Inheritance strategy for older parents, not just for the rich
Want to provide tax-efficient income to your grandkids or worried your child’s partner will walk off with part of your estate? This is what to do.
More than half the wills being prepared by parents are attempting to exclude their children’s spouses or partners from being eligible for a share of their estate if they separate, say family law specialists.
Parents are switching from traditional “straight gift” wills to those that include testamentary trusts (providing asset protection and tax strategies). Some are also encouraging their children to sign binding financial agreements with their partners to stop claims against inheritance.
Advisers suggest that households with comparatively modest estates of more than $500,000, as well as the mega rich, consider these types of strategies to address similar potential problems.
There might be cheaper alternatives, such as binding agreements, that provide protection and lower the risk of expensive legal challenges by an aggrieved party.
But those considering using trusts to defend their assets must decide whether their estate justifies the initial and ongoing administration and costs.
Strategies for excluding “undeserving” partners have been increasing as divorce rates rise and the number of blended families climb.
Breakdowns in around half of first marriages and more than half of defacto and second marriages are also forcing many parents to consider how their estates might be divided, say specialists.
“Parents are fearful about what might happen to their estates if their children are involved in a relationship breakdown,” says Anna Hacker, Australian Unity Trustees Legal Services general manager of estate planning.
“They’re thinking, ‘I don’t want that undeserving or unworthy person getting their hands on my possessions’,” Hacker says.
More than 90 per cent of wills drafted by lawyers include testamentary trusts, says Hacker. The trusts are incorporated into the will and typically don’t come into force until the death of the will maker.
Saving tax
Rather than leaving assets directly to a beneficiary, they are transferred into a trust and held on behalf of an individual or group of beneficiaries.
It is possible for a will to have more than one testamentary trust. Separate trusts for each child of a family provides tax planning options in addition to protecting part of an estate from a beneficiary with mental, drug or alcohol problems.
Chris Balalovski, a partner with professional consultancy BDO Australia, says “a testamentary trust provides options for asset protection as well as lowering tax payable on distributions”. This means a trustee (the person responsible for managing the assets) can consider tax efficiency and beneficiaries’ needs when deciding appropriate amounts to be distributed.
This can result in “very tax-effective structures” for distributing income to beneficiaries who earn little or no income, such as grandchildren, says Balalovski.
Income distributed to children under 18 is taxed at ordinary adult marginal rates (including the $18,200 tax-free threshold, rebates and offsets), which means the total amount that can be earned before tax is around $25,000.
A popular trustee strategy is to distribute income to spouses and children who earn no other income, rather than an adult on a high marginal tax rate.
For example, a beneficiary on a higher tax rate receiving an annual distribution of $40,000 from assets they inherited under a will without the tax options of a testamentary trust would pay $18,800 tax.
A trustee using a testamentary trust could distribute the $40,000 in equal tranches of $20,000 between a non-tax-paying spouse and child where no tax would be paid as the amounts were below their tax-free thresholds.
Safeguarding assets
A testamentary trust can also make loans to a beneficiary, such as for buying a house, if permitted by the trust’s deeds.
Tara Lucke, director of the Art of Estate Planning, which advises lawyers, says: “Lending capital is a great idea because loaned money can come back to the trust. Loan terms can be decided by the trustee and do not have to be on commercial terms.”
Balalovski says lending money means trustees retain control over the capital, which they would lose if the money was gifted to a beneficiary.
“In the event of a relationship breakdown, they can call the loan in,” he says. “This provides a degree of asset protection.”
Cost considerations
The cost of establishing and maintaining a trust will depend upon the size of the estate and complexity of instructions, which includes the number of beneficiaries. Most will cost $2000 to $5000 to set up.
Ongoing costs will depend on whether it is handled by an accountant or professional trustee, who can charge a percentage and annual fee. Accountants’ fees will depend on whether there is taxation and compliance advice on top of tax returns. This might range from a few hundred dollars a year to $2000 to $5000 for more complex structures.
The high costs mean trust structures are hard to justify for estates with investments and funds (excluding property) valued at less than $500,000, say lawyers and accountants.
“Anyone considering a trust needs to consider regular costs and other potential expenses. But these costs could be a bargain compared to the expense of a lengthy legal dispute or tax savings from a well-administered trust,” says Hacker.
Courting trouble
Courts won’t be bound by a trust’s terms and conditions where there is evidence that strict adherence would be unfair, particularly for young children in the care of the non-family spouse.
“The Family Court will look straight through strategies intended to thwart its intention to look after both parties,” says Balalovski.
Courts will review the trust structure and look at the parties who hold key positions of control – such as the trustee (who is responsible for managing trust property on behalf of another person) or appointer (who has power to change the trustee).
“Trustees need to be at arm’s length. It is hard to argue that’s the case if the trustee, or other key appointee, is your brother or best friend,” says Hacker, who adds a court will also look for evidence of abuse or improper behaviour.
“The advantage of an independent trustee is that they are seen to be impartial,” she says.
Lucke adds: “Choosing a trustee is really critical. Make sure you get the right skill set coming to the role that will faithfully represent the beneficiaries, especially when minors are involved.”
Divorce proofing
She recommends trusted family members and friends who have the beneficiaries’ interests at heart and can be relied upon to engage third-party experts, such as financial advisers or lawyers, when required.
An alternative way to “divorce-proof” an inheritance is for an adult child and partner to sign a binding financial agreement.
It offers couples, particularly those who have been divorced before, a means of preserving their assets if the relationship breaks down.
Both parties will need to engage lawyers so expenses could run to thousands of dollars.
Lawyers say couples, particularly those considering a second or subsequent marriage, need to have a frank discussion about property arrangements for current and future children before exchanging vows.
These agreements are not recommended for first-time marriages unless one party has significantly more than the other.
They are more popular in subsequent marriages when one party has been through a divorce and wants to protect assets for their children.
The High Court, the nation’s highest, and the Family Court have ruled that unfair agreements under which undue influence was used to obtain the agreement of a spouse could not be upheld.
The High Court case involved an overseas bride in her 30s whose 67-year-old wealthy property developer partner said the wedding would not go ahead unless she signed a pre-nuptial agreement that in effect excluded her – and any future children from their relationship – from his will.
The agreement, signed four days before the wedding, was rendered void despite the woman agreeing to sign after warnings from two financial advisers.
In another recent decision, the Family Court unwound a prenuptial agreement that failed to disclose more than 90 per cent of the value of the husband’s assets.
Courts have warned they will unwind unfair agreements forced upon a spouse and their children, or if there is evidence of fraud or unconscionable conduct.
This article was first published in The Financial Review by Duncan Hughes, view article.
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