Taxation of Testamentary Trusts Explained

What Is a Testamentary Trust?

A testamentary trust is a trust created by the will of a deceased person. It only comes into existence on the will-maker's death, and only if the will validly creates it. The trust deed is, in substance, the relevant trust clauses of the will: the appointment of the trustee, the identification of the beneficiaries, the dispositive provisions, the trustee's powers, and the rules for vesting. There is no separate "deed" document — the will itself is the trust instrument.

Testamentary trusts come in many shapes. The most common in modern Australian estate planning is the discretionary testamentary trust, where the trustee has a wide discretion to distribute income and capital between a class of family beneficiaries. Other forms include life-interest trusts, protective trusts for vulnerable beneficiaries, and capital protected trusts for spendthrift beneficiaries. The tax treatment of each turns on its specific terms — there is no one-size-fits-all answer.

Estate Administration vs Testamentary Trust

The deceased estate and the testamentary trust are two different taxpayers, even where the same person is executor of the estate and trustee of the testamentary trust. The estate exists from the date of death and lasts until full administration; the testamentary trust exists from the date of appropriation of assets to it and can last for decades. The transition from estate to trust is rarely a single moment — it occurs progressively as different assets are appropriated to the trust.

See our companion articles on who pays tax on estate income, when an estate income tax return is required, when a deceased estate ends for tax purposes and whether an executor can distribute before tax is finalised for the deceased estate side of the transition.

When Does the Testamentary Trust Start?

A testamentary trust starts when the executor (in their capacity as such) appropriates assets to the trustee (in their capacity as such), and the trustee accepts those assets on the terms of the will. From that point, income derived on the appropriated assets is income of the testamentary trust. Prior to that point, income on those assets is income of the deceased estate.

In practice, the executor and the trustee are often the same person, and the appropriation is internal — a paper entry rather than a physical transfer. That does not change the tax position: the asset, and the income it generates, must be allocated to either the estate or the trust on a principled basis, year by year. Accountants typically agree an effective transition date with the executor/trustee and apply it consistently for tax reporting.

Trustee Taxation Principles

The central principle of trust taxation in Australia is set out in Division 6 of Part III of the Income Tax Assessment Act 1936. The trust itself is not a separate taxpayer in the company sense — it is a flow-through vehicle whose net income is taxed in the hands of either the presently entitled beneficiaries or the trustee, depending on the circumstances:

• Section 97: where a beneficiary is presently entitled to a share of the net income and is not under a legal disability, that share is included in the beneficiary's assessable income and taxed at the beneficiary's marginal rate.
• Section 98: where a presently entitled beneficiary is under a legal disability (most often a minor), the trustee is assessed on the beneficiary's share, with concessional rates available where the income qualifies as excepted trust income.
• Section 99: where no beneficiary is presently entitled and the trust qualifies for deceased estate rates, the trustee is assessed on the undistributed income at the ordinary individual rates with the tax-free threshold.
• Section 99A: where no beneficiary is presently entitled and section 99 does not apply, the trustee is assessed on the undistributed income at the top marginal rate (currently 45% plus Medicare).

Which provision applies to a particular slice of trust income is determined annually, slice by slice, on the basis of who is presently entitled and the character of the income.

What Is Trust Income?

Two different concepts of "income" apply to a trust: trust law income (sometimes called "trust income" or "distributable income") and net income for tax purposes. Trust law income is what the trustee can actually distribute under the deed — it depends on accounting treatment and trustee discretion. Net income for tax purposes is calculated under the Tax Act and includes capital gains, franking credits, and other tax adjustments. The two figures are usually different.

The High Court's decision in Bamford v Federal Commissioner of Taxation [2010] HCA 10 settled that the "proportionate" approach applies: each beneficiary takes a share of the net income for tax purposes equal to their proportionate share of trust law income. The deed and the trustee's resolutions therefore determine the slice of taxable income each beneficiary inherits. Trustees should make sure the deed allows the trustee to determine what counts as income — otherwise the trustee may be locked into a definition that doesn't match the tax position.

Present Entitlement

Present entitlement is the legal concept that determines who is taxed on trust income. A beneficiary is presently entitled if, at year-end, they have an immediate, vested and indefeasible right to demand payment of a share of the income, even if payment is in fact deferred until later. For minors and other beneficiaries under a legal disability, present entitlement still arises if they would have a right to demand payment but for the disability.

