Are you a business owner that is expecting to inherit assets from your parents one day? Do you want to protect your inheritance from creditors and other third- party claims? How can your parents help you?
When it comes to asset protection, its’s important for business owners separating their business risk from their private wealth. This essentially comes down to operating your business through a company and not owning assets in your own name but rather in the name of: your non-business owning spouse; a trust designated for the holding of passive assets; or your self-managed super fund. But what about your inheritance? Can you protect that from creditors if you are a business owner or even a bankrupt?
Testamentary Trusts
Business owners are vulnerable to lawsuits and bankruptcy. Size does not matter. If, you are lucky enough to be expecting an inheritance from your parents in the future, you may not want your inheritance to be available to third party claimants. In this case, you might suggest to your parents that rather than gifting you your share of their estate directly, i.e. “I give 50% of my residual estate to my son Joe Blow”, they gift it to a testamentary trust with you, Joe Blow, as the nominated beneficiary.
Testamentary Trusts are a special kind of discretionary trust established by a person’s Will (aka their testament). These are set up upon the death of the testator and hold a nominated beneficiary’s share of the estate. Like the well-known ‘family’ trust, a testamentary trust is usually a discretionary trust with the class of potential beneficiaries defined around one person, in this case, you.
There are several advantages to this kind of trust, but for the purposes of this article, we will focus on asset protection for a business owner. In most cases, testamentary trusts are beneficiary controlled, the controller of the trust is also the primary beneficiary. If you hold the role of appointor in the testamentary trust, you can nominate an appropriate trustee for the testamentary trust. For example, your non-business owing spouse or a corporate trustee. You may not wish to nominate yourself as trustee because of the hassle of proving to third parties that you do not own the assets of the trust in your own name, but rather as a trustee for a range of beneficiaries.
If a testamentary trust is utilised then upon inheriting, then should a third-party claim be made against you as a business owner, your inheritance has the protection of the trust. How? Because trusts create a legal distinction between the person who owns the assets (the trustee) and those who benefit from them (the beneficiaries). This separation can protect assets from personal liabilities and creditors since a beneficiary does not have a ‘fixed interest’ in the assets of the trust. What they have is an expectation of being distributed an income or capital from the trust at the discretion of the trustee.
Bankruptcy
Bankruptcy law provides that anything a bankrupt inherits during their bankruptcy period vests in the trustee in bankruptcy. This means, if a beneficiary is a bankrupt, the executor of a Will must give those assets intended for the bankrupt beneficiary to the trustee in bankruptcy. These assets will be used to satisfy the demands of the bankrupt beneficiary’s creditors, with only the surplus (if any) going to the beneficiary.
Once again, a testamentary trust is your friend. As mentioned above, this is because the assets are not owned by the beneficiary, but rather by the trustee of the testamentary trust for and on behalf of the beneficiary, with a discretion to distribute to a range of beneficiaries from time to time. This means assets are insulated from potential third- party claims made against individual beneficiaries.
If you are a bankrupt at the time of writing their Wills, your parents may wish to appoint an independent trustee (for example, the Executor) to act as trustee, putting further distance between you and the vulnerable assets.
Accommodation
If you are a bankrupt and your parents wish to provide you with specific accommodation under their Wills, this may be done in one of two ways:
- By giving you a life interest in a property that allows you to either live in the property or to generate income from it for your lifetime; or
- By giving you right to occupy a specific property with the property reverting to your estate on your death. This right is sometimes called a ‘right to reside’.
In our view, if a beneficiary is bankrupt, a right to occupy may be the better option.
A life interest is an asset that can be used to generate income, and as such, if the beneficiary living in the property is forced to declare bankruptcy, there is a possibility that they could be forced to move out of the house and rent it out so that they can use the income to pay creditors. However, if the beneficiary has a right to occupy only, they cannot be forced out of the home.
That said, if you are a bankrupt beneficiary with a life tenancy to occupy a property, be aware this may have unintended consequences in terms of income contribution assessments. Even though you are not receiving what is traditionally thought of as ‘income’ for income tax purposes, the Bankruptcy Act 1966 (Cth) specifies certain situations, such as the free use of property, may also be deemed as income for the purposes of income assessment. This may result in the bankrupt being liable to their creditors for the deemed ‘income’ of the life tenancy, even though they are not receiving a specific cash benefit.
For these reasons, the terms of a life tenancy need to be carefully drafted in a Will.
We understand it is a delicate business broaching the question of an inheritance with your parents but as much as you, they would not wish to see your inheritance fall into creditors’ hands. Testamentary Trusts protect inheritances in Wills. They ensure assets remain secure against bankruptcy, whether a beneficiary becomes bankrupt before or after the benefactor’s death. This prevents inherited assets from falling into creditors’ hands and ensures you and your family benefit from their generosity, protecting generational wealth.
