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Consider debts when setting up a trust

By Matthew Gallagher, Senior Solicitor

First published in The Press 13 April 2009

While trusts are a valuable way of protecting family assets from creditors, special attention needs to be given to any existing debts that could be affected by the transfer of assets to a trust.

Take this fictitious example, which is borne out by the findings in a recent case.

Mr Jones operated a small jewellery manufacturing business out of his home, through his company JonesCo.  During 1999, JonesCo became heavily indebted to its main supplier, Smiths Ltd.  Smiths agreed to continue making supplies to JonesCo on its usual credit terms - provided the existing debt was converted into a term loan with regular monthly payments and Mr Jones agreed to personally guarantee the loan to provide additional security.  Mr Jones agreed to this so that the business could continue trading.

In 2001, the accountant for Mr and Mrs Jones suggested that they speak to a lawyer about transferring their home, which was their only substantial asset, to a family trust.  They were sceptical but agreed to obtain legal advice.

Some of the benefits outlined to them included:

• Flexibility in succession planning;
• Preserving assets for future generations;
• Removing assets from means testing calculations; and
• Sheltering assets from claims by business creditors.

The couple decided to go ahead and the trust was set up with them and their lawyer as trustees.  As is the usual practice, they sold their home to the trust at market value and loaned the purchase price to the trust to allow it to complete the purchase.  At the same time, they started a gifting programme to write off the maximum allowable amount of the loans to the trust each year.  By 2007, this was completed.

The debt owing to Smiths Ltd was not discussed with their lawyer and Mr Jones did not tell Smiths about the transfer of the home to the trust.

In 2008, the recession took its toll on JonesCo.  While it had kept up payments to Smiths under the term loan and this was almost repaid, over $150,000 was owed to Smiths for ongoing supplies.  JonesCo failed and Smiths sought to recover the debt by first liquidating the company and then by bankrupting Mr Jones under the personal guarantee.  With significant money still owing to Smiths following these processes, Smiths turned its attention to the family home.  But, wasn’t this safely protected in the trust?

The Supreme Court has recently considered a similar situation in Regal Castings Limited v Lightbody in the context of provisions in the Property Law Act, which allow a transfer of an asset to be reversed if:

• The transfer was made with the intention of defrauding creditors; and
• The person receiving the property was aware of this intention.

In this case, there was no suggestion that Mr Lightbody had a dishonest intention to cause loss to Regal in transferring his house to the trust.  But from the Court’s perspective, it was enough that he must have been aware that the house was being placed beyond the reach of Regal and that, as he was also a trustee of the trust, the trust was aware of this.  Important factors for the Court in reaching this conclusion were:

• The home was Mr Lightbody’s only substantial asset;
• The transfer to the trust was done without Regal’s knowledge;
• The financial position of the company at the time of the transfer was not strong and it was unlikely that it could have repaid all monies owing to Regal if required to do so;
• Although the transfer was at market value, no money was actually received by Mr Lightbody as the purchase price was forgiven over time; and
• Mr Lightbody and his family continued to occupy the home.

The trustees were ordered to transfer a half-share in the home (subject to the existing mortgage) to the Official Assignee for the benefit of Mr Lightbody’s creditors.  This represented Mr Lightbody’s share that had been transferred to the trust.

This case is a reminder that, while a trust is a valuable tool for limiting the ability of business creditors to obtain repayment from family assets, care needs to be taken in establishing the trust.  Particular attention needs to be given to any existing debts that could be affected by the transfer of assets to a trust.

• By Matthew Gallagher, a senior solicitor at national and trans-Tasman law firm Duncan Cotterill. M.gallagher@DuncanCotterill.com

Disclaimer: the content of this article is general in nature and not intended as a substitute for specific professional advice on any matter and should not be relied upon for that purpose.