Succession planning: When are trust assets at risk?

For many Australians, discretionary trusts sit at the centre of their strategy for growing and preserving wealth and creating a legacy for their family. Discretionary trusts have long been relied on for their asset protection benefits and, despite the evolution of the law, they still offer significant benefits when used for that purpose. There are, however, ways that trustees can inadvertently erode the benefit of that protection. Below we consider two common areas where the estate plan can have a significant impact on trust assets.

Succession and control issues in family trusts

Assets held in a family trust are not assets of an individual’s estate. However, usually an individual has a few roles within the management of a trust which need to be contemplated as part of a holistic estate plan. The key roles are usually the trustee and the appointor (sometimes called the principal), but some deeds contain additional roles – a “guardian” is a common example of this.

While there is legislation governing trusts, most of the rules around how a trust will operate can be found in the governing documents for the trust – primarily the trust deed and any variations to it.

The role of the trustee

The trustee of a trust is the decision-maker. The trustee makes the day-to-day operating decisions of the trust, including buying and selling assets, investing assets and borrowing and granting security over assets. Some trustee decisions are critical to the ongoing operation of the trust and the trustee can often make changes to the terms of the trust, change where the trust is domiciled and add or remove beneficiaries to the trust. Critically in a discretionary trust (which most family trusts are), the trustee usually decides when to make distributions of income and capital, and who to make those distributions to. Depending on the terms of the deed, the trustee may have the power to distribute the entire capital of the trust (being all of the assets held by the trust) to a beneficiary without the prior consent of any person.

Where a trustee is one or more individuals, the deed will usually prescribe circumstances in which the role becomes vacated, including the death or incapacity of a trustee. The deed may also provide for what happens if the role of trustee is vacated. Common provisions are that the legal personal representative (being the executor) of the last surviving trustee steps into that role.

Where a trustee is a company, the company will continue after the death of a key individual. In that case, proper planning looks at who the shareholders of the corporate trustee are and how a new director is appointed to control the company once a key person can no longer act.

It is often easy to overlook the role that an attorney appointed under an enduring power of attorney can play in these related entities. Many people consider that their personal finances are separate from assets held in their related entities and in most cases they are right in this. However, shares in corporate trustees are often held by the individual and are a personal asset. These shares might not have much in the way of tangible value, but they allow the person controlling those shares to vote on certain decisions for the company. One of those decisions is the appointment and removal of directors.

Where a shareholder loses capacity, the attorney under an enduring power of attorney usually has power to vote in relation to that person’s shares. In some cases this is appropriate. However, many clients like to draw a line between control of their business assets or assets held in related entities and control of their personal financial matters. An unintentional blurring of this line can occur if the decision-maker deemed suitable for personal financial matters can make shareholder decisions for a key related entity.

The role of an appointor or principal

The specific nature of the role of an appointor/principal depends on terms of the trust deed. The appointor usually has the key power to change the trustee of the trust. Sometimes the appointor will have additional powers, including consenting to certain trustee decisions (such as variations to the trust or distributions to large amounts of capital).

Some practitioners refer to the appointor as the ‘ultimate controller’ of the trust. While the appointor has considerable power over the control of the trust (in that it can decide who the trustee is), there are limitations to the effect of this oversight. For example, if a rogue trustee has unconstrained power to distribute capital of the trust, it could do so before the appointor even becomes aware that there is an issue and arranges for the trustee to be replaced.

That being said, the role is still critical from a succession planning perspective. The appointor is usually an individual person who needs to be replaced in certain circumstances. There is little to no consistency between deed providers as to the circumstances in which an appointor is replaced, and the mechanism by which the appointor is replaced. This lack of consistency means that a standard clause in estate planning documents is rarely sufficient to give effect to a client’s succession objectives.

Further, many deeds provide that the role of appointor will fail if the appointor loses capacity, but don’t provide an appropriate mechanism to fill that vacancy. That same deed may allow for an appointor to appoint a successor via the terms of their Will. However, if the individual has stopped being the appointor before their death (because they have lost capacity), their Will is not going to be effective to appoint a successor to that role.

Reviewing the terms of the particular trust is a key part of a complete estate plan. Trust deeds are not consistent and there is no standard law which applies in relation to the succession of the role of the appointor in particular, so the use of standard clauses in Wills to deal with succession comes at a significant risk to the overall estate planning strategy.

Loans and unpaid present entitlements

It is common to see large loans owed to beneficiaries recorded on balance sheets for family discretionary trusts. These usually arise where:

1. A person has contributed capital to a trust which has been recorded in the financials as a loan to the trust rather than a gift to the trust;
2. The trustee has made distributions of income to a beneficiary who has paid tax on those distributions but has not received the distribution itself (unpaid present entitlements or “UPEs”).

Amounts recorded as owing to an individual are assets of the individual and that value is no longer protected by the trust. Accordingly, those loans are subject to all of that individual person’s risks, whether that is death, divorce, creditor or bankruptcy risk.

In the deceased estate context, amounts owing to a person who has died are assets of the estate. Absent a direction otherwise, the executor has an obligation to call in the assets of the estate for the benefit of the beneficiaries. Unless so directed, an executor will not have the power to forgive a loan or gift an unpaid present entitlement back to the trustee of a trust without risk of breaching their obligations.

The potential consequences can vary depending on the family dynamic and the asset composition of the trust. A beneficiary who has the right to call on a UPE can exercise significant control over a family trust, particularly where the assets of that trust are illiquid.

In some cases, the proposed solution to this issue is to ensure that unpaid present entitlements are ‘forgiven’ in the terms of the Will. There is some uncertainty in the law as to whether an unpaid present entitlement can be considered a debt in the usual context of forgiveness, so generic provisions contained within the terms of a Will may not be sufficient to deal with a UPE.

Even if an appropriate clause is included in a Will, the ‘asset’ (being the amount owed to the estate) may still be an estate asset which can be at risk to a family provision application by an excluded beneficiary. A claim brought by an eligible person for further provision out of an estate in Queensland is limited to assets forming part of the estate. That is, assets in family trusts and other entities will be protected from a claim, but an unpaid present entitlement would not be.

It is likely that an unpaid present entitlement, even if forgiven or released from payment by the deceased in the terms of their Will, could still be an asset of an estate at risk to a claim by a beneficiary for further provision. Inherently, this can place the value of the trust at risk if any part of the unpaid present entitlement is required to be called upon to satisfy or settle the claim.

However, UPEs can also be an excellent succession planning tool when used appropriately. UPEs can enlarge the value of the estate available for distribution, which means more assets are available to pass into the tax effective testamentary trust structures often set up under Wills. In addition, a larger estate can allow more opportunities to make cash available to equalise benefits between children or other beneficiaries, particularly where there are valuable real property assets (such as farms) which might be intended to benefit only one beneficiary.

Ultimately, there is no single appropriate strategy for dealing with UPEs and loans from a trust in an estate plan. Each case will turn on the circumstances of the particular person and should be the subject of careful consideration and advice.