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Planning for the future is challenging for anyone, but it can feel particularly overwhelming for those who may be leaving behind vulnerable children or other loved ones. Protective trusts are commonly used to provide for individuals with intellectual disabilities or mental illness, as well as in circumstances where there are concerns about an individual’s financial immaturity, addictions, or risks of financial exploitation.

This guide explains how protective trusts can help families financially plan for and protect assets to benefit their vulnerable loved ones after they pass.

What is a protective trust?

A protective trust is a type of trust structure specifically designed for beneficiaries who may not be in a position to safely or efficiently manage an inheritance on their own due to some risk or vulnerability they may be experiencing.

With a protective trust, rather than gifting an inheritance to a vulnerable beneficiary outright, a trustee is appointed to retain control over how the trust funds are applied for the benefit of that individual. This is intended to better ensure financial support is delivered and applied in the beneficiary’s best long-term interests.

Families may consider setting up a protective trust with the following goals:

• allow flexible and responsive financial support tailored to, and restricted to, the vulnerable beneficiary’s needs;
• prevent misuse or mismanagement of funds;
• protect against financial abuse or potential family property disputes;
• preserve capital for the beneficiary’s long-term security; and/or
• maintain the beneficiary’s eligibility for social security benefits where possible.

How are protective trusts different from other types of trusts?

• Discretionary (family) trusts – Family trusts are typically established for more general generational planning or asset protection purposes. Unlike protective trusts, they are not necessarily customised to protect a vulnerable person from exploitation or financial risk, although sometimes they may serve that purpose.
• Special Disability Trusts (SDT) – SDTs are established under the Social Security Act 1991 (Cth) and are specifically designed for individual’s with severe disabilities to preserve their eligibility to receive the Disability Support Pension (DSP). SDTs are considerably more restrictive in terms of who qualifies and how funds can be spent. SDTs are considered in more detail below.

Why might someone consider setting up a protective trust?

Significant risks can arise for vulnerable beneficiaries when they are gifted their inheritance directly or through third parties.

When a beneficiary receives an inheritance outright, they are ultimately free to use those funds in any way they wish. This exposes them to risks of making poor financial decisions, as well as suffering exploitation or financial abuse. Moreover, as that inheritance becomes their personal financial asset, this leaves them open to losing that asset to potential bankruptcy/creditor claims or, in the event of separation, relationship property claims. It may also affect one’s eligibility to receive certain means-tested Centrelink benefits.

Some families may also consider giving the money to a friend, sibling, or carer to be “held for” their vulnerable loved one. However, this is generally quite risky considering there may be no explicit legal obligation in these circumstances that the money be used for the intended beneficiary. Again, those funds may also form part of the “holder’s” personal assets or resources, thus exposing the inheritance to debts, bankruptcy, divorce, or death.

How are protective trusts established?

A protective trust can be created in two ways:

1. By will – This is the most common method, otherwise known as a “testamentary trust”, and is done by including a protective testamentary trust in one’s will to be activated upon their death.
2. By deed during lifetime – Though less common, this method can be useful in certain situations, particularly where early asset protections or inter vivos funding is required (i.e., giving assets away during one’s lifetime).

This guide primarily focuses on protective trusts established by way of testamentary trust.

What issues should be considered when setting up a protective trust?

Protective trusts should be carefully drafted and customised to the beneficiary’s specific needs – there is no “one size fits all” approach.

When considering the terms of a protective trust for a vulnerable loved one, family members should consider various important issues, such as:

• directions about health, care, accommodation, education, transport, etc, for the individual;
• the scope of trustee discretion – i.e., guidelines/restrictions for applying funds and preserving capital to ensure long-term support;
• mechanisms for the appointment and removal of trustees; and
• any events that might trigger termination of the trust – e.g., upon the beneficiary’s death or some other event.

How are funds distributed from a protective trust?  

One of the key advantages of establishing a protective trust is the level of flexibility it offers in respect of how its funds can be used to provide support to its beneficiaries. It is ultimately up to the person setting up the protective trust to establish the scope for which the funds can be distributed by the trustee.

One may wish to draft a trustee’s distribution powers broadly or narrowly depending on the beneficiary’s specific circumstances. For instance, one might wish to grant the trustee full discretion to decide how and when funds will be distributed and to whom.

It is also common to establish a non-binding wish list of preferences that the trustee must follow when exercising their powers to ensure funds are only distributed for purposes concerning, for instance, the beneficiary’s financial security, health and wellbeing, and overall quality of life. These preferences might cover expenses reasonably incurred in relation to:

• education and training;
• accommodation;
• care and support (e.g., medications, personal carers/support persons, medical appointments, therapeutic services);
• transport; and
• general daily living and lifestyle support.

It is important, however, that the trustee is granted enough flexibility to allow them to regularly review the beneficiary’s circumstances to ensure distributions remain appropriate and responsive over time. This, of course, critically relies on appointing a trustee whose judgment can be relied on.

These preferences may also set out wishes regarding who these funds should be distributed to – specifically, whether they should be released to the beneficiary personally or to providers directly on behalf of the beneficiary. Considering the purpose of a protective trust, it is often preferable for the trustee to avoid handing large sums directly to the beneficiary unless it is appropriate to do so and the funds are unlikely to be misused or place the beneficiary at risk.

What are a trustee’s duties and responsibilities?

A trustee (whether of a protective trust or otherwise) is responsible for the overall day-to-day governance and management of the trust, and as such, must comply with various legal obligations.

In New South Wales, a trustee is subject to:

• statutory duties – set out in the Trustee Act 1925 (NSW); and
• common law and equitable duties – established by the courts.

