A trust is a relationship between the legal owner of the trust’s property (the trustee) and those who benefit from the property of the trust (the beneficiaries). The trustee must administer that property on behalf of and for the benefit of the beneficiaries. One type of trust is a testamentary trust. This article explains how testamentary trusts operate and their advantages and disadvantages.
Key Terms
Settlor – this person is usually a lawyer or accountant who sets up the trust and deposits the first asset e.g. a nominal amount of $10. They usually have nothing further to do with the trust beyond setting it up.
Appointor – the person who appoints or removes a trustee, though not all trusts have an appointor.
Trustee – the person who holds the trust assets and manages them on behalf of the beneficiaries. They are responsible for distributing the income and capital proceeds of the trust according to the terms of that trust.
Beneficiary – the person who is entitled to receive the income and capital proceeds from the trust.
There are several types of trusts, including discretionary and unit trusts. A testamentary trust is a type of discretionary trust.
Testamentary Trust
An individual creates a testamentary trust in a will or a codicil to a will. A will is a written document that reflects a person’s last wishes concerning the disposition of their property. Likewise, a codicil is a document that supplements an earlier will. It adds to, alters, confirms or revokes a will or a part of a will. A testamentary trust is unique because it does not relate to the transfer of property between living people. It only comes into effect after the death of a person.
A testamentary trust can be a private trust, and often, these kinds of trusts can be for a charitable purpose. You can form testamentary trusts in the same ways as other trusts. The testator appoints a testamentary trustee in their will who must hold individual, defined property for the benefit of third parties. The testamentary trustee is subject to fiduciary obligations and must maintain the same strict standards as other trustees.
Advantages of a Testamentary Trust
A testamentary trust can be a good idea if a testator wishes to safeguard assets or distribute them in a flexible and tax-effective manner. Perhaps the most critical reason that testators make these kinds of trusts is to protect their property from dissipation. You should note that the trust beneficiaries do not hold title to the assets of the trust. The most they hold is the right to be considered by the testamentary trustee. As such, in situations of financial difficulty or family breakdown, the assets remain untouched.
Testamentary trusts are also ideal if the beneficiaries are young. You can avoid the risk of the beneficiaries mismanaging and potentially losing the trust capital where the testamentary trustee has the discretion to distribute as they fit. Additionally, testamentary trusts are flexible in so far as a testamentary trustee has discretion. They can distribute assets or income of the trust to a specified beneficiary at a time they perceive advantageous and to an extent or degree that they feel is best.
Testamentary trusts are also tax-effective because they permit income splitting among beneficiaries. If one beneficiary has a high income and another a lower one, the trustee may apportion more income from the trust to the latter. That minimises income tax paid on the trust income. Of course, you can never use a trust to avoid tax obligations. It is merely a good way of minimising them.
Disadvantages of a Testamentary Trust
In considering a testamentary trust, it is essential to note the risk that the trust’s set up may not accurately reflect the deceased person’s wishes. This is because the trust only comes into existence after their passing.
Further, the role of the trustee is to ensure they reflect the deceased person’s wishes in the administration of the trust. This is a big responsibility since the trustee has limited options to seek clarification of the deceased’s wishes. They can only refer to what is stipulated in the will. Likewise, not everyone engages a lawyer to draft their will, making some aspects difficult to interpret. This can impose a significant burden on the trustee to understand the deceased’s wishes and act accordingly.
Lastly, it can be challenging to remove a trustee if they do not honour the deceased person’s wishes. The level of evidence required to prove that a trustee has not acted following their powers and obligations as per the trust deed is high. This is especially in instances where they have the discretion to make distributions to the beneficiaries.
Frequently Asked Questions
A testamentary trust can be a good idea if a testator wishes to safeguard assets or distribute them in a flexible and tax-effective manner. Also, testamentary trusts are ideal if the beneficiaries are young. You can avoid the risk of the beneficiaries mismanaging and potentially losing the trust capital.
In setting up a testamentary trust, there is the risk that the trust may not accurately reflect the deceased person’s wishes. This is because the trust only comes into existence after their passing. Also, in managing the trust, the trustee has limited options to seek clarification of the deceased’s wishes and can only refer to the will for guidance. Lastly, it can be challenging to remove a trustee if they do not honour the deceased person’s wishes.
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