Trusts need tailoring to needs

By Richard Lang, Associate

First published in The Press, 10 March 2008

Brendon and Sara took a leap of faith. Abandoning the safety of their old jobs, they set up a funky new designer furniture retail business. The store, which they leased, was in a perfect location in town, they had contacts with unique suppliers, a fantastic new brand, a new company, and a big bank overdraft. It was an exciting new world.

Then, at a celebration dinner, Sara heard one of her friends talking about family trusts. Another friend was also talking about how they had protected their home from the risk of their business failing by setting up a family trust. Brendon and Sara had acknowledged the possibility that their business might fail. But they hadn’t considered a family trust. They were prepared to run the risk of the business failing, but they didn’t like the prospect of losing their family home just because things didn’t work out.

Do Brendon and Sara need a family trust? The answer is yes, they probably do. Family trusts can protect key assets for people in business as well as providing a range of other benefits. But they aren’t for everyone, and there are a number of things to consider.

How does it work?

Family trusts are a hot topic among business people. These days, virtually everyone seems to have a family trust – but many don’t understand why they have their family trust or how it works.

Most people are already familiar with the basic concept of a trust. If you have ever given money or property to another person with instructions to use that property for the benefit of a third party or a specific object, you have probably created a trust. The very term “trust” means that you trust someone else to carry out your wishes. However, the family trust has moved on and today family trusts are very flexible structures and the people setting them up tend to retain more control over the continuing operation of the trust.

In simple terms, a trust is like a separate legal entity and property of all kinds can be transferred to it. The people who set the trust up (e.g. Brendon and Sara) are called the settlors. The people who hold the trust property and run the trust (e.g. Brendon and Sara and perhaps an independent person) are called the trustees. They hold the property transferred to the trust for the ongoing benefit of the beneficiaries (in this instance, Brendon and Sara, their children and family).

Most modern family trusts are discretionary trusts, which means that the trustees have complete discretion as to who of the beneficiaries will receive benefits from the trust from time to time. The trustees can decide that one or more beneficiaries should receive all of the benefits and the others nothing if they wish. The trust assets, and income earned from them, can be distributed to beneficiaries, loaned to them, or held in trust. Ultimately (within 80 years), the trust has to be wound up and the assets distributed to the beneficiaries.

The objective of a trust is the protection of family assets built up from the efforts of the settlors for themselves and their family.

The tricky part is the transferral of assets. Brendon and Sara can’t just gift their $540,000 house to their trust, because Gift Duty is payable where a person makes gifts in a calendar year totalling more than $27,000. What Brendon and Sara can do is sell their house to their trust for its current market value. The problem with that is, unless their trust has an income of its own, it won’t have any money with which to buy the house from Brendon and Sara.

The usual answer is for Brendon and Sara to sell their house to their trust, but to simultaneously lend the trust enough money to pay the purchase price. Then they progressively forgive (i.e. gift) the debt the trust owes to them until the house is paid off. However, the limit on gifting means this can only be done over a long time. For example, if Brendon and Sara’s house is currently worth $540,000, as they can jointly only gift $27,000 each (i.e. $54,000 in total) in each year, it will take them 10 years to complete their gifting programme. The capital gain in the value of the house in the meantime, however, will belong to the trust.

What this means is that gift duty acts as a sort of legislative handbrake, allowing people to transfer their assets to family trusts, but ensuring that it has to be done over a reasonable period, so that family trusts are not used as emergency measures to move assets in order to evade creditors.

The fact that transferring significant assets to a family trust takes time is one good reason to start early. Another is that the sort of assets that you might consider transferring to a family trust (e.g. a family home, bach, or company shares) hopefully increase in value, meaning that if you wait before setting a family trust up, the asset will increase in value in the meantime and, therefore, take even longer to transfer.

What are the benefits?

The fact that family assets can be transferred into the ownership of a trust is useful to business people. For instance, if Brendon and Sara’s venture fails and they are pursued personally for the debts of the business, their family home will be safe because it is owned by their family trust and not by them.

However, there are a few things to keep in mind:

1. Where a company has been set up to operate the business, you already have some protection. Brendon and Sara operate their business through their company, Funky Designer Furniture Retailing Ltd. If the business fails, the creditors of Funky Designer Furniture might have that company liquidated, but as shareholders in the company, Brendon and Sara have limited liability (although any capital or loans they have invested in the company may be lost). That said, companies can only provide so much protection. There are two main problems. The first is personal guarantees. The second is directors’ duties. If Brendon and Sara have given personal guarantees to their bank, their landlord, and their suppliers, they could be personally made bankrupt and their assets taken to repay these creditors of their company. Likewise, if they have breached their duties at law as directors (e.g. their duty not to trade recklessly), they could be personally liable for the company’s debts.

2. Even where you do have personal liability for a business, a family trust can’t protect you from being sued personally or being made bankrupt. If Brendon and Sara’s business fails, their suppliers, their landlord, and their bank can still sue them and make them bankrupt where they have given personal guarantees for Funky Designer Furniture or if they have breached their duties as directors. While the house may be protected because it is owned by the family trust, this may not extend to Brendon and Sara personally. They cannot avoid creditor claims and property that has not been transferred to the trust will still be at stake.

3. Assets are only protected once the transfer of those assets and all gifting in relation to those assets is complete. If Brendon and Sara’s company goes into liquidation five years after they set their family trust up, they will only have completed five years’ gifting, and so their family trust will still owe them (on paper) $270,000. That debt owed to Brendon and Sara will be seen as an asset in their personal names if they are pursued by their creditors under their personal guarantees of Funky Designer Furniture.

4. There are also other legal protections for creditors. Liquidators of companies and the Official Assignee in bankruptcy can review certain transactions (including gifts to a trust) if they took place within a certain timeframe before the failure of the business or the bankruptcy. There is also power to review transactions that were undertaken to defraud creditors. Accordingly, trusts set up solely to protect assets from business creditors can be at risk.

Family trusts have a number of other benefits aside from protecting assets from business risks, including succession and estate planning and protecting the needs of children.

On the other hand, family trusts also have disadvantages. These include the cost (both of setting up the trust and of the ongoing administration), difficulties in reversing or winding up satisfactorily in the event of disputes, additional complication, and a degree of loss of control.

The important thing is to get good advice early as to whether a family trust will suit your particular needs in the first place.

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