A trustee’s paramount duty is ultimately to act in the best interests of the beneficiary. This involves a number of key responsibilities, including duties to:

• act honestly, loyally, and impartially for the benefit of all beneficiaries in accordance with the terms of the trust;
• exercise their powers personally and actively, unless otherwise authorised by the terms of the trust or by law;
• manage the trust with a level of care, skill and diligence that a prudent person would exercise in managing the affairs of other people (including investing trust funds responsibly where appropriate); and
• maintain accurate records of all income, expenses, and distributions associated with the trust, as well as all decisions made in respect of the trust.

Who can be appointed trustee of a protective trust?

There are no formal requirements when determining who is to be appointed as trustee of a protective trust. However, choosing the right trustee is one of the most important estate planning decisions to make.

It is common for individuals to appoint family members or close friends, but they may also consider a professional trustee company. Each have advantages and disadvantages.

If individuals are chosen, then they are taking on a serious responsibility and risk. They may, for example, be subject to demands or actions against them by the beneficiary. This means the individual must be suitably qualified, diligent, and eager to take on the task. It would also be desirable for them to be of an appropriate generation – i.e., likely to be around for much of the life of the beneficiary, with provisions for future appointments.

Trustee companies vary in charges and ability. Sometimes it is a matter of considering what quality of service one should pay for in the circumstances. There are, for instance, some trustee companies who would provide a more boutique and customised service at greater cost.  That may be justified by the circumstances and the size of the trust.

When choosing a trustee, it is vital that an individual considers the following:

• Is the proposed trustee reliable? Do I trust them?
• Are they financially competent?
• Can they act impartially? Are there risks that they may be easily pressured or influenced by other family members?
• Are there risks of conflict with beneficiary or other family members?
• Are they understanding of the beneficiary’s needs?
• Are they capable of meeting their reporting and compliance obligations?
• If they are a professional trustee, are their fees fair and transparent?
• Is there an ability to replace a trustee without exit fees, and if so, who would have that right?

What are the tax implications for a protective trust?

For the purposes of the Income Tax Assessment Act 1936 (Cth), protective trusts are typically treated no differently than other types of discretionary trusts.

How is trust income taxed?

The tax implications for a trust will depend on whether income from that trust has been distributed to beneficiaries during that financial year:

1. Trust income retained – If no distributions are made from a trust during a financial year, the trustee will be required to pay tax on the income retained in the trust at the highest marginal tax rate (currently 47%).
2. Trust income distributed to beneficiary – If a beneficiary receives income from a trust during a financial year, they will (assuming they are of legal capacity) be taxed in accordance with the normal marginal tax rates. They may not, however, be liable to pay tax if they are an Australian Resident and the trust income falls within the tax-free threshold for that financial year (currently $18,200).
3. Trust income distributed to beneficiary under legal disability (incl. minors) – If trust income is distributed to a beneficiary who is under a legal disability (which includes individuals under 18 years), the trustee will only be taxed at the highest marginal tax rate if the income does not constitute “excepted income” (e.g., income from a testamentary trust that was created from one’s inheritance) or was less than $416, in which case normal marginal tax rates will apply.

How are capital gains taxed?

Capital gains (i.e., funds received when as asset is sold for more than its base cost) are generally treated as part of ordinary trust income and therefore taxed in accordance with the above.

However, it is possible for these gains to be “streamed” to specific beneficiaries if permitted by the terms of the trust. In such circumstances, a beneficiary can be made specifically entitled to a certain amount of the capital gain, allowing them to be taxed on that gain personally. This can be beneficial if the beneficiary is eligible for the 50% capital gains tax (CGT) discount.

How does Centrelink treat protective trust assets?

Trust assets (whether part of a protective trust or otherwise) will, unless in very specific circumstances, typically be counted as a beneficiary’s personal assets for the purposes of Centrelink asset assessments if they can benefit financially from the trust. This can have a considerable impact on one’s eligibility to access Centrelink benefits, particularly those seeking to access the Disability Support Pension (DSP).

It was for this reason that Special Disability Trusts (SDTs) were established.

When might a Special Disability Trust be more appropriate?

A SDT is a statutory trust structure governed under the federal Social Security Act 1991 (Cth) which is intended as a means for family members to leave assets for their vulnerable loved one without affecting their eligibility to receive the DSP.

However, it can only be used in circumstances where the beneficiary has a “severe disability” – i.e., their level of impairment would otherwise leave them eligible to receive the DSP.

There are also significant restrictions imposed in respect of how SDT funds can be used. For instance, the level of discretionary spending available is limited to a specific amount each year (currently $14,750), and these funds cannot be used to pay immediate family members for any service they provide the beneficiary.

Considering this, a SDT will not be appropriate in all circumstances, but they can indeed prove beneficial for individuals with severe disabilities in cases where DSP access is essential.

Conclusion

Protective trusts can play a vital role for families wishing to safeguard the financial future of their vulnerable loved ones, potentially offering greater flexibility and long-term security, and reducing financial risk.

However, as everyone’s circumstances are unique, a protective trust must be carefully tailored to a person’s specific needs and vulnerabilities.

Families and financial professionals should always seek independent legal and financial advice to ensure a protective trust is the most appropriate and effective tool for them.

If you are considering setting up a protective trust or are looking to review an existing estate plan, our team is here to assist every step of the way.

This article was written by Selwyn Black and Chelsea O’Grady of Carroll & O’Dea Lawyers on 17 December and is based on the relevant state of the law (legislation, regulations and case law) at that date for the jurisdiction in which it is published. Please note this article does not constitute legal advice.

If you have questions on this article, please contact Selwyn Black. If you ever need legal advice or want to discuss a legal problem, please contact us to see if we can help. You can reach us on 1800 059 278.