Bankruptcy: Family and Discretionary Trusts
Family assets are commonly protected by the use of a structure named a discretionary trust (sometimes referred to as a ‘family trust’). This type of trust provides a firewall of protection for family trust assets.
What happens, however, if the trustee or appointor of a discretionary trust goes bankrupt? Or the beneficiary submits to personal insolvency?
Benefits of a Discretionary Trust
The trustee of a discretionary trust owns the assets legally, which are held on trust for the benefit of others. Beneficiaries receive income or capital distributions at the trustee’s discretion.
Discretionary Trust Distributions
Unlike the trustee of a unit trust, the trustee of a discretionary trust has the discretion as to whether or not to make distributions to a bankrupt beneficiary. As any distributions owed to a bankrupt vest in their bankrupt estate (meaning the trustee is entitled to realize distributions or outstanding entitlements) it is common for a trustee of a discretionary trust to decline to make distributions to a bankrupt. Further, the trustee in bankruptcy cannot compel the trustee to exercise its discretion in favour of the bankrupt beneficiary.
Discretionary Trust Assets
Family or discretionary trust assets are generally protected from claims by creditors of a bankrupt beneficiary as the trustee of a discretionary trust is the legal owner of those assets.
The trustee will hold any property beneficially for the beneficiary which means the property cannot be taken by a creditor in bankruptcy, unless the debt relating to the creditor was a trust debt. The same applies when property is held on trust by a corporate trustee. Any properties held in trust can only be attacked by creditors of that trust.
Fortunately for trust beneficiaries, a recent NSW Court of Appeal decision[i] has confirmed that a trustee in bankruptcy will not be able to seize family trust assets for the benefit of creditors in the event of a bankrupt trustee or appointor (except if the trust is set up as a sham)[ii]. In that case, property held by the bankrupt in trust transferred to the trustee in bankruptcy but it was subject to the existing trust (ie, not available to creditors).
Purpose of Trust
If a bankrupt has tried to prevent trust property from being divisible amongst the bankrupt’s creditors by transferring trust property at a time when they were insolvent or on the edge of insolvency, the trustee may rely on s 121 of the Bankruptcy Act 1966 (Cth) (Act) to apply to the court to void the transfer.
The discretionary or family trust is a fairly robust investment structure however it is not without its limitations.
The proper establishment of a discretionary trust through a carefully drafted trust deed is essential. Those who are run a high risk of becoming bankrupt due to employment or nature of business dealings should be excluded as directors of corporate trustees should not hold the position of appointor and should only hold a small percentage of shares (or none at all).
Furthermore, loans or gifts to a trust, unpaid distributions and default beneficiaries are all open to attack from trustees in bankruptcy and claw back provisions under the Act (see ss 120 and 121 of the Act).
For more information on bankruptcy and family trusts, contact the team at Rapsey Griffiths on (02) 4929 3019 for a confidential consultation.[i] Lewis v Condon  NSWCA 204 [ii] s 116(1) Bankruptcy Act 1966 (Cth)