Asset Protection and Trusts - October 2011

Asset protection becomes more important as a person’s wealth increases and as a person faces greater risks. These risks often arise when a person works in a managerial or partner capacity in an organisation, such as a director, partner or as a trustee. A person’s wealth is also at risk where they run a business or incur debts in their own name. As such they may wish to protect their wealth and assets as much as possible.

In situations where a person’s wealth is at risk structuring becomes important. The best form of asset protection a person can achieve is not to own any assets in their own name. Usually this means having assets owned by a spouse or an entity such as a company or trust. It is important to understand that asset protection techniques are not secure.

There has been a recent crack down on asset protection rules which stem from situations where taxpayers use asset protection structures to avoid liability. Asset protection structures are particularly hard on creditors who have the last claim to assets in bankruptcy situations. The tougher rules are directed at situations where assets are diverted for the purpose of defeating creditors’ claims.

Under these rules the Bankruptcy Act allows a trustee in bankruptcy to claw back or defeat certain transactions undertaken by a bankrupt before they become bankrupt.  For example, they allow a trustee in bankruptcy to claw back assets that the bankrupt has transferred to a relative, company or trust before becoming bankrupt for the purpose of defeating their creditors.

However, these special rules have limitations and often will not apply where a person has structured themselves properly from the outset and at a time where there was no indication or thought that they would get into financial difficulty.

Discretionary trust for asset protection

The discretionary trust has become widely viewed as an effective way of protecting assets. The reason that discretionary trusts have been so popular stems from the fact that a beneficiary’s interest in a discretionary trust has not traditionally been considered to be “property”. This means that if the beneficiary becomes bankrupt or is sued personally, assets held in the discretionary trust are protected against those claims because they do not form part of the beneficiary’s property or assets.

Further, if the trustee of the trust is sued (for example the trust gets into financial difficulty) then the beneficiaries are not liable to make up any shortfall (this is the same for shareholders in a company where the company gets into financial difficulty). So a discretionary trust has the best of both worlds, if the trust itself gets into difficulty the beneficiaries are protected and if a beneficiary gets into difficulty the assets of the trust are protected.

Compare this with a unit trust or a company, where if the unitholder or shareholder is made bankrupt or is sued personally, then one of the assets that unitholder or shareholder owns are their units or shares in the unit trust or company.  As such the assets of the unit trust or company are not fully protected. This asset protection advantage is one of the reasons that many people hold assets in discretionary trusts.

Despite the long held view that discretionary trusts are the primary way of protecting a person’s assets a recent decision by the Federal Court has cast some doubt on this proposition. In the Richstar case the Federal Court held that in the particular circumstances the beneficiary had an interest that came within the meaning of “property” as defined in s.9 of the Corporations Act. The Court found this on the basis that the beneficiary controlled the trust in such a way that it was his alter ego and he had effective control of the assets in the trust and therefore had a contingent interest in the trust.

It is important to understand that all the Court ordered was that the trustees had to disclose the assets of the trust to the receiver of a beneficiary of the trust. No order was made that the assets of the trust could be obtained by the beneficiary’s receiver.  However, it highlights that asset protection strategies are never 100% secure.

For asset protection reasons it is usually best to have a company act as trustee. This is because a trustee is personally liable for the debts and transactions they undertake on behalf of the trust as the trustee is the relevant legal entity. Therefore, it is the trustee that is sued if anything goes wrong.

Whilst the trustee can limit their personal liability by making it clear at the time they entered into the transaction that they contracted in their capacity as trustee only and not on their own behalf, this may not always be clear. The trustee may then have a fight on their hands to protect his personal assets. Having a new company which acts as trustee and not in any other capacity should prevent this argument from arising.

Finally, whilst it is best practice to have a corporate trustee so that the principal’s personal assets are generally not at risk, it must be understood that the directors of a corporate trustee can be made personally liable for the liabilities of the trust where, for some reason, the company is not entitled to be fully indemnified out of the assets of the trust. For example, where the company acts beyond its powers as set out in the trust deed or there has been a breach of trust by the corporate trustee.  Further, directors of a corporate trustee can be held personally liable for taxation offences of the trustee company.

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