Trusts and the insolvency of trustees and beneficiaries

We have in the past considered the issue of people using trusts in an attempt to avoid creditors, which may or may not be successful. This month we look at the problems created by insolvency from a different perspective. What happens if a trustee becomes insolvent? What are the options for trustees if a beneficiary is about to be declared bankrupt? Or perhaps the settlor, when planning to make a settlement, is concerned that one of his beneficiaries may become bankrupt in the future?

 

The size of the problem 

In 2018 the number of UK individuals falling into insolvency hit a seven-year high (according to the figures provided by The Guardian). Namely, a total of 115,229 people became insolvent after failing to repay their debts, up 16% on 2017 and the highest level since 2011. The overall increase was mainly due to the 20% increase in IVAs (Individual Voluntary Arrangements) which are formal agreements between debtors and creditors to repay outstanding debt over a fixed schedule of repayments. An IVA will lead to a formal bankruptcy if the debt is not repaid. Based on these figures it is estimated that, roughly, one in 400 adult individuals was declared insolvent in 2018 which is quite alarming. So how does insolvency or bankruptcy affect trustees and beneficiaries?

 

The trustee becomes insolvent

A typical question we tend to come across is whether a trustee who becomes insolvent is automatically barred from being a trustee or whether someone who is bankrupt may be appointed as a trustee. The answer to this is that it depends on the type of trust. Automatic disqualification takes place only in certain circumstances if the trust is a charity or a pension scheme.

 

Charities

Until 2018 section 72 of the Charities Act 1993 disqualified anyone who was an undischarged bankrupt (or who had had his/her estate sequestrated) from acting as a trustee of a charity. The Charities (Protection and Social Investment) Act 2016, which came into force on 1 August 2018, extended automatic disqualification to more sets of circumstances and a wider range of people. 

Namely, a person is disqualified from being a charity trustee if:

• they are convicted of an offence involving dishonesty or deception (unless the conviction is spent);
• they are an undischarged bankrupt or have entered into certain other voluntary agreements with creditors.

 

Pension schemes

Section 29(1)(b) of the Pensions Act 1995 disqualifies an undischarged bankrupt from being a trustee of a pension scheme unless the disqualification is waived, on application, by the Pensions Regulator. Therefore, in this case automatic disqualification is narrower than for charities.

 

Other trusts and estates

There are no restrictions on an undischarged bankrupt that would prevent them from acting as a trustee of any other trust or as an executor of a will. Of course, there will be other reasons why a bankrupt should not act as a trustee even if they are not automatically disqualified (see below). 

For completeness we should clarify the position in relation to powers of attorney. In England, the making of a bankruptcy order against the donor (person conferring power) revokes the lasting power of attorney so far as it relates to their property and affairs. An individual who is an undischarged bankrupt may not be appointed as a donee (recipient) of a lasting power of attorney in relation to the donor’s property and affairs, but bankruptcy does not terminate the appointment of a donee or revoke the power related to the donor’s personal welfare.

 

Should a bankrupt be a trustee even if legally they can be?

An undischarged bankrupt suffers from a number of legal disabilities which are likely to affect their being able to properly carry out their duties as a trustee.

For example, it is an offence for an undischarged bankrupt to act as a director of, or directly or indirectly take part in or be concerned in the promotion, formation or management of a company, except with the leave of Court.

If a company has adopted Table A as its Articles of Association, a director is obliged to vacate office if they become bankrupt or make any arrangement or composition with their creditors generally.

In many cases where trust assets include shares in private companies, a trustee of such a trust may well also be a director of the company. Clearly therefore difficulties may arise if such a person is declared bankrupt.

There may also be problems with operating a bank account. An undischarged bankrupt is not prohibited by law from operating a bank account but the restrictions on obtaining credit apply to the operation of any post-bankruptcy account.  An undischarged bankrupt will not necessarily find it easy to open or operate a bank account as individual banks make their own commercial decisions and may have a policy of refusing to operate accounts for undischarged bankrupts. Even if a person acts in their capacity as trustee and not in their personal capacity, it is likely that bankruptcy will affect the person's ability to use a bank.

Apart form the legal disabilities there will be the most important question as to whether (possibly substantial) funds beneficially owned by someone else (trust beneficiaries) should be entrusted to a person who (well, at least in most cases) is clearly unable to look after their own financial affairs

 

A beneficiary becomes insolvent

Types of trust

As with all trust-related matters the key first question to determine will be the type of trust involved.

