Estate planning

Fixed v discretionary testamentary trusts:
what families need to understand after the Federal Budget announcement

“Many families use testamentary trusts for flexibility and protection — not simply tax outcomes. The recent Federal Budget announcement has prompted renewed discussion about whether fixed or discretionary structures may be more appropriate in the future.”

The recent Federal Budget announcement proposing a 30% minimum tax for discretionary trusts has created significant discussion within the legal, accounting and financial planning professions.

One area causing particular uncertainty is whether the proposal will affect discretionary testamentary trusts created under wills.

At the time of writing, the Government has not yet released detailed draft legislation explaining exactly how the proposed rules will operate, including whether and how testamentary trusts may be treated differently.

However, the discussion has already prompted many families to ask an important question:

If discretionary testamentary trusts become less tax-effective, could fixed testamentary trusts become the preferred alternative?

The answer is not straightforward.

For many families, the real purpose of a discretionary testamentary trust has never been tax alone. It has been flexibility, protection and the ability to respond to circumstances that cannot be predicted years in advance.

What is the difference between a fixed and discretionary testamentary trust?

A testamentary trust is a trust created by a will after death.

Broadly speaking:

• fixed trust structures involve beneficiaries having defined or predetermined entitlements; whereas

• discretionary trust structures generally give trustees flexibility in relation to distributions of income and capital within the terms of the will.

In practice, there is no single “standard” testamentary trust structure. Trusts can be drafted in many different ways, and some arrangements may contain both fixed and discretionary features.

The current public discussion has largely focused on discretionary trusts because the Budget announcement appears directed toward discretionary trust taxation. However, the precise treatment of testamentary trusts remains uncertain.

Why flexibility matters

When parents prepare wills, they are often trying to solve a difficult problem:

“How should a will-maker provide for children whose future circumstances may differ significantly over time?”

A fixed structure can work well where circumstances are stable and predictable.

But many families are not predictable.

Succession planning frequently involves balancing competing objectives, including:

• flexibility;

• certainty;

• protection;

• administrative simplicity;

• family harmony; and

• taxation outcomes.

Different families may prioritise those objectives differently.

Example: a child with additional needs

Imagine parents with three adult children.

At the time their wills are prepared, the children’s circumstances appear relatively equal. However, one child has a disability, illness or support need that may significantly change over time.

Under a more fixed structure, each child may receive a predetermined entitlement to income and capital.

That may appear appropriate initially.

However, circumstances can change over many years after a parent’s death. One child may later require:

• specialised accommodation;

• additional medical support;

• ongoing care funding; or

• financial assistance substantially beyond the needs of the other siblings.

A structure with limited flexibility may make it more difficult to direct additional financial support toward the child whose needs have increased.

By contrast, a discretionary testamentary trust may allow the trustee greater flexibility to distribute income or capital having regard to the changing circumstances of beneficiaries over time.

For many parents, that flexibility is not primarily about tax planning. It is about attempting to ensure a vulnerable child can continue to be supported if circumstances materially change in the future.

Example: addiction, gambling or financial vulnerability

Families are also sometimes concerned about beneficiaries who may struggle with:

• addiction;

• gambling;

• impulsive spending;

• relationship instability; or

• creditor issues.

In some circumstances, parents may worry that an immediate or inflexible entitlement may not be appropriate where a beneficiary has demonstrated significant financial vulnerability or impaired decision-making.

A discretionary testamentary trust may provide a structure that allows distributions to be managed with greater flexibility because distributions remain subject to trustee discretion.

Depending on the terms of the will, this may allow a trustee to:

• pay for housing, treatment, education or living expenses directly;

• distribute funds gradually;

• delay distributions during periods of instability; or

• manage the inheritance in a more controlled way.

This may reduce the risk that an inheritance is received in circumstances that a will-maker considered inappropriate or potentially harmful.

Importantly, trustee discretion is not unlimited. Trustees remain subject to the terms of the will, fiduciary obligations and duties requiring powers to be exercised properly and in good faith.

The effectiveness of any testamentary trust structure will depend heavily on the suitability of the trustee, the drafting of the will and the practical administration of the trust after death.

Again, the objective in these situations is often less about minimising tax and more about attempting to protect a vulnerable beneficiary from foreseeable risk.

The difficulty with “one-size-fits-all” planning

The current public discussion sometimes frames testamentary trusts primarily as tax structures.

In practice, estate planning lawyers often see them used for much broader succession-planning purposes, including:

• protecting vulnerable beneficiaries;

• balancing fairness between children with different needs;

• managing blended family risks;

• protecting inheritances from bankruptcy or family law disputes; and

• accommodating changing family circumstances over decades.

That is why the distinction between fixed and discretionary trusts matters.

A fixed trust may provide greater certainty and may ultimately receive more favourable treatment under any future tax reforms.

However, certainty and protection are not always the same thing.

Equally, discretionary structures are not automatically preferable in every case. Greater flexibility can also involve:

• increased complexity;

• ongoing administration;

• trustee decision-making burdens; and

• potential disagreement between beneficiaries regarding the exercise of discretion.

Discretionary structures can also create tension where beneficiaries hold differing expectations about how trustee powers should be exercised.

Conversely, in some families, certainty itself may be regarded as protective, particularly where beneficiaries are financially independent, relationships are stable and the will-maker wishes to minimise future trustee discretion or family conflict.

The appropriate structure depends heavily on the family, the assets involved and the objectives of the will-maker.

What families should do now

At present, there remains significant uncertainty about how the proposed reforms will operate.

Importantly:

• no draft legislation has yet been released;

• the treatment of future testamentary trusts remains unclear;

• the meaning of references to “existing testamentary trusts” is uncertain; and

• the final structure of any exclusions or concessions is not yet known.

For that reason, families should be cautious about making rushed decisions based solely on media headlines or incomplete commentary.

Instead, this may be an appropriate time to:

• review existing wills;

• reconsider the reasons a testamentary trust was originally included;

• discuss whether flexibility or certainty is more important for the family; and

• obtain updated legal and accounting advice once further details are available.

Final thoughts

The real question for many families is not simply:

“Should we still have a testamentary trust?”

It may instead become:

“What type of testamentary trust best balances flexibility, certainty, protection and future tax uncertainty for our family?”

Good estate planning has always involved more than taxation outcomes alone.

At its best, it is about protecting people and attempting to provide a structure capable of adapting when life does not unfold exactly as expected.

If you already have a will containing testamentary trust provisions, this may be an appropriate time to review whether the structure still reflects your family’s needs and objectives.

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This article is general information only and does not constitute legal or taxation advice. Families should obtain advice tailored to their own circumstances before changing estate planning arrangements.