Discretionary trusts (commonly known as ‘family trusts’) are a common tool for people to operate businesses, hold investments and pass over control of assets. Family trusts can be excellent vehicles for all of these things, but they do come with their own risks.
Over the last few years, we have seen an increasing number of disputes in relation to family trusts. Usually these disputes come about once the first generation (i.e. the parents who established the trust) have passed away or are no longer involved with the trust. The second generation have competing objectives or plans for the trust and end up in a deadlock. Alternatively, one member of the second generation takes control of the trust to the exclusion of the other members, resulting in unfair operation of the trust or distribution of its income and assets.
The core problem with family trusts is that they are discretionary, meaning that how the trust is operated and how its value is divided is at the discretion of the ‘trustee’. The trustee has the day-to-day management of the trust and makes all the big decisions (for example investments, borrowings, income distributions, capital distributions) for the trust. For that reason, people can fall into the trap of thinking that the trustee has control over the trust. But that is not the case.
Most family trusts also have a role of ‘appointor’ which can change the trustee. Sometimes the appointor role may go by another name in the Trust Deed, such as ‘guardian’ or ‘principal’. Because the appointor has the power to change the decision-maker for the trust, the control of the trust really lies in the appointor.
Many people who establish family trusts do not think about succession of the trustee or appointor roles at all. They assume that the trusts will be dealt with under their Wills along with the rest of their estate. But trusts do not fall within a person’s ‘personal estate’, which comprises of the assets that are dealt with by a Will. Trusts have a life of their own, so it is important to consider what the trust’s ‘life’ will look like once the people who established it are gone.
There are a number of strategies that we adopt to help people plan for the succession of their family trusts. The right strategy depends on the terms of the Trust Deed, the nature of the trust and its assets, the value of the trust, and the family dynamics involved. We discuss some of the most universal strategies below.
Succession of the appointor role in the original Trust Deed
Trusts that are being established for a particular purpose or to hold particular assets (for example, family farms) often have a very clear plan from outset about who will be taking over control of the trust in the future. When this is the case, a good strategy can be to build in succession of the appointor role in the original Trust Deed of the trust by naming the intended successors. It is also important that the Trust Deed specifies when the successor appointors will take over from the initial appointors (for example, on mental incapacity or death, or the earlier of the two).
The downside to this approach is that it can be difficult to change the successor appointors once the trust has been established, as it will require a variation to the Trust Deed.
Conditional Deed of Appointment
A Deed of Appointment is the document that is typically used to give effect to a change of the trustee or appointor of an established trust. The person making the deed will be the person with the power at a particular time to change the trustee or appointor (usually this the existing appointor).
A conditional Deed of Appointment is a Deed of Appointment that comes into effect on the condition of one or more events occurring. For example, the change to the trustee or appointor may only come into effect on the mental incapacity of the existing person in that role. As such, a conditional Deed of Appointment can be a very useful tool for people who want to specify during their lifetime the person or people who will succeed them in their role.
A conditional Deed of Appointment is the most universally helpful strategy for dealing with the succession of the key roles for a family trust. It also has the benefit of flexibility, in that it can be changed at any time prior to the trigger event occurring. However, the person making the deed needs to be aware that once the trigger event occurs, the appointment will take effect.
Appointment of successors in Will
Some Trust Deeds contain provisions that allow appointors to name their successor in their Will. When this is the case, it can be a simple and cost-effective option to include provisions in the existing appointor’s Will to do this.
The main downside of this strategy is that it does not take care of any period during which the existing appointor may be unable to carry out their role in the lead-up to their death. With the increasing instances of dementia and other illnesses that impact a person’s capacity, what happens in the time between loss of capacity and death needs to be considered. It is common for Trust Deeds to stipulate that a person’s legal personal representative steps into their shoes in a role during any period of incapacity. In that scenario, it means that a different person to the person nominated as successor in the Will (for example, the person appointed as the existing appointor’s attorney under an Enduring Power of Attorney) may carry out the role in the interim.
Share split and Constitution update for corporate trustee
Many family trusts use a company as their trustee, which is known as a ‘corporate trustee’. A corporate trustee can provide additional flexibility and an enhanced sense of asset protection. However, it can also cause headaches when it comes to succession due to certain aspects of the company’s share structure and voting rights.
Most corporate trustees are established as a “one-dollar company” that have one share on issue with a value of one dollar. The person who is intended to have control of the corporate trustee is then made the sole shareholder in the company. Having such a simple share structure is fine when the company is established and operated by the first generation. But passing the one share in the company to the second generation is problematic, as there is usually more than one intended beneficiary of that share.
A solution to this problem is to incorporate corporate trustees with more than one share initially, and preferably an easily divisible number so that the shares can be divided equally between the intended beneficiaries when the original shareholder passes away. We generally recommend 300 shares, as this number divides neatly into 2, 3, 4 and 5. If a corporate trustee is already acting as trustee of a trust, it is possible to ‘split’ the existing share (or shares) in the corporate trustee to ensure there is a larger and more easily divisible number of shares on issue.
The other complication that comes up with corporate trustees is the way that decisions of shareholders are made. Under the Australian corporations law and most company constitutions, decisions of shareholder can be made either by a simple majority vote (i.e. >50%) or, for some more significant decisions, by special majority vote (>75%). Again, while the corporate trustee is being controlled by the first generation, these decision-making ratios are generally not a concern. However, when control of the corporate trustee is passed to the second generation, there is the potential for “ganging up” (i.e. 2 against 1, or 3 against 1).
It is our view that generally the fairest way for decisions to be made by successor shareholders (i.e. the second generation of shareholders) is unanimously. If a proposal does not drum up the required unanimous support, the proposal does not go through and the ‘status quo’ is maintained. The only way to specify unanimous shareholder decisions as a requirement is to amend the constitution of the corporate trustee to insert provisions to that effect. It is important to note that amending a company constitution also requires unanimous shareholder consent, so it is best to tackle this issue from the outset while the corporate trustee is still under the control of the first generation shareholder.
Family trusts can be a great option for investing in a flexible and inter-generational way. However, these trusts come with their own problems, and it is beneficial for everyone if these are given proper consideration from the outset.