The principal and controller of a family discretionary trust (FDT) may have died. The trustee of the FDT (Trustee) may be inclined to distribute income of the trust at financial year end (ITFYE) to his or her deceased estate (DE) for two apparent reasons nevertheless:

• the Trustee may seek to broadly maintain, at least in transition, the same pattern of distribution of ITFYE to family beneficiaries where the deceased had been a major discretionary beneficiary of the FDT prior to his or her death; and
• the Trustee may believe that the DE, as an Australian tax resident DE, has or is expected to have the tax advantage of income tax at rates equivalent to an adult resident individual including the tax free threshold available for three years following death in Schedule 10 of the Income Tax Rates Act (C’th) (ITRA) 1986 (Schedule 10).

But will this distribution of ITFYE to the DE be effective?

A distribution of income of the FDT made both before death and, where permitted by the trust deed of the FDT, the end of the financial year say to a terminally ill beneficiary:

• does not give rise the difficulties considered in this blog post; and
• can be income of the DE under sub-section 101A(1) of the Income Tax Assessment Act (ITAA) 1936 where the entitlement to ITFYE arose before death (with evidence of a resolution to distribute then) where the beneficiary dies later before the end of the financial year.

However a trustee of FDT may not follow, may not utilise or have the opportunity afforded by a trust deed to distribute current year income of the FDT on a timely basis before the beneficiary dies.

The beneficiary after death?

After the death of a deceased beneficiary:

1. the deceased is no longer a person, both physically and legally;
2. the DE arises as a separate entity, including, for income tax purposes: as a trust: paragraph 960-100(1)(f) of the ITAA 1997 and by the inclusion of executors and administrators (of DEs – in the view of the Commissioner of Taxation – ;see below) in the definition of trustee in sub-section 6(1) of the ITAA 1936;
3. property belonging to the deceased, including any property that would have been due to them after the date of death had he or she survived, constitutes property of the DE; and
4. that separate entity, the DE, is not ordinarily a beneficiary of the FDT.

The implications of these parameters, and their interplay with the income tax rules relating to distributions of ITFYE of FDTs in particular, need to be examined to better understand whether or not a distribution of ITFYE can be made to a DE.

1.       BENEFICIARY NO LONGER LEGALLY A PERSON

In essence a discretionary distribution from a FDT is a gift by the trustee in exercise of a discretion to appoint income or capital of the FDT to a discretionary beneficiary of the FDT. It is fundamental that a deceased person cannot receive a gift. Lord Parker formulated when a gift can be valid this way:

I think, well to bear in mind certain general and perhaps somewhat elementary principles. At common law the conditions essential to the validity of a gift are reasonably clear. The subject-matter must be certain; the donor must have the necessary disposing power over, and must employ the means recognized by common law as sufficient for the transfer of, the subject-matter; and, finally, the donee must be capable of acquiring the subject-matter. If these conditions be fulfilled, the property in the subject-matter of the gift passes to the donee, and he becomes the absolute owner thereof and can deal with the same as he thinks fit. The common law takes no notice whatever of the donor’s motive in making the gift or of the purposes for which he intends the property to be applied by the donee, or of any condition or direction purporting to affect its free disposition in the hands of the donee. It is immaterial that the gift is intended to be applied for a purpose actually illegal – as, for example, in trade with the King’s enemies – or in a manner contrary to the policy of the law – as, for example, in paying the fines of persons convicted of poaching. In either case, the essential conditions being fulfilled, the gift is complete, the property has passed, and there is an end of the matter. A gift at common law is never executory in the sense that it requires the intervention of the Courts to enforce it.

With regard to the conditions essential to the validity of a gift, equity follows the common law. On the one hand, if the subject-matter be property transferable at common law, equity will not as a rule aid a gift which does not fulfil the essential conditions. On the other hand, when the property is transferable in equity only, equity also requires that the subject-matter must be certain, that the donor must have the necessary disposing power, and must employ the means which equity recognizes as sufficient for a of the subject-matter, and that the donee must be capable of acquiring the subject-matter.

