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 dies 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 with a dead Wife with no Will? Child Maintenance Trust to the rescue
- Dad gets probate. The Will does not need to be varied. Dad does not need to renounce.
- Dad creates a Post-Death Testamentary Trust (also called Child Proceeds Trust, Poor Man Testamentary Trust or Child Maintenance Trust)
- the trust is created for the benefit of the 6-month-old
- it was 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? Can you still set up a Child Proceeds Trust?
Sorry, the Post-Death Testamentary Trust only works if:
- a parent dies; and
- 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 Child Proceeds Trust at 18 years of age?
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 estate?
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.
Joint Tenancy assets vs Child Maintenance Trust?
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 to the Child Proceeds Trust when 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 when you die without a Will?
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? Div 6AA
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 from 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” for Division 6AA?Child Maintenance Trust
In Confidential Trust v FCT  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”? Section 102AG exemption
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:
- taxable pensions, payments from Centrelink or the Department of Veterans Affairs compensation or superannuation
- a divorce
- damages from an injury
- an estate
Private Ruling 1011602878465
One example of a basic or ‘bare’ testamentary trust occurs when someone gives a gift to a person who is not legally able to manage it, such as a child under 18 years of age.
This is what happened in the ATO’s private ruling 1011602878465. In this matter:
- The beneficiary, a child, received money as gifts, which their parent invested on their behalf.
- The money came from various sources, including an inheritance from a deceased relative. (Division 6AA exempt income under section 102AG?)
- The parent held this money in a bank savings account with the label ‘[Parent’s name] in trust for [child’s name].’ (This is a ‘bare’ trust.)
- According to the dead relative’s Will, while the child is under 18, a specific amount is given to their parent or guardian to manage for the child’s benefit.
- Is this income taxed at 66%? Or is it ‘excepted trust income’ taxed more favourable under section 102AG – and therefore taxed at more liberal ‘adult’ tax rates?
- ATO stated that the portion of interest income considered ‘excepted trust income’ depends on how much of the original money in the bank account came from the deceased relative’s estate compared to other non-estate gifts.
- So the dead ‘relatives’ money from the Will is protected. Any other money that derives income is taxed under the Division 6AA penalty children’s tax rates.
The moral of the story is to keep assets, with different tax rules, separate. Similarly, Family Trust assets should not go into the Will.
Does the ATO check Child Maintenance Trusts?
Yes, the ATO pays close attention to Post-Death Testamentary Trusts. We have found that the Post-Death Testamentary Trust often contain drafting errors. Legal Consolidated ensures that:
- Post-Death Testamentary Trusts comply with Division 6AA and Section 102AG Income Tax Assessment Act 1936 (Cth).
- the correct annual minutes of distribution are upheld
- proper tax considerations are met
- 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 can 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 Adj Professor, Dr Brett Davies (Partner) and Madeleine Baxter (Solicitor) at Legal Consolidated Barristers & Solicitors