How can business borrowing affect your family trust? Annabel Sheppard, partner, and Charlene Sell, solicitor, from Wynn Williams & Co, discuss the risks of taking out a business loan secured by trust assets.
Why a family trust?
Family trusts are becoming increasingly popular amongst business owners as a means to protect their personal assets from business creditors. Transferring personal assets, such as the family home, to a trust, allows you to separate your personal and business assets. From a business owner’s perspective this separation protects your personal assets from claims by creditors.
Other benefits include protecting assets from relationship property claims and spendthrift beneficiaries and potentially limiting the assets subject to asset testing for residential or hospital care subsidies.
Setting up a family trust
Your trust needs to be flexible to take account of changes in circumstances but secure enough to provide the greatest protection for trust assets. When setting up your trust, it is important that the trust deed accurately reflects how you want the trust to run.
However, before deciding to set up a trust it is important that you are aware not only of the advantages but also the potential complexities and disadvantages of a trust.
Once your assets are transferred to your trust, you give up ownership of those assets to your trustees. The trustees decide what can or cannot happen in respect of trust assets. As you no longer own the trust assets, those assets will no longer automatically be available to meet personal liabilities that you might incur through your business. While you may still be personally liable for business debts, your personal assets available to meet these debts will be diminished to the extent that your personal assets have been transferred to your trust.
Once established, a trust creates enforceable obligations on trustees. These will be contained in the trust deed and the Trustee Act 1956.
In particular, trustees have a duty to invest trust funds prudently with the same care, diligence and skill as a business person managing the affairs of others. This is an onerous obligation on trustees. Professional trustees must attain a higher standard when making investment decisions as a trustee. They must ensure that they exercise the care, diligence and skill that a prudent person working in their profession, employment or business would exercise in managing the affairs of others. Therefore, a professional trustee is more likely to scrutinise proposals of self-interested trustees that may not be advantageous to all beneficiaries.
Another disadvantage is that even once property has been transferred to a trust, it can still be vulnerable if there is a substantial debt owed by the trustees to the settlors (a settlor is a person who establishes a trust and settles property on the trust).
What borrowing options do I have?
At some point, most businesses will need to seek funding from a bank. If you want to take out a business loan, the bank will require security and for many small business owners their most valuable asset is their home. However, if your home is owned by your family trust, there are a number of issues to consider.
Your trustees have a few options available when deciding whether, and how to best enable you to obtain the loan. You may be the borrower, and the trustees may agree to use the family home as security. Alternatively, the trustees (as the owners of the home) may become the borrower, lend the funds to you and use the family home as security. Either way, the bank will usually insist on personal guarantees from both yourself and the trustees.
What should trustees consider?
If they are asked to use the trust assets as security for business loans for one of the beneficiaries of the trust then it is important that the trustees take into account the following:
make sure that they have all the information necessary to make an informed decision e.g. how much is being borrowed?, how will the loans and interest be repaid?, what assets, income and liabilities does the business have?
consider the interests of all beneficiaries before making any decisions;
make sure that the borrowing and/or the use of trust assets as security complies with the trust deed and any obligations imposed on trustees pursuant to the Trustee Act;
keep a record of the trustee decisions;
consider the extent to which the trustees, having agreed to the use of the trust property as security, will have the ability to monitor and control the liability that the security covers.
Allowing trust assets to be used as security is not a decision trustees should take lightly. Trustees must consider the interests of all beneficiaries and evaluate any risks in using the family home as security for a business loan. It is important to remember that beneficiaries can sue trustees if they believe trustees have made the wrong decision.
Before asking the trustees to consider using trust assets as security for your borrowing, you should first look at why you set up the trust. For many business owners, one of the main reasons for setting up a family trust is to protect the family home from creditors. Therefore, you need to carefully weigh up the advantages and disadvantages before asking your trustees to effectively negate this protection by using the family home as security for business borrowing. The trust was set up to protect the family home, but by borrowing against it for business purposes, the separation between the business and personal assets is no longer maintained.
If you are wary of risking the family home, you should consider whether the business has sufficient assets to provide security without relying on trust assets. Whenever possible, business assets rather than trust assets should be used to secure business borrowing.
Guarantees from trustees
If the family home is used as security, the bank is likely to require personal guarantees from yourself and the trustees. Many banks require unlimited guarantees. These guarantees will cover all of the borrower’s liability to the bank (not just the new loan). Some guarantees also extend to cover future lending to the borrower. Once a guarantee is given, the bank will not always advise the guarantors of any increase in lending to the borrower. This makes it very difficult for the trustee guarantors to monitor their liability to the bank at any given time. Therefore, the trustees will need to consider the overall risk to trust assets when deciding whether to provide guarantees and use trust assets as security, and how this could erode the potential asset protection that may have been the reason for setting up the trust in the first place.
Non-beneficiary trustees, such as professional trustees, usually only need to give limited guarantees. This means their liability to the bank (if things go wrong) is limited to the net assets of the trust. However, if you are a trustee and also a beneficiary of the trust your guarantee is usually unlimited. This provides the bank with the option to pursue your own personal assets if the borrower defaults.
What if my business gets into trouble?
One advantage of securing a business loan against the family home is that the interest rate charged may be less than in respect of a business loan secured against business assets. This, however, has the disadvantage of putting at risk the trust assets in the event the business fails.
If the borrower defaults, the bank can sell the family home if this has been used as security. Instead of, or as well as, the family home, the bank can call upon the personal assets of beneficiary trustees who have given a guarantee.
Consequently, you need to assess the risks and provide the trustees with sufficient information to enable them to make an informed decision about whether to provide the family home as security. It is not always advantageous to mix family trusts and business borrowings.
If you are a business owner with a family trust and you are considering taking out a business loan, you should first seek advice from your Lawlink lawyer about options available to you.