In a discretionary testamentary trust, present entitlement usually requires the trustee to exercise a discretion, which must be validly made by the date the deed or tax law requires — commonly 30 June, though some deeds impose an earlier date. A resolution can be evidenced by records created after 30 June provided those records genuinely show that the decision was made by the required date; a resolution backdated or fabricated after the event is not effective. Some deeds also contain a default-beneficiary or automatic-distribution clause that confers present entitlement on a nominated beneficiary if the trustee does not resolve otherwise — trustees must check the deed before assuming that no resolution means no present entitlement. Where genuinely no beneficiary is presently entitled, the income is assessed to the trustee under section 99A at the flat top rate, unless the Commissioner forms the opinion under section 99A(2) that it would be unreasonable for section 99A to apply, in which case section 99 applies instead — a discretion that is not automatic and that trustees should not assume will be available.

Streaming Income and Capital Gains

Streaming is the ability to direct particular categories of income to particular beneficiaries. Two specific streaming regimes apply:

• Franked dividends — Subdivision 207-B of the ITAA 1997 allows the trustee to make a beneficiary "specifically entitled" to a franked distribution, so that the dividend and its franking credits flow to that beneficiary.
• Capital gains — Subdivision 115-C of the ITAA 1997 allows the trustee to make a beneficiary "specifically entitled" to a capital gain, so that the gain (and any CGT discount) flows to that beneficiary.

Streaming requires three things: an appropriate clause in the deed (most modern testamentary trust precedents include one); a valid resolution before year-end; and accurate calculations under Division 6E (which carves the streamed amounts out of the section 97 entitlement so the same income is not taxed twice). Streaming poorly drafted or implemented is a major source of trustee error.

Minors and Excepted Trust Income

This is where the tax advantage of a testamentary trust shines. Income distributed to a minor by an ordinary (inter vivos) discretionary trust is taxed at penalty rates under Division 6AA — effectively 45% plus Medicare on amounts above the small threshold (currently $416). The policy reason is to prevent parents from splitting investment income with their children.

Income distributed to a minor that qualifies as excepted trust income under section 102AG is treated very differently: it is taxed at ordinary adult marginal rates, including the tax-free threshold (currently $18,200) and the low income tax offset. Income derived from property that devolved to the testamentary trust from the deceased estate (and from the proceeds of such property) generally qualifies.

Practical illustration. A testamentary trust holding Australian shares inherited from the deceased estate can distribute franked dividend income to minor grandchildren, with the assessable amount for each grandchild comprising the cash dividend received plus the attached franking credit (the "grossed-up" amount). Where that income qualifies as excepted trust income under section 102AG, each grandchild is taxed on their share at ordinary adult marginal rates (including the tax-free threshold and the low income tax offset) rather than at the Division 6AA penalty rate that would apply if the same income were instead distributed by an ordinary inter vivos discretionary trust. The franking credit itself only reduces the beneficiary's tax, or is refunded, where the beneficiary is a "qualified person" for the purposes of the former section 160APHO holding-period and related-payment rules (now part of the Division 1A / former Part IIIAA imputation integrity rules carried into the current law) — broadly, the shares must have been held at risk for at least 45 days (90 days for certain preference shares) — and the trustee has validly made the beneficiary specifically entitled to the distribution under Subdivision 207-B of the ITAA 1997. The precise dollar outcome depends on the amount of the dividend, the franking percentage, each beneficiary's marginal rate and offsets, and should be calculated by an accountant for the trust's actual circumstances rather than assumed from a generic example.

The 2019 Tightening of Section 102AG

From 1 July 2019, section 102AG was amended to confirm that only income from assets that come from the deceased estate (or their direct proceeds) can be excepted trust income. The change was directed at arrangements where new assets were injected into a testamentary trust after death — gifts from parents, borrowings against the trust assets, family business interests transferred at undervalue — with the resulting income claimed as excepted trust income.

The lesson for will-makers is to fund the testamentary trust generously at the outset (within the practical constraints of the will). The lesson for trustees is to keep clear records of which assets are estate-derived and which are not, and to segregate later contributions in separate sub-trusts or accounts so the excepted trust income calculations remain defensible on audit.

Adult Beneficiaries

Adult beneficiaries who are presently entitled to a share of the trust's net income are assessed on that share at their personal marginal rates under section 97. There is no headline rate advantage for adults — the tax case for adult beneficiaries is in flexibility, not concessional rates. Typical uses include:

• streaming investment income to a non-working spouse or low-income adult child to use the tax-free threshold and low marginal rates;
• streaming franked dividends to a low-rate beneficiary to obtain a refund of franking credits;
• streaming capital gains to a beneficiary who has unused capital losses;
• accumulating income in years where no beneficiary needs the cash (subject to the section 99/99A issue below).

