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Discretionary Trusts And Bankruptcy

written by Lucy Padula
10 · 9 · 20

When family assets have been placed in a discretionary trust and one of the trustees or beneficiaries files for bankruptcy, the other interested parties may be left wondering where they stand.

Establishing a discretionary trust can be an effective way to protect family assets should one of the beneficiaries become bankrupt.

In doing so, it is crucial that the trust deed is carefully drafted, and that any parties who may be at risk of becoming bankrupt in the future are excluded as directors of any company set up to act as trustee.

Why Set Up A Trust?

There are many reasons why people choose to set up a trust. These include:

  • Separating the owner of assets (the beneficiary) from control of the assets. This happens through the appointment of a trustee. This may be desirable for several reasons, including the beneficiary being underage, or suffering from a disability which might inhibit their ability to make sound decisions.
  • To provide greater flexibility in tax planning, such as avoiding capital gains tax.
  • To protect the assets held within the trust, and the beneficiaries, from being open to financial claims.
  • To be used as a business entity for investment purposes such as purchasing real estate, stocks or the creation of a share portfolio.

What Elements Are Needed for a Trust?

There are several elements needed before a trust can begin operating.

The first is a settlor. The settlor is the person who sets up the trust, appoints a trustee and names the beneficiaries. For tax reasons, a settlor should not be one of the beneficiaries of the trust.

The second is a trustee or trustees. The trustee holds and administers the assets on behalf of the estate and the beneficiaries. They must act in a way that abides by the rules set out in the trust.

A trust must also have named beneficiaries. The beneficiaries are people or companies who the trust has been created to benefit.

There are primary beneficiaries and general beneficiaries. Usually, only primary beneficiaries will be named in the trust, and general beneficiaries tend to be children or other relatives of the primary beneficiaries.

Finally, for a trust to be valid and operational, there must be a trust deed. A trust deed is a formal document that sets out how the trust will operate. A trust deed should be drafted by an experienced lawyer to ensure the deed is legally binding.

What is a Discretionary Trust?

A discretionary trust, also known as a family trust, is the most common type of trust used by families.

There are several benefits to setting up this type of trust. They are beneficial from a tax point of view as they enable the trustee to distribute assets to the beneficiaries according to their relative tax brackets, meaning the entirety of the estate makes significant tax savings. They also allow assets to be passed down through the generations without facing taxes and duties.

In most cases, family trusts are also immune from creditors or legal action should one or more of the beneficiaries named in the trust become insolvent.

What Happens When a Beneficiary Becomes Bankrupt?

When a beneficiary of a discretionary trust becomes bankrupt, whether voluntarily or involuntarily, they will be subject to the laws of the Bankruptcy Act 1966.

This means that a trustee will be appointed to take control of the bankrupt party’s assets, which will usually be sold off to pay creditors and other debts.

Unlike certain other forms of trusts, when the beneficiary of a family trust becomes bankrupt, it is generally at the discretion of the trustee as to whether or not the bankrupt party will continue to receive distributions from the trust.

Likely, the trustee who is given control of the bankrupt party’s finances will use the distributions from the trust to pay off outstanding debt.

Therefore, it is usual practice for the discretionary trust trustee to decline to continue making contributions to the bankrupt beneficiary.

Discretionary Trust Assets and Bankruptcy

Because discretionary trusts make the trustee the legal owner of the trust’s assets, the assets are generally protected from creditors when one or more beneficiaries faces bankruptcy.

Similarly, if a trustee becomes bankrupt, the trustee in charge of the bankruptcy proceedings is not allowed to seize assets in the discretionary trust to pay the trustee’s debts.

Setting Up a Discretionary Trust

Setting up a discretionary trust can be a wise choice for families looking to pass assets between generations while making considerable tax savings and protecting their assets from anybody involved who becomes bankrupt.

If you decide you would like to set a family trust, you will need to undertake the following steps:

Appoint a Trustee – The trustee must be one or more people, or a private, proprietary limited company set up expressly to act as the trustee. While there is some initial financial outlay in setting up a company for this purpose, it does offer certain benefits, including minimising the risk of personal liability.

Draft A Trust Deed – When drafting a trust deed, it is vital to talk to a qualified lawyer who can make sure the deed is legally binding.

Settle The Trust – The trust deed must then be signed the settlor, who pays a nominal ‘settlement sum’ (usually $10)  to the trustee. The settlor is someone unrelated to the trust such as an accountant or justice of the peace. Once this transaction has taken place, the settlor will generally have no further involvement with the trust or its administration.

Trustees Sign The Trust – Once the trust is settled, the appointed trustees then gather, agreeing to their roles and to be bound by the terms of the deed. They then sign the trust deed.

Stamping of The Trust Deed – In NSW, every new trust that is set up must pay a stamp duty of $500 within three months of the trust being established. This can be paid directly through the NSW Office of State Revenue or with the assistance of your lawyer or accountant.

Applying for an ABN and Tax File Number – After paying stamp duty, and the trust has been established, you will need to apply for an Australian Business Number and a Tax File Number through the Australian Business Register.

Open a Bank Account – Once your trust has an ABN and TFN, a bank account should be opened the name of the trustee acting for the trust. The first deposit into this account must be the settlement fee before any other transactions take place.

Lucy Padula

Lucy is the Principal of anderson Family Lawyers and is an Accredited Family Law Specialist who considers it of utmost importance to assist her clients in resolving family law matters fairly and with integrity.