If a trust is fully discretionary, so that no beneficiary has an immediate right to any benefit (and will benefit only if the appointor under the trust (the settlor or the trustees) makes an appropriate appointment), then clearly the bankruptcy of any potential or discretionary beneficiary will not matter so the trustees need not worry about this. On the other hand, the more recent changes to the taxation of trust income have resulted in many trustees of discretionary trusts creating (usually revocable) life interests so that trust income vests in a beneficiary (and so is taxed at the beneficiary's tax rates, potentially avoiding the need for trust tax returns and the imposition of the higher trust income tax rates). In such a case the trust will then become an interest in possession trust, dealt with below.

If a trust is a bare (absolute) trust then, given that the beneficiary is already absolutely entitled to the trust assets, there will be nothing that the trustees can do to avoid creditors getting their hands on the trust assets, unless they can convince the Court to change the trust terms. The Courts have on occasion agreed to defer a beneficiary's entitlement, but this would be unusual. 

The third type of trust is an interest in possession trust, typically one under which the trustees have an overriding power of appointment. Following the changes to the IHT treatment of trusts in 2006 such trusts are created less frequently during lifetime but often made in wills, as they benefit from being treated as immediate post-death interest (IPDI) trusts for IHT purposes. There is also the practical objective of many testators of leaving a right to income to one beneficiary (often the spouse of the testator) with the capital passing to another (usually the children) on the death of the life tenant.  It is the trustees of this type of trust that may need to worry about the possibility of the life tenant becoming insolvent. 

Options for trustees of interest in possession (IIP) trusts 

In this scenario the trustees (assuming they do have the usual overriding power of appointment) will typically have two solutions available to them. First, they can exercise their power of appointment to create a discretionary trust for a class of beneficiaries including the insolvent life tenant. This can be done before or after the bankruptcy order is made but will involve potentially adverse tax consequences. This is because for IHT purposes there will be a chargeable lifetime transfer (CLT) (from the life tenant) and also potentially a gift with reservation of benefit (GWR) (if the life tenant remains a beneficiary) although the actual "damage" will obviously depend on the sums involved and the size of the estate of the life tenant (which is likely to be minimal given the insolvency). And, of course, there will be the income tax consequences. 

The second option is to take advantage of a nearly hundred years old but still very useful piece of legislation, namely section 33 of the Trustee Act 1925 which allows for protective trusts to be created.

Protective trusts

These can be made at the time when a settlor is creating a trust or at any time by the trustees exercising their overriding power.

Most protective trusts are in fact created at the outset with the settlor simply stating in the trust deed that the property is to be held on protective trusts or by referring to the above-mentioned section 33 Trustee Act 1925.

Briefly, the effect of  a protective trust is to give the beneficiary an interest in possession in the fund until he or she commits any "divesting act", (such as trying to sell it or going bankrupt), when the fund automatically converts into a discretionary trust under section  33(1)(ii) Trustee Act 1925 for that beneficiary and their family.

If the trustees wish to use section 33, this can only be done before the bankruptcy order against the beneficiary is made.

The benefit of this route is that the creation of a protective interest will generally be tax neutral (provided no new IIP is created - obviously careful drafting will be required with the assistance of a professional).

Some consider this to be a rather old-fashioned type of trust nowadays, but it will ensure that the beneficiary(ies) rights will be protected, even if they are unlucky or even irresponsible.

Special rules apply as far as the IHT treatment of these trusts is concerned under section 88 IHT Act 1984 which provides that for IHT purposes the divesting act is simply ignored. The beneficiary continues to be treated as beneficially entitled to an interest in possession in the property. 

Following the changes to the IHT rules for trusts in Finance Act 2006, these rules apply to IIPs which are treated as "estate" IIPs, namely IPDIs, TSIs and disabled person’s interests. This means that where a protective trust is created on or after 22 March 2006 and the beneficiary’s underlying interest is an IPDI,  a disabled person’s interest, a TSI  and the beneficiary is treated as beneficially entitled to an IIP as a result of a divesting act, the interest is treated as a continuation of the said IPDI, disabled person’s interest or TSI and as if that interest had not come to an end.

Where the protective trust is created on or after 22 March 2006 and the beneficiary’s underlying interest is not an IPDI, TSI or a disabled person’s interest the relief in section 88 does not apply.

 

COMMENT. 

Given the different tax consequences of the possible solutions available to trustees, careful consideration of all circumstances will be required (as ever) before the trustees embark on any particular course of action. The IHT relief for certain protective trusts will often be attractive although some consider the idea of a protective trust as generally too restrictive.  Given that the "divesting act” includes the beneficiary trying to sell or gift their interest, a protective trust would restrict the beneficiary's IHT planning opportunities. In such a case an application to the Court would be required to vary the trust.  Clearly, no one solution fits all but it is important that trustees are aware of their choices.