What happens to your assets if your beneficiary goes bankrupt?

Using a Testamentary Discretionary Trust

Bankruptcy is a very real possibility for anyone in business, even as fears about a slowdown in China, the over-heated property market and fluctations in the stock market abound. While many canny business people structure their current circumstances to avoid losing assets in the event of bankruptcy, very few have given thought to what might happen if one of their adult children goes bankrupt. What happens to your assets, if left to a bankrupt child in your will?

Those assets are lost to your child's creditors.

But there is a way of planning for this possibility.

A testamentary discretionary trust is a type of trust created under a will, comes into existence only upon the administration of the deceased estate and has four elements: the trustee(s), the assets, the beneficiaries and the discretion. One of major advantages of using a testamentary discretionary trust is for asset protection. There are three examples assets can be protected.

Bankruptcy

Consider this scenario: you have retired after a lifetime of work, and you have your home, your super, and some investments. You’d like to pass on these assets for your son’s benefit and the benefit of his children. Your son is a successful businessman, but the GFC hit him hard. He lost revenue and staff, and now the banks are closing in, threatening to sell off his assets to repay their debts. If you were to die, and your will passes your assets directly to your son, your assets could be used to satisfy your son’s creditors. Section 116 of the Bankruptcy Act 1966 says that when someone becomes bankrupt, all property vests to the trustee in bankruptcy. But S116 (2)(a) adds that this does not extend to property held in trust for another person.

A better approach is to use a testamentary discretionary trust to be created to come into effect upon your death. The trust will own the assets rather than passing directly into the name of your son. Making your son a beneficiary of the trust means that he can obtain the benefits of the assets held in trust without the risk of owning the assets outright. If Sam goes bankrupt, the creditors can’t place a claim on the assets in the testamentary discretionary trust.

This part of the law is extremely complex. Simply creating a testamentary discretionary trust will not solve the problem. The trust must be structured in a certain way, and tailored to meet the client’s specific circumstances. If the trust is properly structured and carefully planned, none of the beneficiaries has an absolute entitlement to capital or income, and for a trustee in bankruptcy to say otherwise would then impact on the rights of other potential beneficiaries.

High-Risk Professions

Because a testamentary discretionary trust is the legal owner of the assets, rather than a person, it is highly attractive to beneficiaries who are at risk of being sued, such as solicitors, doctors, company directors and business owners. Any legal action against them personally cannot take the assets of the trust, which protects the assets for future generations. It is common for such professionals to take care not to own assets in their own names throughout their career, but what about the people they might receive an inheritance from?

Alan is a financial planner in a partnership of four. A regular audit discovered that one of his partners has been conducting business dishonestly, investing funds on behalf of clients that the clients did not authorise. A group of clients launches legal action against the partnership for damages. Fortunately Alan owned very little in his name, preferring to keep assets well out of his (and his creditor's) legal reach. However, when his father died in the same year, his strategy fell apart. His father had made no provisions in his will to take into account Alan’s risk of being sued. The assets were inherited in Alan’s name, and used immediately to satisfy his creditors. Rather than his father’s assets being used for his family’s benefit, they were lost.

A testamentary discretionary trust established by his father would have avoided this scenario. The assets would have been owned by the trust and the creditors would not have been able to touch them. This is a what-if scenario rarely considered by someone who doesn’t know succession law thoroughly.

Spendthrift

Finally, a testamentary discretionary trust can be used to protect assets where a family member has a vulnerability. Inheriting a chunk of assets or money is not always in the best interests of a beneficiary, and a trust can distribute income or capital with discretion not available under a normal will.

An example would be for a child with a gambling problem. Rather than receiving his share of the estate in one big transaction, a trust can distribute an income stream or small capital distributions so that the gambler can’t lose the assets. In this way, assets can be protected from his compulsion for the benefit of his children or other family members.

Bryan Mitchell is an Accredited Specialist in Succession Law (Qld).