Asset Protection 3: Discretionary Trusts (2 March 2011)
This is the third of a series of articles about asset protection and it discusses the use of discretionary trusts to protect assets.
A trust involves the legal ownership of property by one person – the trustee – for the benefit of others – the beneficiaries.
In the case of a discretionary trust, the trust deed:
(1) will define a class of beneficiaries, typically one or two specified beneficiaries (who are named in the trust deed) together their relatives by blood or marriage (who are not named) and often their related trusts and companies as well;
(2) will empower the trustee to determine, in his or her discretion, who of the beneficiaries will receive income or capital from the trust, when and how much;
(3) will usually give one or more family members the power to remove the trustee and appoint a new a trustee (known as the appointor).
The usefulness of a trust for asset protection purposes arises from the fact that no person owns the benefit of the assets: the trustee is merely the legal owner holding the trust assets for the benefit of others, and beneficiaries only receive income or capital distributions if the trustee so decides, having what the courts term a “mere expectancy”.
If an individual who is a trustee, a beneficiary and/or an appointor of a trust becomes bankrupt, the assets they own as trustee, their rights as a beneficiary and their power of appointment do not “vest” in (ie do not become owned and controlled by) their trustee-in-bankruptcy.
If a company which is a trustee goes into liquidation, it continues to own the trust assets only as trustee for the benefit of the beneficiaries of the trust, and the appointor will be able to remove the trustee and appoint a new trustee of the trust.
However there are a number of important restrictions on the ability of a discretionary trust to protect assets.
The trustee’s “right of indemnity”: trust assets are not protected from trust creditors
A trustee is entitled to be indemnified out of (ie to be paid from) the trust assets for liabilities it properly incurs as trustee of the trust.
This is known as the trustee’s right of indemnity and it is secured by a lien (a right of possession) and a charge (similar to a mortgage) over the trust assets.
The trustee’s right of indemnity means that assets of a discretionary trust are available to pay the creditors in whose favour such liabilities have been incurred by the trustee, ie trust creditors.
Where the trustee conducts a business – that is, a trading trust – the creditors of the business will also be trust creditors, and will have recourse to the trust assets.
If a trustee becomes insolvent, its right of indemnity will vest in the trustee-in-bankruptcy or liquidator, empowering the trustee-in-bankruptcy or liquidator to retain possession of and realise the trust assets to pay trust creditors.
Removing an insolvent trustee and replacing it with a new trustee does not alter the position, because the outgoing trustee retains its lien or charge over the trust assets.
This makes it extremely important that the trustee of a discretionary trust that holds valuable non-business assets should not engage in any trading or other risky activity (for example, giving guarantees) so as to avoid endangering the trust assets.
Unpaid present entitlements
Unpaid present entitlements occur where a trustee makes a distribution in favour of a beneficiary, often for tax minimisation reasons, but does not immediately pay it.
The unpaid present entitlement gives the beneficiary a direct beneficial interest in the trust fund to the extent of the unpaid present entitlement, enabling recourse by the beneficiary’s creditors to the trust assets to the extent of the beneficial entitlement if the beneficiary becomes insolvent.
For this reason, corporate beneficiaries should never be companies which trade or engage in any risky activity, and their shares should only be held in discretionary trusts which themselves do not trade or engage in risky activity.
Debit loan accounts, voidable transactions and breach of director’s duties
These were discussed in the first article in this series and they apply equally where the trustee of the discretionary trust is a company.
Conclusion
The three asset protection tools discussed in this series – the private company, the registered debenture and the discretionary trust – are very powerful.
Used properly, they can very effectively protect family wealth and key business assets.
Misused, they will be ineffective, and indeed the consequences can be ruinous.
For more information about asset protection, do not hesitate to contact Demian Walton or David Lurie of our firm on (03) 8602 4000.
The content of this publication is intended only to provide a summary and general overview of the subject matter covered. It is not intended to be comprehensive nor does it constitute legal advice.
