Asset protection: Are trusts a good idea?

What good is a wealth accumulation plan if your hard earned savings and assets are at risk? Asset protection should be an integral part of your wealth management plan as your savings and assets accumulate.

Asset protection though can mean different things to different people. Starting at the ground level, simply having a Will is a good first step in ensuring your assets are protected and dealt with appropriately once you pass on.

Having appropriate ownership structures is another easy means of protecting your wealth, particularly in the event of matrimonial disputes and especially following the introduction of the Property (Relationships) Act. For example, should you be owning assets as “Tenants in Common” rather than joint property? Should you contract out of the Act?

For business owners asset protection takes on a new dimension. Here, ownership structures play a more significant role - especially for protection against creditors though also for tax reasons. The decision to operate as a sole trader, in partnership, or as a company can have significant ramifications in terms of protecting your assets should something go wrong.

For this article we focus on the most commonly used mechanism for personal asset protection – the Trust.

What is a Trust?

Trusts are autonomous legal entities – recognised in law virtually in the same light as an individual person. The trustees can hold assets, invest and borrow money, and operate businesses. They also pay tax. Setting up a trust means creating a legal entity that operates under strict rules. The trust comes with responsibilities and paperwork.

Why form a Trust?

Trusts are set up for a whole host of reasons, but mainly to protect assets on behalf of beneficiaries (which can include yourself). The list below is not exhaustive, though if you find yourself ticking a number of these boxes, then a trust may be of real benefit to you and your family.

Who’s who in a Trust?

A Trust is like an independent body that involves several stakeholders. The main people involved are:

There are three main types of trust but the most common is known as a single trust. An example of this is where you as settlor set up a trust for your benefit as well as for other beneficiaries such as your family. You and your partner might be trustees, along with another independent trustee such as a solicitor.

Mirror Trusts and Dual Trusts are less common. They are used today when the parties are concerned about the reintroduction of estate duty. In these trusts, the arrangements are more complex – for example two trusts are established to separate the beneficiaries and the settlor.

In the past, rigid non-discretionary trusts were most common but today trusts usually have more room for changing circumstances by being discretionary. The trustees are given discretion as to the distribution of income and capital to the beneficiaries.

How does it work?

The basic idea is for you the settlor to transfer assets into the trust. The assets can include your house, your investments or perhaps the beach home. Once these are in the trust, you can’t readily get them out again. If you just gift these assets over in one lump you’ll incur gift-duty. So what happens is, you sell the assets to the trust.

How can this happen when the trust has no money to pay you? The usual arrangement is for the trust to owe you the purchase price by way of an interest free loan. The debt the trust owes you can be ‘forgiven’ by way of gift at the rate of $27,000 per annum per person without incurring the gift duty. A husband and wife can jointly reduce the debt at a rate of $54,000 per year.

This is shown in the example below. The debt back to John and Mary is $1,000,000 while gifting at the rate of $54,000 per year means it will take around 18 years to forgive the entire debt and thus transfer the full value of John and Mary’s house and their investment portfolio to the trust.

	Sell House and Investment Portfolio to Trust for $1,000,000
John & Mary		Family Trust
	Debt owing to John & Mary of $1,000,000

One big benefit here is that when John & Mary’s assets are sold to the trust for $1,000,000, any increase in value occurs in the name of the trust, not in the name of John and Mary.

From now on these assets are basically untouchable. The couple could lose their shirts in a business venture, but the trust assets are legally separate. In this manner, the beneficiaries of the trust are protected. However, any debt the trust owes you is still a personal asset subject to attack.

Obviously it is preferable to transfer assets to a trust early on and before you have accumulated a large amount of wealth – this reduces the gifting period. For high income earners, drip feeding savings into a trust makes a lot of sense. The cash you put in though will have to be either a gift or a loan to the trust.

What about tax?

Income generated by a trust can be distributed to the beneficiaries and the tax payable by beneficiaries depends in part on what other incomes they earn. Adult beneficiaries with little other income will only pay tax at 19.5%, but unfortunately minor beneficiaries aged under 16 are taxed at a full 33c on every dollar earned from income derived from trusts.

If the trustees choose to retain any income back in the trust, then tax will be payable by the trust on that income - currently at the rate of 33c in the dollar. This retained income is added to the trust capital. Any distributions of capital to beneficiaries are not assessable for income tax. A trust can save you tax, but not in all cases so it’s important to have the relevant advice to ensure you can weigh up the options with confidence.

For high income earners ie. those in the 39% tax bracket, paying tax at the trustee rate of 33% can amount to a significant saving, and on top of this, if you have a spouse that is not working, distributions taxed at 19.5% can represent a further significant saving. So in the current environment, “income splitting” through the use of trusts can legitimately minimise tax as well as protect your assets.

The rules and record keeping

Paper alert! Accurate record keeping is essential. The trust’s purpose should be stated clearly when it is established and the trustees must ensure all investment decisions are recorded in full. This is done by way of “resolutions” that record decisions to invest in property or purchase shares etc. We recommend a set of accounts (balance sheet and income statement) for trusts with a large range of assets including investments.

By keeping full records, and by ensuring the trustees are fully involved with decision-making, there is less chance of the trust being construed a ‘sham’ or being open to attack from unhappy beneficiaries. A case commonly referred to by legal advisors involved the trustees investing in a portfolio of interest bearing securities only to satisfy one beneficiary who had entitlement to income only and not capital. Some years down the track, when the other beneficiaries found that their portfolio had dwindled in real value, they were successful in taking the trustees to court for inappropriate investment of the trust funds.

And don’t try beating those gifting-duty limits. If you are concerned particularly about asset or means testing, don’t forget that Work and Income New Zealand can ‘look back’ to check on how much and when you gifted assets to a trust.

Advantages and disadvantages?

In conclusion, asset protection is a serious business and requires careful thought, especially when setting up an accumulation program or if you have valuable assets.

Good legal and tax advice in relation to ownership structures and Wills is fundamental in ensuring your assets are appropriately protected. Trusts very often form part of an asset protection program because of additional benefits such as income splitting, minimising tax and succession planning.

So the main points to remember are – start early, be prepared to pay for quality advice and to give up a measure of control over your assets, and ensure your record keeping is up to date and squeaky clean.