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 does not arise automatically. The trustee must exercise a discretion to make a beneficiary presently entitled, almost always by a written resolution made before 30 June. Failing to make a valid resolution by year-end is the single most expensive mistake a trustee can make: it defaults the income to section 99A and the top marginal rate.

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 example. A testamentary trust holds $1,200,000 in dividend-paying Australian shares originally inherited from the deceased estate. Annual dividends are $48,000 fully franked (grossed-up to about $68,571). The trustee streams $17,000 to each of three grandchildren aged 8, 11 and 14, and the balance to the surviving spouse. Each grandchild's $17,000 is below the tax-free threshold; with the low income tax offset and the refundable franking credits, each grandchild receives the distribution tax-free and a refund of franking credits. The same $51,000 distributed to the grandchildren by an inter vivos trust would attract approximately $23,000 of Division 6AA penalty tax.

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 works part-time and is on the 19% bracket; their two children are minors (8 and 12). The trustee streams $18,000 to each child (within the excepted trust income tax-free threshold) and the remaining $4,000 to the wife (at 19%). Total tax: about $760. The same $40,000 retained in the trust or distributed to the son would attract roughly $18,800 of tax.

Franked Dividends — A Worked Example

Practical example. 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. Grossed-up taxable income from the dividend is $20,000. The trustee, by valid resolution before 30 June, makes the surviving spouse (on no other income) specifically entitled to the franked distribution under Subdivision 207-B. The spouse includes the grossed-up $20,000 in her return and applies the franking credits. Below the tax-free threshold, the franking credits become a $6,000 refund. The same dividend retained in the trust with no beneficiary presently entitled would be taxed under section 99A at the top rate, with the franking credits providing only partial offset.

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

Where the trustee does not distribute income — either because no resolution was made or because the trustee deliberately accumulates — the income is taxed in the trustee's hands. The choice between section 99 (concessional, deceased estate rates) and section 99A (top marginal rate) is critical:

• section 99 applies where the Commissioner is of the opinion that section 99A would be unreasonable to apply, considering factors including the source of the trust property, the rights of beneficiaries and the purpose of accumulation;
• section 99A applies as the default for trusts other than certain estate trusts and superannuation trusts, and imposes the top marginal rate.

For a well-administered testamentary trust that retains genuine deceased estate character — held for the deceased's family on the terms of the will, with no artificial arrangements — section 99 is often available. For trusts that drift into routine accumulation, used as a private investment vehicle for family savings, the section 99A risk is real. Trustees should not accumulate routinely without advice on this point.

Practical example. A testamentary trust earns $25,000 of net income in a year where the surviving spouse does not need the cash and no minor beneficiaries exist. The trustee resolves to accumulate. If section 99 applies, the trustee pays tax at individual rates with the tax-free threshold — approximately $1,300. If section 99A applies, the trustee pays tax at 45% plus Medicare — approximately $11,750. The difference is the entire section 99/99A question for testamentary trustees.

Main Residence and Other Asset Issues

A testamentary trust that holds a former main residence of the deceased can access the main residence CGT exemption during the post-death period in some circumstances, but the rules are technical and the two-year window in Division 128 runs from the date of death — not from the date the trust is established. If the testamentary trust continues to hold the dwelling beyond the two-year window without being occupied by an eligible beneficiary, CGT can begin to accrue. 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 and makes loans or unpaid present entitlements to beneficiaries who are also shareholders; 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 also provide asset protection — a beneficiary's interest in a discretionary testamentary trust is generally not available to creditors or to the Family Court in the same way that an outright inheritance is. The tax advantages and the asset protection advantages are different things and need to be balanced. Aggressive tax planning that concentrates income in one beneficiary year after year may weaken the asset protection 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, signed and dated before 30 June;
• 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. Unpaid present entitlements owed by a corporate beneficiary to the trust can be deemed Division 7A loans 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, defaulting income to section 99A;
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 is the most expensive default in trust taxation. Make valid resolutions before 30 June.
• 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