In previous articles we discussed why business owners should use Trusts and in particular, the importance and value of placing personal assets in a Trust so that those assets were protected. Unfortunately, most people think that once assets are placed in a Trust they are protected forever! However, this is simply not the case. If a Trust is found to be a “sham”, then asset protection can be lost.
So what is a Sham Trust? The concept of Sham Trust has evolved over time but for our purposes, it can be thought of as something that isn’t genuine, a disguise or a façade.
Professional Trustees often ‘rescue’ a Trust from the sham stigma. They do this by faithfully and properly carrying out the work of being a Professional Trustee. This means they review the activities of the Trust and ensure that all administration work has been correctly carried out. Why is this so important? Trustees have a legal duty to discuss, agree and document the activities the Trust is undertaking. When this doesn’t occur, the door is opened for a creditor or even a beneficiary to allege that the Trust is a sham, and if the allegation is successful, asset protection can be lost and the trust assets can be “up for grabs”.
Sometimes a Trust can be a sham at its very beginning. This occurs when Settlors and Trustees create a trust and transfer assets to the Trust, but in reality never intend for the Trust to do anything or to operate properly. Usually, what is really happening is that the Trust has been set up to conceal the real intentions of the parties or to conceal a transaction.
A common type of Sham Trust we see today is called an Emerging Sham. This is where a genuine Trust is established but it becomes a sham over time. For example, the Trustees start out practicing good behaviour, but then stop meeting, discussing and documenting what activities they will undertake on behalf of the Trust. What then happens is that records documenting Trustee discussions or decisions are not kept and frequently, the Settlor starts to treat the Trust assets as if they were his very own property. A regular example of this is where the Settlor withdraws money from the Trust’s bank account for his own personal use (or worse, for someone else’s use) without the agreement of his fellow Trustees or without documentation. It’s important to note however that a lack of documentation won’t of itself make a Trust a sham, but it does assist a Court in finding that a sham exist.
As noted above, when a Trust is found to be a sham, loss of asset protection can result. Take the case of Prime v Hardie. This case involved a Trust which had two Trustees being a husband and his friend. The Trust held a property, which the wife, the husband and their two children lived in.
The husband decided that he wanted to leave his wife but did not want to share any assets, including the Trust’s property, which he viewed as being his own. After much trickery, the husband persuaded his wife to move out of the home and temporarily into a motel with their children and to rent out the house to an unrelated third party. Once this had occurred, the husband told his wife he was leaving her and that she couldn’t go back to the house as the house had been rented out by the Trustees.
When this matter when to Court it was found the Trust was effectively the husband’s ‘altered ego’. In New Zealand the terms ‘sham trust‘ or ‘constructive trust’ are far more common. The Court made this decision because the husband had to a large extent treated the assets of the Trust (eg: the home) as if it were his own and the Trustees had not acted in the best interests of the Beneficiaries.
Another consequence of a Sham Trust finding is that Trustees can become personally liable for the losses the Trust and its Beneficiaries incur. This is because Trustees are charged personally with meeting their legal duties. At law, Trustees enjoy a right of indemnity to be reimbursed from the Trust fund for all costs and expenses reasonably incurred in undertaking their duties however this right can be lost if Trustees don’t meet their duties. When this occurs, Trustees may have to sell their own assets to meet the loss. This is a very important consequence to consider when family and friends ask you to be the Trustee of their Trust.
Lastly, adverse taxation consequences, including tainting and large differences in tax liabilities arising from the differences between the way Trusts and individuals get taxed, can result. This is especially important if a Trust is receiving income such as in the case of trading Trusts.
If Trustees follow these rules successfully sustaining an allegation of a Sham Trust becomes more difficult:
Ensuring a Trust structure is strong rests with the Trustees of the Trust. If Trustees follow the above rules, attacking a Trust and successfully substantiating an allegation of Sham Trust becomes more difficult. Additionally, appointing an Independent Professional Trustee who does their job can demonstrate that the Trust is real and should decrease the chances of a successful allegation of Sham Trust. Recently, in a couple of cases, the Courts have favoured the appointment of Professional