Bowman v Secular Society [1917] A.C. 406

A deceased person is not a donee capable of acquiring the subject-matter of a gift in these terms.

This passage remains authoritative and was referred to more recently in Australia in Grain Technology Australia Ltd v Rosewood Research Pty Ltd (No 3) [2023] NSWSC 238.

The beneficiary principle

Any trust, including a FDT, must meet the beneficiary principle:

For  there  to  be  a  valid  trust  there  must  be  beneficiary  (corporate  or human) in whose favour performance of the trust may be decreed unless the trust falls within a group of exceptional anomalous cases when it is valid but unenforceable so that the trustee may perform it if they wish. 

which was formulated as far back as Morice v. Bishop of Durham (1804) 9 Ves 399, 405 in these terms:

every other [than charitable] trust must have a definite object

(An object in this context is a cestui que trust viz. a beneficiary.)

Few kinds of trusts can escape the beneficiary principle and must have beneficiaries which are persons. The exceptions include charitable trusts and some other types of trusts for purposes rather than persons. A deceased person is neither.

To emphasize the point let us say a A gives B property on trust to hold for either C, A’s son or D, a blow-up inflatable woman as B shall select in B’s discretion. The prospect that D could potentially take all of the property of the trust can cause the trust to be invalid as it fails the beneficiary principle. If D is, instead, a deceased person then I see the position as indistinguishable.

Doctrine of lapse

The courts apply a doctrine of lapse to a testamentary gift to a person who does not survive the will-maker. Lapsed testamentary gifts to a deceased beneficiary with descendants who survive the deceased beneficiary are saved by “anti-lapse” statute so don’t fail due to lapse. e.g. in NSW, section 41 of the Succession Act 2006.

The doctrine of lapse and anti-lapse statute do not apply to non-will (inter vivos) trusts but the doctrine illustrates how a gift or distribution to a deceased person will fail.

2.      THE DECEASED ESTATE ARISES AS A SEPARATE ENTITY TO THE DECEASED

Notionally, at least, a DE can be a trust with a trustee and so could receive a distribution of property from a separate trust such as a FDT.

But, shortly after the death of a deceased, a DE is in its early stages of administration and, until probate is granted viz. the Will of the deceased is “proven”, the DE has no executor and trustee: Income Tax Ruling IT 2622 – Income Tax : Present entitlement during the stages of administration of deceased estates and F.C. of T. v Whiting [1943] 68 CLR 199.

The Commissioner of Taxation states in IT 2622:

5. Even where a will does not envisage the creation of a testamentary trust, the executor must assume a trustee’s fiduciary capacity for some period after death. The responsibilities of the executor are similar to, though legally separate and distinct from, those of a testamentary trustee. The estate represents a legal entity or relationship quite separate from the testamentary trust. In practice it is only in rare cases that two different persons assume the roles of executor and testamentary trustee and, for income tax purposes, the estate and the testamentary trust are treated as one and the same. In fact, the term “trustee” is defined in subsection 6(1) of the Income Tax Assessment Act 1936 (“the Act”) to include persons acting as executors or administrators.

Paragraph 5 of IT 2622

Until a DE has reached the stage of a testamentary trust under the will of the deceased, or until the DE has a trustee once the executor and trustee under the will of the deceased has been granted probate, the DE has no apparent legal standing or business in receiving a distribution from a FDT whatever its entity status for income tax may be.

Let us say this problem of the personality of the DE is overcome and an executor and trustee of the DE can putatively receive a distribution from a trust. Then on what basis can the distribution be made by the FDT to a DE?

3.      A DECEASED ESTATE IS NOT ORDINARILY A BENEFICIARY OF ANOTHER TRUST

Usually or frequently a trust deed of a FDT will not name or specify a DE as a beneficiary of the FDT. The trust deed of the FDT could be amended on a timely basis to include a sufficiently administered DE as a beneficiary before a distribution to the DE is attempted.

