Proactive planning will help protect your lifestyle from bankruptcy, writes TressCox Lawyers partner Matthew Payne.
At the start of each financial year the legal and financial press contains pictures with smiling faces and stories about recent appointments to the partnership of law firms (or as directors of incorporated legal practices) at the big end of town. This is a significant milestone in a legal career and, like any significant milestone in life, should be acknowledged and celebrated.
Joining a partnership or becoming a company director can be incredibly rewarding (both professionally and financially), and partners and company directors have the opportunity to accumulate significant wealth. However, such roles also bear significant risks and responsibilities. Being aware of those risks and responsibilities, and how best to structure your affairs to minimise your exposure to one of those risks – bankruptcy – is essential.
This article outlines how bankruptcy laws operate in Australia, explains what assets are exposed to creditors’ claims and suggests steps that partners and company directors can take to protect their wealth from creditors’ claims and protect their lifestyle from bankruptcy.
Bankruptcy and the Bankruptcy Act 1966 (Cth)
In Australia, bankruptcy is governed by the provisions of the Bankruptcy Act. Bankruptcy is a process that enables a person to sort out their financial affairs by providing a mechanism through which the person’s creditors can be paid (but generally only in part, not in full). Bankruptcy is generally for a period of three years from the date on which the bankrupt filed his/her statement of affairs (section 149(2)), although this period may be extended if an objection is made (section 149A). Upon expiry of the relevant bankruptcy period the bankrupt is released from most, but not all, debts due to creditors before the date of bankruptcy (see section 82).
The provisions of the Bankruptcy Act aim to strike a balance between giving people the freedom to structure their affairs as they see fit and protecting the interests of creditors by empowering a trustee in bankruptcy to challenge, and set aside, certain transfers of property made by a bankrupt prior to bankruptcy. Timing can be critical. If you accumulate wealth then it is best protected from your creditors by not acquiring property in your own name or by transferring it as early as possible in order to minimise the risk that it will be exposed to creditors’ claims.
How to minimise exposure to creditors’ claims
From the start:
- If you are a partner in a partnership, seek an indemnity from your other partners in relation to partnership liabilities (this generally only applies to non-equity partners).
- If you are a company director, ensure you are covered by a directors and officers (D&O) insurance policy and have signed an indemnity deed (also known as an Officer Protection Deed) with the relevant companies.
- Take out and maintain a professional indemnity insurance policy while you are in the business and for a period of seven years after leaving the business. If your business has a policy carefully review it, in particular any special conditions and exclusions.
- Do not give any personal guarantees, particularly if you are a company director.
- Buy your family home in your spouse’s name, minimise your contribution to the purchase and ensure that any home loan is in the name of your spouse so they, not you, are liable to repay the loan.
- Contribute to superannuation.
- Setup a discretionary trust.
- Do not buy assets in your name. Buy assets in your spouse’s name, a company, discretionary trust, unit trust or a combination of them. Seek advice on the best structuring options.
- Spend as much of your income as possible on lifestyle expenses so any mortgage payments or savings can be attributed to your spouse’s income. If there is money leftover, give it to your spouse.
- Loans made by you (e.g. to your spouse, a trust or company) and unpaid trust distributions (i.e. amounts that a trustee of a trust resolves to distribute to you but which are retained within the trust) are assets and are exposed to creditors’ claims. Keep them to a minimum.
- Don’t inherit anything! Ask your parents to make a testamentary trust will so that your spouse and children, not you, receive the inheritance.
- Exclude a bankrupt from being a beneficiary of a discretionary trust or testamentary trust for the period of bankruptcy.
If you have assets and think it’s too late:
- Take steps to protect your assets when you have no creditors.
- If you have assets then transfer them as early as possible so that time starts to run in your favour. Suffer the consequences, if any, later.
- If you transfer assets to your spouse (or another entity or third party) document the reasons for the transfer (e.g. estate planning or tax planning).
- If you transfer assets and receive consideration for the transfer, verify the value of the assets transferred (e.g. by obtaining a valuation) in order to establish fair market value.
- Document any consideration that you receive for any assets transferred.
Superannuation (for everyone):
- Make sure you contribute as a member of a regulated superannuation fund.
- Establish a pattern of superannuation contributions by making both concessional and non-concessional contributions, in particular at any time after receiving a substantial sum of money (e.g. inheritance).
- Maximise concessional contributions in order to minimise assets exposed to creditors’ claims and maximise your tax benefits.
Superannuation (if you have a SMSF):
- Your SMSF should have a corporate trustee, not individual trustees. As the SMSF’s assets are owned by the trustee, not the individual members, if an individual member is bankrupted the SMSF’s assets would not need to be transferred to a new trustee and there would be no dispute as to the capacity in which the assets are owned.
- A bankrupt cannot be a director of a company. If you are a director of the corporate trustee of your SMSF then you will cease to be a director on bankruptcy.
- In order to comply with superannuation legislation you must be a director of the corporate trustee, but you do not have to own shares in the corporate trustee. Any shares in the corporate trustee could be owned by your spouse or the trustee of a discretionary trust.
If you have a discretionary trust, the following structure should minimise the risk that assets held in a discretionary trust will be exposed to claims by creditors:
- The trust should have a corporate trustee, which only acts as trustee of the trust and not in any other capacity.
- You should not be the sole director of the corporate trustee. You should be one out of two or more directors. For example, the directors could be you and your spouse (or another relative) and/or a professional adviser (e.g. your accountant or lawyer).
- You should not own shares in the corporate trustee or if you do then it should only be a small percentage/interest (e.g. less than 10%).
- You should not be an appointor of the trust or, if you are, then you should be one out of two or more appointors who must make decisions unanimously. For example, the appointors could be you and your spouse (or another relative) and/or a professional adviser (e.g. your accountant or lawyer).
- You should not be a default income or default capital beneficiary of the trust.
- You should be one of a number of beneficiaries of an unrestricted class and should not receive distributions from the trust that demonstrate a pattern of distributions or entitlement to an ascertainable proportion of income.
If you and your spouse are both exposed to risk in the practise of your profession (e.g. you are a lawyer and your wife is a doctor) or are exposed to the same risk (e.g. you are partners in the same law firm) then the following alternative structure may better protect trust assets:
- Setup two trusts, one for each of you and your spouse.
- You should be a beneficiary of one trust and your spouse the beneficiary of the other.
- You, or a third party, should control your spouse’s trust (i.e. by controlling the trustee and appointor). Your spouse (or a third party) would control your trust.
- You both should have professional indemnity insurance.
If you or your spouse do not want to relinquish control of the trust to a third party then control of the trust could be vested in the spouse who is more likely to cease work or change their role in the future (e.g. to raise children).
What does all this mean?
Asset protection is an integral part of tax-effective structuring and estate and succession planning. It requires the expertise of lawyers and accountants, but most importantly it requires you to be proactive, not reactive. You should seek advice as early as possible and whenever your circumstances change in order to protect your lifestyle from bankruptcy and minimise the risk of your wealth being exposed to creditors’ claims.
Matthew Payne (pictured) is a partner at TressCox Lawyers. This article is a part of a larger article titled Protecting your lifestyle from bankruptcy, which can be accessed by following this link.