficiary

(b) distribute to minors using the adult taxpayer tax-free threshold

(d) stream based on Bamford’s case

Two problems with 3-Generation Testamentary Trusts

  1. Wealthy people die with few assets in their name. Instead, they commonly use Family Trusts, Unit Trusts and companies throughout their life. Therefore, only assets in their own name can get into the Will and therefore into the 3-G TT.
  2. You have to die to get a 3-G TT – it is the ultimate sacrifice to give your children a tax-haven. But since you have to die one day, it is a wonderful gift to give to your descendants.

SMSF vs Testamentary Trust was written by Adjunct Professor, Dr Brett Davies, Partner, Legal Consolidated Barristers & Solicitors
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