Diana Clement: Recession puts the squeeze on trusts

The business of trust-busting is set for a boost, thanks to the recession.

Failed finance company directors, many of whom appear to be living comfortably while their former customers suffer, will be prime candidates to have their family trusts pulled through court.

The directors of any failed company, or divorcing partner, for that matter, could have their trusts examined. Those who have not followed the letter of the law risk losing their homes and other assets in trust.

A number of recent court cases have produced precedents, or at least fired warning shots, for family trust settlors, beneficiaries and trustees.

When most people think of trust-busting, relationship splits come to mind. But there are many others who may want to bust open trusts. They include: The Official Assignee.

The Inland Revenue Department where individuals are avoiding tax.

Beneficiaries of trusts who feel their interests are not being served.

Work and Income New Zealand (Winz) for rest home subsidy cases.

Chris Kelly, general counsel of Guardian Trust, says one court case in particular - known as the Regal Castings case, which made it to the Supreme Court - set a precedent in an area that could affect large numbers of trusts.

A company owned by a Mr and Mrs Lightbody was in debt to supplier Regal Castings Ltd, but convinced that company to turn the debt into a loan and write off the interest.

Without the knowledge of Regal Castings the Lightbodys transferred their home to a family trust and had gifted back the loan by the time their company went into receivership five years later. When Regal Castings tried to recover the outstanding debt from Mr Lightbody - who had accepted personal liability for the loan - it found that the couple's main asset, a house, had been transferred to a trust.

Regal Castings failed at the High Court and Court of Appeal to have Mr Lightbody's half interest in the house transferred to the Official Assignee for the benefit of creditors, but succeeded at the Supreme Court.

The Lightbodys, says Kelly, gave away their assets "in order to defeat the creditors [and] were technically insolvent before they even started the trust".

There is nothing wrong, says Kelly, with putting your assets into a family trust if you are going into business. But it's always best to do this before the business has even started. "That is what business owners are advised to do traditionally."

Even then it can take years for the debt to be fully gifted to the trust at $27,000 a year, or $54,000 for a couple, and until then the capital is still vulnerable. If it emerges that a trust has become a sham during its life, the assets gifted from that point on could be vulnerable to attack, says John Brown, author of the New Zealand Master Trusts Guide.

Trusts have been busted open because one trustee has acted in self-interest and not in the interest of all of the beneficiaries. One example, says Kelly, is Scott v Scott, where a mother and son were trustees of the family trust. The son made an arrangement to sell a farm owned by the trust to himself at a good price.

Years later his sisters complained. A judge ordered that the farm be put back into the trust.

"Trustees aren't just there to do what they feel like doing," says Kelly. "They can't just ignore the interests of the other beneficiaries. They are there to do what the law says."

Trust-busting in recent years for relationship property cases has become more common. Although the Property (Relationships) Act allows for trusts to be set aside in certain circumstances, such as transfers being made to avoid having to share with a spouse later, it is section 182 of the Family Proceedings Act that ex-spouses tend to use. This section allows the court to inquire into trusts as it "thinks fit" to modify trusts.

In one marital split where a wife was left with just $21,333 after a 22-year marriage, a judge ordered the family trust to provide a home of reasonable quality for the wife to live in. In another case a judge overruled a husband's power to appoint trustees and ordered that a professional trustee company be appointed.

The courts are not 100 per cent consistent, says Kelly. And not all cases heard set precedents. Some fire warnings. In several cases lately judges have sent warring ex-couples away to find a way to sort out their own trust.

Brown adds that the distinctions between one case and the next can be very subtle.

The IRD, warns Kelly, has been quite litigious in the area of trusts in recent years - especially in the case of professionals who use trading trusts to channel money to their spouses and other lower-earning members of the family.

It won one recent case against a dentist, but lost a similar case in March this year where it alleged that two Christchurch orthopaedic surgeons, Ian Penny and Gary Hooper, set up companies and employed themselves on salaries which the IRD argued were lower than market rate. The profits retained in the company were taxed at 33 per cent instead of 39 per cent.

In reality, Bill Patterson, estate planning specialist at Patterson Hopkins, says sham trusts are an unusual situation and also a surprisingly small number of New Zealand trusts are successfully challenged in the courts.

There's also a belief in the public arena, says Patterson, that trusts can be busted by simply showing that they are badly run.

A recent case of the Official Assignee v Wilson and others failed because although the trust was badly run, the settlor, a bankrupt, was not a trustee.

Trusts are more likely to be shown to be a sham in court where the settlor is also the only trustee and apparently makes all the decisions.

Brown says the effect of the Wilson case was to show that bad administration of a trust might evidence a sham, but does not prove it.

Trust-busting cases can be hugely expensive for anyone caught up in them. In Property (Relationships) Act cases the legal fees can range from the tens of thousands of dollars to the hundreds of thousands.

Even in Official Assignee cases such as the Lightbodys and Wilson, the individuals and trusts were not bankrupt so had to pay their own legal fees. Some people can apply for legal aid, but even that must be paid back eventually.

No one knows how many family trusts there are in the country because they don't need to be registered with the IRD, unless they make a profit and need to pay tax.

Numbers are estimated at between 300,000 and 500,000. But what's clear, say the lawyers and trust companies, is that many are very poorly run.

It is common for annual meetings not to be held, resolutions not to be made or recorded, and for settlors to dip in and out of the trust's assets like a personal piggy bank.

The morals of these tales are to keep your nose clean when setting up trusts, always consider that they may be challenged legally, and ensure they are run to the letter of the law. Otherwise the monster you have created can come back to eat you.

Conversely, says Kelly, trusts can be the cat that sits quietly on your lap and purrs away.