Practical example. A testamentary trust earns $40,000 of net investment income. The deceased's adult son is on the top marginal rate; his wife has no other taxable income; their two children are minors (8 and 12). The trustee streams $18,000 to each child as excepted trust income under section 102AG (each amount sits at or below the $18,200 tax-free threshold, so each child pays little or no tax after the low income tax offset) and the remaining $4,000 to the wife, which falls within her own tax-free threshold and is untaxed. On these facts, total tax across the family is minimal. By contrast, the same $40,000 retained by the trustee with no beneficiary presently entitled would (absent the section 99 discretion) be assessed to the trustee under section 99A at the top marginal rate plus Medicare levy — currently 47% — or, if distributed instead to the son, taxed in his hands at his top marginal rate. The comparison illustrates the value of streaming to low-income family members rather than the precision of any specific dollar figure, which will vary with each family's circumstances.

Franked Dividends — A Worked Example

Practical example (2025–26 rates). A testamentary trust holds shares in a major Australian bank. The bank pays $14,000 in fully franked dividends, with $6,000 of attached franking credits, so the grossed-up assessable amount is $20,000. The trustee, by valid resolution before 30 June, makes an adult beneficiary with no other income specifically entitled to the franked distribution under Subdivision 207-B. On 2025–26 resident individual rates (0% to $18,200; 16% from $18,201 to $45,000), the beneficiary's tax on the $20,000 grossed-up amount is calculated as: ($20,000 − $18,200) × 16% = $288 tax payable before offsets. The low income tax offset (maximum $700 for taxable income up to $37,500) more than covers the $288 — but LITO is non-refundable, so it reduces the $288 to nil rather than generating a cash refund of the difference. The $6,000 franking tax offset is refundable: after extinguishing the (already nil) remaining liability, the beneficiary receives a $6,000 refund of excess franking credits. If instead no beneficiary were presently entitled, the trustee would be assessed on the $20,000 under section 99A at the top marginal rate plus Medicare levy, with the $6,000 franking offset applied against that much larger liability rather than refunded — illustrating why streaming to a low-income beneficiary is usually preferable.

Capital Gains — A Worked Example

Practical example. A testamentary trust holds a portfolio share parcel inherited from the deceased. The trustee sells the parcel for $200,000, generating a $60,000 capital gain. Because the trust inherits the deceased's acquisition date for the 12-month rule and the asset was held for more than 12 months in total, the gain qualifies for the 50% CGT discount. The trustee, by valid resolution before 30 June, makes a low-income adult beneficiary specifically entitled to the entire capital gain under Subdivision 115-C. The beneficiary applies the CGT discount in her own return and is taxed on a $30,000 net gain at her marginal rate, rather than at the top rate as would apply if the trustee had been assessed.

Retained Income and Sections 99 and 99A

A deceased estate still under administration is taxed under the ATO's administrative deceased-estate rate schedules — a concession that applies for up to three income years after death and reflects the fact that the estate is being wound up rather than accumulated. A continuing testamentary trust is a separate trust from the estate, and once administration is complete, undistributed income of the testamentary trust does not automatically attract that deceased-estate schedule, the general individual tax-free threshold, or "concessional" treatment merely because the trust originated under a will.

Where no beneficiary of a continuing testamentary trust is presently entitled to a share of income — after checking the deed for a default-beneficiary or automatic-distribution clause that may confer present entitlement without a resolution — that income is assessed to the trustee under section 99A at the flat top rate (currently 45% plus Medicare), unless the Commissioner forms the opinion under section 99A(2) that it would be unreasonable for section 99A to apply, having regard to the matters listed in that subsection (including the circumstances in which the trust arose, the extent to which the income represents income accumulated for beneficiaries under the will, and the purpose of any accumulation). Only if that discretion is exercised does section 99 apply instead, under which the trustee is assessed broadly as an individual — but section 99 does not carry an automatic entitlement to the deceased estate's own concessional schedule, and whether any tax-free threshold or particular rate scale applies depends on the basis on which the Commissioner's discretion was exercised and the assessment actually raised. The section 99A(2) discretion must be actively sought and is not available simply because the trust is a testamentary trust or because the accumulation was well-intentioned.

