Bankruptcy & discretionary trusts

Here we take a look at the benefits and intricacies of discretionary trusts. This includes considering what happens 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 realise distributions or outstanding entitlements), it’s common for a trustee of a discretionary trust to decline to make distributions to a bankrupt. In addition, 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 a creditor can’t take the property in bankruptcy unless the debt relating to the creditor was a trust debt. The same applies when a 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 can’t 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 (i.e., not available to creditors).

Purpose of trust

If a bankrupt has tried to prevent trust property from being divisible among 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.

Advisor tips

The discretionary or family trust is a fairly robust investment structure. However, it’s not without 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).

In addition, loans or gifts to a trust, unpaid distributions, and default beneficiaries are all open to attack from trustees in bankruptcy and clawback provisions under the Act (see ss 120 and 121 of the Act).

[i] Lewis v Condon [2013] NSWCA 204, [ii] s 116(1) Bankruptcy Act 1966 (Cth)