Family trusts protect assets but watch out for pitfalls

By PIP KAY

New Zealanders could be accused of being addicted to family trusts, but do they offer the protection we believe they do?

A typical scenario is the creation of a family trust under which the family home is transferred to the trust, paid for by the trustees by way of a mortgage back to the original owners (Mum and Dad).

The mortgage is expressed to be interest-free and repayable on demand (so as not to attract gift duty or the accrual rules) and the amount of the debt is forgiven by annual instalments (up to $27,000 per annum can be gifted without attracting gift duty).

Sound familiar? Sound bulletproof? Maybe not. A recent High Court decision provides a graphic example of how a family trust can turn sour.

In this instance, an elderly settlor was denied superannuation because she had deprived herself of income by disposing of her substantial assets to a family trust.

The settlor - we'll call her Rachel - sold her family home and paid the proceeds into a bank account, which was opened in anticipation of setting up a family trust.

The trust was duly established with Rachel's nephew and herself as trustees and her family as the beneficiaries. Rachel then handed over the bank account to the trustees and received in return an acknowledgment of the loan.

The trust then bought a home for the family as well as a small business in which Rachel and her children were employed.

About a year later, Rachel's husband qualified for New Zealand superannuation and Rachel applied to be included as a non-qualified spouse. She was turned down.

If Rachel had put the proceeds from the sale of her home on interest-bearing deposit she might have earned at least $25,000. This would have disqualified her as a non-qualified spouse because New Zealand superannuation is income tested.

The Department of Social Welfare (as it was at the time) said that by choosing to loan the proceeds from the sale of the house interest-free to the trust, Rachel had deprived herself of income.

The department's reasoning had teeth, in the form of section 74 of the Social Security Act 1964. This gives the department the discretion to refuse a benefit if the applicant has deprived herself of income which results in her qualifying for that benefit. The High Court agreed with the decision.

Before getting alarmed, it's worth remembering that every case has a different set of facts, and the facts in this case were exceptional.

Rachel's predicament might have been quite different had the trust been established before the sale of the family home. With the benefit of hindsight, Rachel might have ordered her affairs differently and might not have set up a trust at all. This, however, also has its pitfalls.

If Rachel was in need of residential care, for example, and applied for a hospital or rest-home care subsidy, the department has another weapon in its arsenal.

This benefit is means and asset tested, and the department, again, can take into account asset-planning steps a person or his or her spouse might have taken.

There is a possibility that the department will seek to claw back the value of assets, and its current policy is to look back over the five years preceding the application for the benefit.

But the department is not entitled to take into account whether a person is a beneficiary of a discretionary trust.

While this might seem contradictory, the difference between the two scenarios is, simply, the facts. What works in one situation will not necessarily work in another.

Trusts remain a valid tool for protecting assets, but if they are improperly constructed, improperly administered or inappropriate for the circumstances, they will be vulnerable to attack, even by the beneficiaries. But that's another story.

* Pip Kay is a tax analyst at CCH (NZ) Ltd. CCH (NZ) Ltd is a tax, business and employment law publisher based in Auckland. For further information, visit the CCH website or phone 0800 500-224.


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