The practical consequence is that trustees of a continuing testamentary trust should not treat accumulation as a safe or automatically concessional default. Genuinely retaining income without a present entitlement carries a real risk of section 99A assessment at the top rate, and the section 99 alternative should never be assumed without specific advice addressing the section 99A(2) factors and the deed's terms.

Main Residence and Other Asset Issues

A testamentary trust that holds a former main residence of the deceased can access the main-residence CGT concession during the post-death period in some circumstances, but the two regimes involved are distinct and are often confused. Division 128 of the ITAA 1997 governs the CGT death rollover: it deems the deceased's asset to pass to the legal personal representative (or a beneficiary) without a CGT event at death, and determines whether the LPR or beneficiary inherits the deceased's original (pre-CGT or post-CGT) cost base and acquisition date. Separately, Division 118 — specifically section 118-195 of the ITAA 1997 — governs the main-residence disregard itself: broadly, a dwelling that was the deceased's main residence just before death (and not then used to produce assessable income, or acquired pre-CGT) can be disposed of free of CGT if the LPR or beneficiary disposes of it within two years of death (or the dwelling was the main residence of certain eligible occupants throughout that period). The two-year period is not fixed: the Commissioner has a discretion to extend it, and Practical Compliance Guideline PCG 2019/5 sets out safe-harbour circumstances (such as probate delays, will challenges, or the complexity of administering the estate) in which the ATO will generally not review a reasonable extension. Once the dwelling is appropriated into a continuing testamentary trust rather than sold within the concession period, or is rented out to produce assessable income, the position becomes more complex — the income-producing use can affect eligibility, and the interaction between the Division 128 cost base and the Division 118 exemption should be checked with an accountant before the property is sold or transferred. See our article on capital gains tax in deceased estates and common executor mistakes for the underlying rules.

Other asset issues that commonly arise include: Division 7A risks where the trust holds shares in a private company: a loan, payment or forgiven debt made by the company to the trust (or to a shareholder/associate) can be a deemed dividend, and an unpaid present entitlement owed by the trust to a corporate beneficiary can, in some circumstances, be treated as a Division 7A loan back to the trust; small business CGT concessions (the trust generally inherits eligibility based on the deceased's connections); and land tax consequences of holding real estate in a trust structure.

Asset Protection and Tax Planning Limits

Testamentary trusts can offer a measure of asset protection, because a beneficiary's interest in a discretionary trust is often harder for a creditor to reach than an outright inheritance. This outcome is fact-sensitive and not guaranteed. In family law proceedings, the Family Court and the Federal Circuit and Family Court of Australia have a broad property jurisdiction under section 79 of the Family Law Act 1975, and the High Court's decision in Kennon v Spry (2008) 238 CLR 366 shows that, depending on the degree of control a party exercises over a trust and the trust's history, trust assets can in some circumstances be treated as property of a party to the marriage (or otherwise brought to account) for property settlement purposes. The tax advantages and the asset-protection advantages of a testamentary trust are different things, require separate analysis and should not be assumed. Aggressive tax planning that concentrates income in one beneficiary year after year may itself weaken any asset-protection argument by making the trust look like the beneficiary's "alter ego" in insolvency or family law proceedings.

The tax planning case for a testamentary trust is also not unlimited. A high-income beneficiary with no minor children and no low-income spouse may obtain little tax benefit from a testamentary trust, and the annual compliance cost (trust return, accounting, trustee resolutions) may exceed the saving. The will-maker should re-examine the tax case for a testamentary trust periodically, and trustees should be prepared to wind up a trust whose tax case has weakened.

Anti-Avoidance and Artificial Arrangements

Testamentary trusts are tax-advantaged but they are not tax shelters. The general anti-avoidance rule in Part IVA of the ITAA 1936 applies. Where the dominant purpose of an arrangement is to obtain a tax benefit, the Commissioner can cancel that benefit. Arrangements that have attracted ATO scrutiny include: injecting non-estate assets into a testamentary trust to manufacture excepted trust income (now caught by section 102AG); circular distribution arrangements between testamentary and inter vivos trusts; and the use of beneficiaries who do not in substance enjoy the benefit of their entitlements (section 100A reimbursement agreements).

The ATO has published guidance on section 100A (Taxpayer Alert TA 2022/1 and Taxation Ruling TR 2022/4) that applies equally to testamentary trusts. Trustees should ensure that distributions to beneficiaries are real — the beneficiary should receive the funds, or have the funds applied for their genuine benefit, rather than the money flowing back to a parent or other family member.

