How to avoid the many tripwires in trusts

While many accountants and lawyers recommend to their clients that they use a trust in their business structure arrangements, there is no point in using one if it cannot protect you from hidden traps.

Sometimes these traps are due to the way the trust deed is drafted, sometimes by how the trust is used and sometimes by the trustee being unaware of what traps are out there.

The trust will be a burden and not a benefit if it is handled incorrectly and in business, as we all know, you need everything going for you. So let’s have a look at some of the pitfalls in using a trust in a business environment.

Lost trust deed

Lost trust deeds are surprisingly very common. A trust deed is a legal document that sets out the rules for establishing and operating your trust. If you have lost the trust deed, your remedies are limited and there can be significant impacts in the event of a dispute. An unsigned and/or unstamped trust deed cannot be used as evidence in court.

Restatement deed by beneficiaries

Beneficiaries who are sui juris and absolutely entitled and unanimous may direct the trustee to depart from the strict terms of the trust and the trustee will not incur a liability if their directions are followed. Case law going back to 1802 confirms this. Beneficiaries can therefore band together and adopt a restated trust deed. However, s8AA may still apply.

Where is the settled sum?

The Deputy Commissioner of Taxation from time to time will try and set aside a trust as being a fictional entity if he is of the view that he might succeed. Where the settled sum is purportedly paid say, on 1 January 2015, but the trust’s bank account is not open until 10 January 2015 and the settled sum of $100 does not appear in it until 20 January 2015 then an argument may be available to the Deputy Commissioner that on 1 January 2015 the trust was not established at all and never was because you need four things to create a trust: the trustee, the trust property, the beneficiaries and the intention to create a trust – typically evidenced by the trust deed.

If there was no trust property on 1 January, the trust never started at all as it had no assets at the time the trust deed was signed. Needless to say, adverse tax consequences for the trustee and each beneficiary who purported to receive a distribution of income or capital are likely to arise from such an event.

Some banks will not open a trust account until they sight the signed, dated and stamped trust deed. But you need the account opened and the money in the account to create a trust. Catch 22.

A practical alternative is for the trustee to keep good file notes of what happened to the $100 cash that was paid by the settlor to the trustee on 1 January 2015 so that the trustee can show that the trustee had the $100 cash in his hands between 1 January 2015 and 20 January 2015. Pin the $100 note to the trust deed if need be – until the account is opened.

Litigating the meaning of the terms of the trust deed

Earlier this year, the High Court in FCT v Carter [2022] HCA 10 unanimously held that a disclaimer by default income beneficiaries of their interests under a discretionary trust deed after the end of the income year in which (unknown to them) the default provision had been activated in their favour, were ineffective for tax purposes. This litigation could have been avoided if they had read, digested and understood the trust deed.

In other cases, poor drafting can have a significant impact. In Wheatland Holdings Pty Ltd as Trustee for the Rodney Manuel Family Trust [2022] WASC 211, the West Australian Supreme Court said that the words of a clause in a trust deed are to be given their ordinary and natural meaning, read in the context of the trust deed as a whole, unless the words have a special or technical meaning. So in other words, it says what it says.

In that case, the trustee wanted to vary the trust deed to include in the category of “income beneficiaries” a corporate beneficiary as there were likely to be significant tax benefits if that were to be possible.

The power of variation was convoluted and stated that:

“The trustee ... may at any time … by deeds revoke, add to or vary … any of the trusts hereinbefore created by any variation or alteration or addition made thereto from time to time and may … by any other deed … declare … new or other trusts or powers concerning the Trust Fund or any part … of the trusts … so revoked added to or varied … so that such new trust powers, discretions, alterations or variations … may relate to the management or control of the Trust Fund or the investment thereof”.

Did that mean that the trustee could add a corporate beneficiary as one of the discretionary income beneficiaries? The court said that the natural ordinary meaning of the expression, “the power to revoke, add to or vary … any of the trusts”, was a power that extended to enabling the addition of a corporate beneficiary as an income beneficiary.

To avoid expensive court applications, ensure that your power of variation is wide and clear – and not poorly expressed.

Ruling from the grave and memorandum of wishes

When a person who causes the creation of a family discretionary trust dies, he or she frequently leaves a memorandum of wishes to outline to the continuing trustee what he or she wants done with the trust after their death. There are a lot of people who wish to rule from the grave and applying such a concept is fraught with difficulties.

One way forward is to have the trust deed itself make provision for an appointor or successor trustee upon that person’s death. Another, where there is a corporate trustee, is to leave the shares of the corporate trustee to the person that the deceased wants to benefit from the trust. This is a sensible business succession strategy. It is the classic merger of business succession and estate planning.

The trustee, settlor or appointor as a beneficiary?

Clients often ask whether the trustee, settlor or appointor can be a beneficiary of a family discretionary trust. There seems to be some urban myth alive that there is a magical rule of law which prevents any of these individuals from being beneficiaries of trust.

It is quite common that a person is appointed as the trustee of a discretionary testamentary trust in his or her father or mother’s will and that person is also a beneficiary of the discretionary testamentary trust along with other siblings. It is no different to the situation of a settlement created by a trust deed and as long as the trustee undertakes the duties that he or she owes to the beneficiaries – being (inter alia) to keep accounts and supply information, to act in good faith, to consider all of the beneficiaries when making distributions and not to act capriciously or wantonly – then I see no problem with a trustee also being a beneficiary.

However, a trustee can act unreasonably or unfairly to a degree. If there is a high degree of unreasonableness or unfairness, then this may indicate that the trustee has breached one or more of their duties.

There is only one possible reason as to why a settlor, or more particularly minor children of the settlor, should not be beneficiaries of a trust settled by their parent.

The reason lies in s102 of the Income Tax Assessment Act 1936, which provides that if a person creates or settles a trust under which a child of that person under the age of 18 can benefit, then the Commissioner may assess the trustee to pay income tax on income applied for the benefit of the minor child of the settlor on the basis that the income so applied is to be added to the income of the person who created or settled the trust (ie: the settlor/parent) so that the relevant marginal rate of tax of the settlor/parent applies to the income derived by the minor child as if the settlor/parent had earned that additional income.

Of course a simple solution to the tax trap under s102 ITAA36 is to have an independent settlor – for example a friend of the person wishing to create the trust or that person’s solicitor or accountant.

The appointor is usually the person who effectively controls the trust, especially in relation to a family discretionary trust, because that person has the ability to hire and fire the trustee.

If the trustee has died or becomes totally and permanently disabled or has suffered a trauma event or is failing in their duties – perhaps because they have their own financial problems like insolvency or developing a drug habit for example – then the appointor needs to take action.

It’s like the airbag in a car being triggered. Despite these issues, there is nothing preventing an appointor from being a beneficiary.

Other considerations

• The name and the ACN: Get the name right and do not change William to Billy or some other derivative.
• Powers: Does the trust have power to trade in derivatives?
• Vesting date: When does the trust end?
• Execution: Get this right or else. It’s one way to torpedo the trust’s existence.
• Read the deed: And get someone to explain it to you if you do not understand it.

Leigh Adams is special counsel at Owen Hodge Lawyers.

This is Part 1 of two articles. Part 2 of this piece runs on Accounting Times next Tuesday, 11 April.