Alternatively the FDT trust deed may allow for something like a related trusts class of beneficiaries which specifies that trusts, in which named FDT beneficiaries have an interest, are also to be beneficiaries of the FDT. However I understand that a related trusts clause like this will generally be insufficient, by itself, to include a DE of a deceased beneficiary as a beneficiary of the FDT even where, as is likely, the DE will have beneficiaries in common with the FDT. I understand that will be so unless the DE is specifically contemplated in the related trust formulation to be adopted in the FDT The relation that adds beneficiaries of a trust in a related trust beneficiary clause to is given a strict or narrow interpretation by virtue of Attorney-General (NSW) v Perpetual Trustee Co (Ltd) [1940] HCA 12; 63 CLR 209 Dixon & Evatt JJ. stated:

Estates and interests are limited with a view of creating precise and definite proprietary rights, to the intent that property shall devolve according to the form of the gift and not otherwise.

at CLR p. 233

But so naming or explicitly clarifying that a DE as a beneficiary of the FDT has ramifications including ramifications for income tax – I will refer to these ramifications below as the First Ramifications.

Can or should a DE receive the gift or distribution from a FDT?

At the early stage of DE administration an executor seeks probate and then has duties to get the property of the deceased in to his or name and to hold only that property in the DE.

Those duties don’t include getting in property which is not property of, or accruing to the deceased after death because of rights and entitlement of, or connection to the lifetime of, the deceased (Deceased Property).

Once probate of the Will is obtained it is then proper for the Executor to consult the Will which may contain a direction allowing the executor and trustee to receive property other than Deceased Property, including distributions from other trusts, in to the DE. However this has further ramifications including for the same income tax reasons which I will call the Second Ramifications.

In addition to the income tax ramifications I note that the Second Ramifications include:

• an executor and trustee of a DE may be unwilling to take on responsibility for property in the DE beyond and extraneous to Deceased Property;
• a beneficiary of the DE may not want property other than Deceased Property to be included in the DE; and
• the DE may become tainted as it does may not come to wholly hold Deceased Property and so various privileges, concessions and exemptions available to ordinary DEs, including in relation to stamp duty, social security or under foreign tax and investment rules may be lost.

INCOME TAX RAMIFICATIONS

The income tax rates equivalent to adult resident individual rates, including the tax free threshold available for three years following death, in Schedule 10 available to a tax resident DE where the DE is taxed under section 99 of the ITAA 1936 are not available to an executor and trustee of a DE by way of right. Section 99 only applies where the DE negotiates a gateway for section 99 to apply in section 99A.

Generally, in cases where no beneficiary is presently entitled to the income of a trust for an income year, section 99A applies to tax the trustee of the trust at the highest marginal rate of income tax: sub-section 12(9) of the ITRA 1986.

Commissioner’s discretion

The Commissioner of Taxation can determine, in his discretion, that paragraph 99A(2)(a) of the ITAA 1936 is not to apply to a DE when taxing a DE as a trust. Ordinarily, for most DEs, the Commissioner will have no reason to deny section 99/Schedule 10 rates to the executor and trustee. However where the First Ramifications or the Second Ramifications, or both, are applicable to DE then the Commissioner is given reason to deny the concessional section 99/Schedule 10 rates in his consideration of the factors in sub-section 99A(3). Those factors focus on transfers of property between the DE and other trusts explicitly and whether special rights or privileges have been conferred in relation to property in other trusts.

In other words where the Commissioner can form a view that the DE is not wholly comprised of Deceased Property, but includes property transferred in to the DE from other trusts, and that there were clear plans afoot so that could occur, the DE will be treated as a regular trust and not a DE and the ordinary section 99A highest marginal income tax rate will apply to the income of the tainted DE.

Risk to a deceased estate of higher income tax rate

The upshot of a refusal by the Commissioner to exercise the discretion in paragraph 99A(2)(a)  would be that the resident trustee of the DE, as a resident taxpayer, would lose entitlement to adult resident income tax rates and would be taxed at the highest marginal rate on income to which no beneficiary is presently entitled.

Shortly stated it would mean that a resident DE that receives a transfer of property from another trust, such as a FDT, risks losing DE status for tax because the property held in the DE does not wholly comprise Deceased Property.