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Asset Protection

1 May 09 Dymphna Boholt

Long gone are the days where a handshake was as good as an iron-clad contract. Litigation has become common place and some predators and solicitors make a living out of targeting potential litigation victims. This all sounds very sinister, however, just look at events in America today . . . that is where we will be in three to five years...or sooner.  Remember the saying “America sneezes and Australia catches a cold”?

Litigation comes from many sources, some of these include:

  • Action against property ownership – public liability, under-insurance etc. ·
  • Action against individual actions – motor vehicle accidents etc. ·
  • Action against business – product liability, negligence, public liability etc. 
  • Action against professional conduct – coaching, advice, medicine etc. ·
  • Action against family assets – family law, divorce etc. ·
  • Action resulting from business failure/insolvency.

We can structure against such litigation. You can own assets in such a way that you maintain the control and benefits of ownership without the precarious liabilities.

I believe there are three forms of asset protection: STRUCTURE, DEBT and INSURANCE.

 Let’s deal with each of these individually.

  • Structure
  • Debt
  • Insurance

Thinking outside the square

In many cases asset protection strategies are straight forward and simple, such as acquiring assets in a spouse’s name or in an entity where risk to exposure is limited. Sometimes such asset protection strategies are either not available, or too costly to implement (such as where assets have already been acquired by a professional in their own name or by the business entity). In these circumstances, one must begin thinking outside the square to achieve the asset protection without causing a significant tax liability.

The Family Home
The family home is usually one of the most valuable assets, if not the most valuable, a taxpayer will own. Therefore, protecting it from creditors is extremely important. A professional should not own the family home solely in their own name. Preferably, they should have no interest in the ownership of the family home. Whilst having the family home owned by a discretionary trust provides asset protection, the trust is unable to access the main residence exemption under subdivision 118-B.

One of the simplest and most effective ways to protect the family home is for it to be owned by the professional’s spouse. Ownership of the family home by the professional’s spouse provides asset protection in case the professional’s business fails (or the professional is sued for negligence), while maintaining access to the main residence exemption if the home is sold. In the event of a marriage breakdown, there is neither an advantage nor a disadvantage. If the professional already owns all or part of the family home, he/she can gift their interest to their spouse. There should not be any CGT implications, but I would advise you to check before undertaking the transfer. There may, however, be stamp duty implications (depending on the state or territory). This is not a solution if the professional does not have a spouse, or if the spouse is also a professional. In these circumstances, the professional needs to begin thinking outside the square.

The professional may choose a trade-off between asset protection and the CGT main residence exemption. If they believe it is unlikely they will sell the family home for many years, they may choose to acquire it in a family discretionary trust and forego the main residence exemption. Alternatively, if the family home is likely to be sold within the near future, the main residence exemption could be important. Real estate prices have risen significantly of late, so maintaining the main residence exemption is often very important. In these circumstances, they should purchase the family home in their own name, but with funds borrowed from the family trust.

The family trust takes a mortgage over the family home. If money was also borrowed from a bank, the family trust would hold a second mortgage (ranking behind the bank’s first mortgage). If the professional is declared bankrupt, although the family home is one of his/her assets, it is mortgaged in favour of the family trust. The family trust is a secure creditor and ranks ahead of other creditors. If the trustee in bankruptcy sells the family home, the proceeds must first be applied to repaying the loan from the bank and the family trust. The family trust may be able to negotiate to purchase the family home from the trustee in bankruptcy (rather than the trustee in bankruptcy selling it at auction to a third party).

Death
Correct asset protection takes into account the possibility of circumstances changing. There is no point in incurring the cost of the transfer, if the spouse does not have a Will, or if that Will states everything is left to the Professional. The assets are protected whilst the spouse is alive, but if the spouse unexpectedly dies and all the assets end up back in the hands of the professional, the result could be disastrous. Proper asset protection planning must also include the professional and their spouse making tax effective, asset protective Wills. Generally, such Wills involve a testamentary discretionary trust being created on the death of the person.

Tip . . . if a testamentary trust is created, that trust can lend money to a beneficiary of the Will. The beneficiary may use the money in their business (i.e. to purchase business assets, repay loans etc). These loans should be secured by a mortgage over the business, in favour of the testamentary trust. If the business fails, the testamentary trust will be a secured creditor and will rank in priority to the unsecured creditors. Thus the assets of the business are protected to some degree. Parents giving money or assets to children should consider what will occur if the child dies.

Divorce
The implication of a marriage breakdown should also be considered. The possibility of divorce is only one consideration to be taken into account when parents decide whether or not to lend or gift money to a child or grandchild. Obviously, the personal circumstances of the family should be given higher priority. Parents lending/giving money to children TIP . . . parents should consider funding a child’s business venture by way of a loan, to overcome the problems that can arise from a divorce or death. Parents can always forgive the loan, or gift the money, if they wish (even after circumstances change). A loan gives them flexibility.

Protecting both business and personal assets
Asset protection is not only about protecting personal assets, such as the family home. Asset protection should also be applied to business. The simple rule of holding the asset in a separate entity, also applies to business. Many people believe the main reason tax practitioners advise clients to establish a service trust, is to obtain tax benefits. This is incorrect. A service trust should be for asset protection purposes. The business is run in one entity and the business assets are held in another entity. If the business fails, the business assets are protected from the creditors. Care must be taken in establishing the structure. There is no point in a sole practitioner having a service entity own the business assets, if the sole practitioner owns the share in that company. If the business fails and the sole practitioner is bankrupted, then the business assets are not protected (because the trustee in bankruptcy will sell the business assets by selling the shares in the service company).

