Asset Protection and Discretionary Trusts

Individuals who have generated significant wealth over their lifetime are often keen to find a way to protect that wealth and preserve it for future generations. The discretionary trust is one of the most common means to achieve this objective. However, while discretionary trusts undoubtedly can help to place wealth outside the reach of creditors and ensure its orderly distribution as it is passed down from one generation to the next, the level of protection and the extent to which a trust can protect wealth and shield assets depends upon how sophisticated of an approach is taken to the creation and deployment of the trust.  An over-simplistic approach may offer no protection and no shield at all.  This is why the formation and administration of a trust for the purpose of asset protection requires the help of trust professionals well versed in not only trust law but matrimonial laws, estate laws and general commercial laws.

What is a Discretionary Trust?

A trust is a legal arrangement between an individual, known as the settlor, who transfers ownership and control of an asset to a person, known as the trustee, to hold for the benefit of one or more individuals, each known as a beneficiary.  Under the arrangement, legal title to the asset passes from the settlor to the trustee but the beneficial title to the asset passes to the beneficiaries.

A discretionary trust is a type of trust in which the identity of the beneficiaries or the extent to which the beneficiaries receive the benefits of the trust or both is at the discretion of the trustee, meaning that the trustee can decide, subject to the terms of the trust, who will be a beneficiary and how much of the assets of the trust a beneficiary will receive. 

Can a Settlor Control the Assets on Trust?

Given the wide latitude a trustee may have in a typical discretionary trust, the settlor will often try to check the trustee’s discretion through various means.  The settlor may prescribe in the trust deed how the trustee should act.

Alternatively, the settlor may give broad discretion to the trustee in the trust deed but prepare a “letter of wishes” setting out how he or she wishes the trustee to exercise its discretion. Though the letter has no binding effect on the trustee, a trustee will normally have regard to the wishes so expressed within the framework of the trust deed and the trustee’s duties under the law. 

Equally, the settlor may appoint a person known as a “protector” or “appointor” to whom certain powers are reserved under the trust deed.  These powers may include, for example, the right to remove the trustee and appoint a new one or the right to manage the investment of the assets in the trust.

Finally, the settlor may wish to make the trust revocable or structure the trust so that upon the occurrence of certain events, all of the trust assets are distributed, thus bringing the trust to an end.

How Does a Discretionary Trust Protect Assets?

A discretionary trust shields assets from creditors because by its nature, once the settlor transfers his wealth and assets to the trust, those assets no longer belong to settlor. As a general principle, a creditor can only seize the assets of the debtor and has no right to look at the assets of any other person. Thus, creditors can no longer seize those assets to satisfy debts owed by the settlor. At the same time, because the trust is discretionary in nature, individuals who expect to benefit from the trust may hold no interest in the trust assets or they may hold only a limited interest. Again, their creditors are unable to seize the assets of the trust which the trustee might otherwise have gifted to them until the trustee has exercised its discretion to actually make the gift.

How to Ensure a Discretionary Trust Provides a Shield?

The laws of many jurisdictions will define circumstances in which the transfer of assets into a trust can be attacked, the existence of the trust may be challenged, the terms of the trust itself may be modified or the beneficiaries of the trust may be required to surrender the benefits of the trust.  For this reason, it is always important to work with lawyers well versed in trust formation to establish a discretionary trust. It is unfortunately the case that there is no single off-the-shelf “standard” discretionary trust which will produce the wealth protection and asset shielding benefits that a client may expect.

An experienced trust lawyer will not only leverage the nature of a discretionary trust but also give due regard to the applicable laws which may, given the specific circumstances of a specific family, affect when and how assets are injected into the trust, the manner in which the trust is operated and the requisite terms of the trust.  In so doing, the trust lawyer will limit the risk that the trust will fail to provide the protection which it is intended to provide.

In light of the foregoing, what are some of the key considerations for someone considering the use of a discretionary trust to protect their assets?

Fraudulent Dispositions and Preferences

Perhaps most obviously, many jurisdictions have laws which allow creditors to attack the validity of transactions undertaken with intent to defraud creditors or which unfairly prefer certain creditors over other creditors.  So, for example, in the most obvious case, where a settlor who owns a business transfers some of the business’ key assets into a trust immediately before bankruptcy, the creditors of the business may seek to claw back those assets to meet their claims against the settlor.

Illusory Dispositions

As noted above, one of the problems a settlor often faces is the desire to retain control over the assets which have been placed into a discretionary trust.  The extent of control is a matter which requires great care in many jurisdictions because if too much power is reserved to the settlor, the transfer of assets into the trust may be regarded as illusory, with the effect that at law the assets are regarded as never having been transferred at all.  

The circumstances in which the transfer of assets to a trustee may be regarded as illusory will depend on the terms of the trust itself.  Particularly where the settlor is both the protector and a beneficiary of the trust, as powers are increasingly reserved to the protector, there is a greater risk that the transfer of assets to the trustee will be regarded as illusory. 

Sham Trusts

While the enquiry as to whether a disposition to a trust is illusory depends upon the terms of the trust, in some jurisdictions, the context of the formation of the trust goes to determining whether the trust exists and thus, whether transfers of assets to the trust are effective.  Where the context suggests that there was no common intention to transfer ownership and control of the assets to the trustee despite the formation of the trust through an executed trust deed, the trust deed may be regarded as a sham and the trust may fail.  So, for example, where the settlor at all times regards the assets within a trust as his own and intends despite the trust to retain ultimate control over them, there is a risk that a court may regard the trust as a pretence to mislead other people and thus, invalidate the trust on the basis that the trust deed is a sham.

Matrimonial Laws

In some jurisdictions, matrimonial laws can have a significant impact on the structure and timing of the formation of a trust and the manner in which the trust is operated.  For example, legislation may enable a court to vary the trust as if it were a nuptial settlement (i.e. as if it were a pre- or post-nuptial agreement).  Equally, for example, as in the case of a fraudulent disposition, legislation may empower a court to set aside dispositions of property into a trust if the disposition was for the intention of defeating a claim for financial provision of a spouse.  Finally, for example, if there is an expectation that a spouse will receive benefits under a trust, the court may treat those benefits as assets of the spouse even if the trust is discretionary and the trustee has yet to exercise any discretion in favour of that spouse.

How Can We Help?

It will be readily apparent from the foregoing that setting up a discretionary trust requires a level of sophistication to achieve asset protection objectives. Drawing upon the expertise of our lawyers at our affiliated law firm, Timothy Loh LLP, we can help you to meet these objectives.

For example, in a family trust, if the desire is to protect the assets from distribution to a spouse of a child, we can look at the type of interest the child may have in the trust, the circumstances in which distributions are made to the child and the type of distribution made to the child as may be necessary or prudent.