Death, taxes and inheritance — what you really should know
To adequately protect your wealth for your family after you die, it’s worthwhile spending time on careful planning to counter Australia’s ‘backdoor death taxes’. SMSFs and testamentary trusts have a very useful role to play. But, you can only gift what’s yours. Australia abolished death duties in 1979, but, some inherited income and capital transactions can be taxed. Indeed, according to an article in The Australian newspaper, a Will drafter “must take into account the ‘backdoor death taxes’ that apply in Australia”. These “four ‘modern death taxes’ are ordinary income tax, capital gains tax, superannuation death benefits tax and an array of other taxes that potentially apply on death, including foreign inheritance taxes, state stamp duties and land taxes”.
The high divorce rate (put at 46% by NationMaster) complicates matters. This can be both via ill-advised people leaving tax-ineffective allotments to offspring, or the increasingly common court fight of children from first marriages against the step-parent and “second family”.
Because any Will can be challenged today it’s important to draft it very thoroughly. Law changes mean more people are eligible to be provided for in an estate, so, therefore, can contest a Will. (This can include “partners in clandestine affairs” — as was splashed about the late Richard Pratt in newspapers in May.)
Indeed, a successful Will is all about passing your assets as tax effectively as possible to those you want. It also has to take into account “the complexity of modern relationships”.
Sounds simple, but — and there’s always a “but” — it takes a specialist, including tax and financial advisers.
If you think seeing a specialist is “a bit over the top”, read on for some implications.
1. Superannuation death benefit taxes
It’s not uncommon to bequeath the proceeds of a life insurance policy to offspring. However, such proceeds going to a non-dependent child from a superannuation fund are taxed at 31.5%.
Mike Fitzpatrick, principal at Clarendene Estate Planning, gave this example to The Australian: a man set up a life insurance policy for his adult son from his first marriage, thinking that son would be catered for, with the rest of his estate going to his second wife and their children.
But that son had to pay 31.5% of his inheritance. Fitzpatrick said, “That is basically leaving one-third of your estate to the government. That’s an example of how tax can intrude significantly to those who aren’t properly advised.”
2. Income tax
Generally, couples structure their finances so income is shared, which gives them 2 tax thresholds. However, when one dies and the survivor receives all the assets, there is only one tax threshold. Mostly, this means that the survivor pays more tax.
Fitzpatrick gave this example to The Australian: a couple owns income-producing investments earning $40,000, declaring $20,000 each when they lodge their tax returns. While the tax on that is minimal, it suddenly goes up when the surviving partner (who is usually the wife) must pay tax on the whole $40,000.
Fitzpatrick said, “Quite often the [tax] increase is in the order of 40-70%, and the greater increase happens at the lower end of the income spectrum.”
So those who perhaps need the income the most, may cop a tax they cannot afford.
3. Capital gains tax (CGT)
The Tax Office says “rollover provisions apply to some disposals, one of the most significant is transfers to beneficiaries on death, so that the CGT is not a quasi death duty”.
However, Mike Fitzpatrick told The Australian, while CGT was drafted on the basis that it shouldn’t be “a tax that visits on death”, in practical situations, it is.
He gave this example: a person left their BHP shares to their 2 children equally. If, when they died, one of those children has been living and working in the UK, the shares left to them will be treated differently, having been deemed as sold the day before the person died. (Technically, that trigger is called a “CGT event K3”.)
The shares left to the child who’s a resident in Australia do not incur CGT.
4. Combination of local and overseas taxes
Fitzpatrick told The Australian a combination of local and foreign taxes, such as stamp duty on transfers of property, land taxes and even actual inheritance tax, was the “fourth effective death tax”.
He gave this example of a couple with 2 or 3 investment properties.
Very similar to the income tax example, while they’re both alive, state land tax doesn’t cost them much, because they’re sharing the cost. When one dies however, the survivor is again left with a much bigger tax bill.
Then there’s the overseas example.
The UK, Fitzpatrick told The Australian, has “severe, almost draconian, inheritance tax laws”. Estates worth more than £320,000 (AUD 534,534) cop a 40% tax. So that’s 40% of that asset lost, he says, “not even to the Australian government, but to the [British] government”.
How do you minimise these taxes?
After your death, it’s too late. All structures need to be in place before you die. It’s not morbid to plan these things, it’s smart.
Sometimes, a Will is straightforward, and things can be bequeathed directly. Mostly, however, there needs to be a more thought-out process — particularly if the family has hard-earned wealth it wants to protect (including from the threat of divorce), businesses and so on.
a) Testamentary trust
According to Find Law Australia, discretionary testamentary trusts have 2 significant advantages:
- taxation advantages in terms of income splitting; and
- protecting bequeathed assets from financial (or other) difficulties the beneficiaries may suffer
They are probably the best way to ensure a Will:
- is as tax-effective as possible, and
- ensures the assets go to the chosen beneficiaries
In a nutshell, they are safe from divorce, litigation and bankruptcy.
They can also be particularly useful for those concerned about spendthrift children and looking after handicapped children.
b) Self-managed super funds (SMSF)
SMSF are also a good way to hold money for estate planning.
Jan Prescott, MD of financial and estate planning firm Blueprint Financial Specialists, told The Australian, “You can build into your fund’s trust deed the provisions of what you want done with your assets, which is quite an interesting strategy because that then binds the trustee to deciding what happens to those assets.”
However, the same article also had a warning not to “push the envelope”. Clarendene Estate Planning’s Mike Fitzpatrick said, “Before the last significant reform of superannuation, which happened in 2007, the Treasury papers made it clear that the SMSF was not intended to be an estate planning vehicle. It was intended to be a vehicle for people who wanted to take control of their superannuation.”
You can only gift what’s yours
Bartram Lawyers’ Principal, Leanne Bartram, has a final reminder that, surprisingly, some people overlook: you can only gift what’s yours.
Bartram told The Australian that “even in relatively straightforward family situations” people need to understand their Will “can only dispose of assets they own”. In other words, what’s personally in your name.
“For example, you can’t gift something in a Will that is an asset of trust because it’s not yours. Everyone thinks if they set up a trust, its assets are personally theirs, but they’re not.”
Most Australian family businesses — including farms — are held in a trust structure, so cannot simply be bequeathed in a Will.
Bartram suggests that clearly understanding the asset’s ownership will allow it to be passed to the person you wish.
Mike Fitzpatrick said asset ownership structures, overlaid with the complex modern family relationships now recognised by law, are a “recipe for potential chaos” if people make a simple newsagent “kit Will” or just ignore having one.
It’s estimated that in the next 20 years, $2 trillion across Australia will be passed down through inheritances. Worth protecting really.
This article is an overview only to give broad information about the taxes that can affect inheritances, Wills and some areas to think about. To discuss the contents in detail, and the relevance to your situation, please contact your Summerhill adviser.
Sources: Australian Taxation Office; NationMaster.com/country/as-australia/peo-people; Find Law Australia; “Certainty of death and taxes: inheritance”, 10 March 2010, James Dunn, The Australian, Business Section
Tags: CGT, Estate planning, estate taxes