Trustee Duties

The trustee of a testamentary trust owes the usual fiduciary duties to the beneficiaries: to act in their best interests, to invest prudently, to keep proper accounts, to maintain even-handedness between beneficiaries (subject to the deed), to avoid conflicts of interest and to keep the trust property separate from the trustee's own property. The tax decisions a trustee makes — present entitlement, streaming, accumulation — are exercises of fiduciary discretion and must be made in good faith and in the interests of the beneficiaries, not for the trustee's personal benefit.

See our companion article on executor duties in Victoria for the underlying framework. Many of the same duties apply to a testamentary trustee, with the added complication that the duties continue for the life of the trust rather than ending with administration.

Record Keeping

Good records are the foundation of every tax-effective testamentary trust. At a minimum the trustee should keep:

• annual financial statements;
• annual trustee resolutions creating present entitlement, validly made by the date required by the deed and by tax law (commonly 30 June), together with contemporaneous evidence capable of showing the resolution was actually made by that date (minutes, file notes, correspondence);
• records of the source of every asset (estate vs later);
• records of every distribution paid to or applied for the benefit of each beneficiary;
• cost base records for every CGT asset;
• all tax returns and ATO correspondence;
• trustee appointment, retirement and deed-amendment records.

Records should be kept for the longer of the relevant statutory period (generally five years for tax records, seven for trust accounts) and the period of any beneficiary's minority plus a buffer.

Distributions

Distributions of trust income should be paid or applied in the income year to which they relate, or be supported by a valid present-entitlement resolution made before year-end with payment to follow. Distributions of capital are different — they are not income distributions and do not attract section 97 treatment, but they may have CGT consequences depending on what is being distributed and to whom. A capital distribution of an appreciated asset to a beneficiary may trigger CGT event E5 or E7 in the trustee's hands.

Business Interests in a Testamentary Trust

Where the testamentary trust holds shares in a family company or an interest in a family business, additional tax issues arise. Division 7A applies to loans, payments and forgiven debts to shareholders and their associates, and a testamentary trust that is a shareholder is caught. An unpaid present entitlement owed by the trust to a corporate beneficiary (i.e. an amount the trust owes the company, not the reverse) can be treated as a deemed Division 7A loan from the company back to the trust in some circumstances. See our article on what happens to a business when the owner dies for the broader framework, and our service page on commercial and business law for the matters Parke Lawyers handles in this area.

Common Trustee Mistakes

1. failing to make a valid present-entitlement resolution before 30 June, which (unless the deed's default-beneficiary or automatic-distribution clause operates, or the Commissioner exercises the section 99A(2) discretion to allow section 99 rates) exposes the undistributed income to section 99A top marginal rate taxation;
2. treating the trust as a passive savings account, with no advice on the section 99 vs 99A risk;
3. injecting non-estate assets and claiming excepted trust income on the resulting income;
4. failing to stream franked dividends where the deed allows it, wasting franking credits;
5. distributing nominally to minors who never see the funds (section 100A risk);
6. failing to keep cost base records for inherited CGT assets, leading to over- or under-payment of CGT on later sale;
7. treating trust assets as the trustee's personal property;
8. proceeding with a major transaction (sale of a key asset, deed amendment, sub-trust split) without accounting and legal advice.

When to Obtain Accounting and Legal Advice

Accounting advice should be obtained at the will-drafting stage, at trust inception, before each 30 June, before any major transaction and before the trust vests. Legal advice should be obtained at the same trigger points and also whenever a beneficiary disputes the trustee's conduct or seeks an account. For the firm's services in this area see wills and estate planning and probate and estate administration.

Key Takeaways

• A testamentary trust is a tax-effective structure primarily where minor or low-income beneficiaries are involved.
• Tax treatment depends on the deed, the character of the income, beneficiary entitlements and trustee decisions made year by year.
• Excepted trust income gives minors the full adult tax-free threshold — but only on income derived from estate-sourced property.
• Streaming franked dividends and capital gains can materially improve the after-tax outcome where the deed and the resolutions support it.
• Section 99A top marginal rate taxation is the most expensive outcome for undistributed trust income — but it is not automatic. Check the deed for a default-beneficiary or automatic-distribution clause, and consider whether the Commissioner's section 99A(2) discretion for section 99 rates may apply, before assuming the worst-case rate. Make valid resolutions before 30 June wherever possible.
• Testamentary trusts are not automatic tax shelters. Part IVA, section 100A and section 102AG limit aggressive planning.
• Obtain accounting and legal advice at every meaningful decision point.

Frequently Asked Questions