Structures for Investments
Structuring for investment is an important consideration, whether taxpayers are investing for their retirement, or saving for their children's education. There are a myriad of structures available to choose.

Factors to consider when choosing an Investment Structure

Investments, like business assets, can be held in a number of different structures. Common structures available include individual, partnership, company, trust (discretionary, hybrid or fixed), superannuation fund or any combination. Some of the factors to consider when choosing an investment structure are as follows:

  • How easy is it to set up and maintain the investment structure? ·
  • Risk profile of the taxpayer. ·
  • How straightforward is the investment structure to understand? ·
  • Will the structure provide protection from militant children or estranged spouses? ·
  • Stamp duty costs. ·
  • Treatment of the assets in the event of divorce. ·
  • Will the structure provide easy entry for new partners or participants? ·
  •  What types of assets are intended to be held e.g. Australian or foreign? ·
  • The general status of the taxpayer, i.e. age, marital status any dependants, income levels and current investments. ·
  • Is asset protection is required? ·
  • The needs of the individual, e.g. do you want to donate money to a church or charity? ·
  • The future plans of the individual, e.g. intention to go into business or retirement. ·
  • Whether other participants are involved. ·
  • Who will control the assets? ·
  • Taxation considerations. ·
  • Type of assets being acquired. ·
  • Type of income to be derived e.g. ordinary income, foreign income, capital gains. ·
  •  Will negative gearing will be an issue? ·
  • Whether pre-payments are likely to be made. ·
  • The tax rate of each structure and those involved. ·
  • Timing of payments. ·
  • Cash requirements of the taxpayer. ·
  • The availability of income, capital or foreign losses.
  • Salary Packaging Benefits
  • Rental income and deductions must be split in accordance with the ownership interest.

Strategies to consider for an individual investor High P.A.Y.G income earners should consider acquiring negatively geared assets in their own name; for high income earners who earn their income through a structure, this is irrelevant.

Distribution of tax-free amounts
The structure that allows greatest flexibility in distributing these amounts and allows these amounts to be distributed tax-free will provide the greatest benefit. Amounts can only be distributed purely tax-free from a discretionary trust. It is almost impossible to distribute amounts tax-free from a company and generally difficult to distribute such amounts from a unit trust. Winner - Discretionary trust by a long way.

Retention of Profits
Although a discretionary trust, company and a unit trust can all retain profits, the lowest a rate of tax applies to a company -- being 30%. If a discretionary trust or a unit trust accumulates income, a tax rate of 48.5% applies under S.99A ITAA 1936.

Streaming of Income
Streaming of income is the distribution of different types of income and capital gains to particular beneficiaries to minimise the overall tax payable. The streaming of income can provide the following advantages:- · Income splitting - by being able to stream income to beneficiaries under a low marginal tax rate on a discretionary basis. · The ability to reduce tax by streaming different classes of income to different beneficiaries on a discretionary basis e.g. streaming capital gains to a taxpayer with capital losses. One of the main advantages of a trust is that the income retains its character when it is distributed to beneficiaries. Therefore, if a trust has interest income, trading income and a capital gain, each beneficiary who receives a distribution will receive a proportion of each type of income and the tax paid by the beneficiary (or trustee) must be calculated accordingly. Streaming between years also may provide good opportunities. The ability to stream income to taxpayers, who have reduced income in a particular year, is a great tax advantage. Streaming is only possible through discretionary trusts, and unit trusts on a more limited basis. Companies provide limited opportunity on the first point, but are the only entity to provide streaming between years. Winner - A discretionary trust generally provides the greatest opportunities for streaming.

Asset Protection
Asset protection is a critical consideration today, particularly for sole traders such as professionals, as they are at risk of being sued for negligence. Asset protection is only achieved where they do not hold any assets. Tax Warning . . . A common misconception is asset protection can be achieved by shifting the assets to a company or unit trust and then having the shares or units held by the individual. Asset protection is not achieved, as the shares or units are now the asset at risk. The asset protection problem arises when the net asset owned by the company or unit trust increases in value. This leads to a corresponding increase in the market value of the underlying shares or units. The shares or units can then be realised by the trustee in bankruptcy. Asset protection can only be achieved by holding the assets in a discretionary trust, or where a discretionary trust owns the shares or units in a unit trust. As pointed out in the tax warning above, no one owns the trust, so if the primary beneficiary is bankrupt, the assets of the trust are protected. Winner -- Discretionary trust In summary, a discretionary trust is generally the best all-round investment alternative. A Testamentary Trust A Testamentary trust can be a worthwhile planning tool for succession purposes. A testamentary trust is established under a Will that comes into effect when the taxpayer dies. The assets pass across to the trust, where they are administered on behalf of the beneficiaries (as distinct from a normal Will where the assets pass directly to the beneficiaries). The advantages of using a testamentary trust are as follows:- · Protection against spendthrift beneficiaries · Distributions taxed at adult rates can be made to minors. · Protection of beneficiaries against creditors and bankruptcy. · Asset protection from the child’s spouse, in the event of a marriage breakdown.

Summary
Asset protection is more than divesting assets. This is only one aspect. Furthermore, divesting assets will not always work. Assets should be originally acquired in the entity that offers the greatest asset protection, such as a family discretionary trust. The professional would not need to divest himself of any assets and the Bankruptcy Act 1966, will not come into play. The best asset protection planning is being proactive not reactive. Useful Combinations The company is a good vehicle to conduct business, as it is a separate legal entity. If required, it can pay tax at the company tax rates, rather than having the profits paid out as salary, wages or Director’s fees. The company vehicle is also well recognised in business circles and it does provide some degree of protection between the risks associated with a business and the personal assets of the individual owners.

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