Peter Rayney looks at the protection offered by trusts to owner-managed businesses in the context of divorce.
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Like many tax professionals, I have been privileged to all kinds of private insights into family life.
Owner-managers often confide in me about their deepest fear – DIVORCE. They often have a personal trepidation about the family wealth being dissipated as a result of a future divorce settlement in the family. Consequently, owner-managers may be reticent to directly pass significant stakes in the family company to offspring during their lifetime.
I was recently embarrassed to witness one client saying to his son – “You are not having any shares unless you get a pre-nup!”. The son had been in a long-term relationship with his fiancé and felt very troubled by this; he did not think a pre-nuptial agreement (PNA) was very romantic. Nevertheless, PNAs can often be a sensible approach. The leading case Radmacher v Granatino [2010] UKSC 42 confirmed that PNAs are likely to be followed by the courts provided they are fair, freely negotiated between both parties, and the parties have a full understanding of its implications. However, they are not for everyone!
One of the questions that I often get asked is whether a family discretionary trust offers suitable protection against divorce settlements. As with most questions tax professionals are asked, the answer is, “it usually depends!”
Creation of trust
Shares in an owner-managed trading company can usually be transferred into a discretionary trust without any immediate tax cost. Capital gains tax (CGT) holdover relief can be claimed under TCGA 1992, s 260 (this takes priority over gift relief under TCGA 1992, s 165 in such cases) as long as the trust is not a settlor-interested trust within TCGA 1992, s 169F (TCGA 1992, s 169B).
Furthermore, no inheritance tax cost should generally arise due to 100% business property relief.
Disclosures from beneficiaries
As part of divorce proceedings, beneficiaries of a trust must disclose any interests held through a trust, even contingent interests. Courts can require beneficiaries to disclose trust documents. Invariably, beneficiaries must obtain this information from the trustees. In this context, trustees must ensure that they only disclose information to beneficiaries or their advisers. Trustees have a fiduciary duty to act in the best interests of the beneficiaries as a whole and should only provide information that they would provide to any beneficiary in the absence of divorce proceedings; this could include the letter of wishes.
The courts have the power to ask trustees to explain historical trust distributions, or to produce accounts and any other details that they consider necessary for the purpose of dealing fairly with a divorce settlement.
Available financial resources
A divorcing party can apply for a lump sum, a property adjustment, a pension order, or a periodical adjustment (i.e., maintenance). Courts must make applications that are fair having regard to the factors set out in the Matrimonial Causes Act 1973 (which applies in England and Wales). Judges must therefore consider each spouse’s current financial resources and those they are likely to have in the foreseeable future. The extent to which assets held in a trust are regarded as available to the beneficiary – and therefore considered in their divorce settlement – will depend on the precise facts of each situation.
The courts will set aside ‘sham’ trust structures, – where the settlor and the trustees have set out to mislead others about the correct basis on which the asset is held – often with the intention of sheltering them from a financially ‘weaker’ spouse.
Shares in an owner-managed company held through a discretionary trust potentially offer protection in a divorce settlement since the trust creates a barrier between the trustees and the beneficiaries of that trust. A beneficiary’s interest is contingent upon the trustees exercising their discretion in the beneficiary’s favour – they do not enjoy any automatic right to the trust’s income or capital. A court might therefore take the view that the assets of a discretionary trust are not a financial resource that is available to a beneficiary.
However, the courts are sometimes prepared to rule that shareholdings in a family company held through a discretionary trust should be considered when arriving at a ‘fair’ divorce settlement. The courts will consider a number of factors in reaching its decision. Thus, if the trustees have made regular income distributions or prior advancements of capital, a court will normally assume that the same resources are likely to be available in the future to a ‘divorcing’ beneficiary.
Judicious encouragement
If there is no track record of prior distributions of income or capital, the courts may sometimes apply the concept of ‘judicious encouragement’. This principle has often been criticised by trust professionals, who regarded it as tantamount to bullying trustees to exercise their dispositive powers in favour of specific beneficiaries.
Nevertheless, the family courts take the view that the ‘judicious encouragement’ doctrine does not disturb basic trust principles, since it simply requires them to look at the reality of the relevant circumstances.
In Thomas v Thomas [1995] 2 FLR 668, the principle was clearly expressed by Lord Justice Glidewell as follows:
“If, on the balance of probability, the evidence shows that, if trustees exercised their discretion to release more capital or income to a husband, the interests of the trust or other beneficiaries would not be appreciably damaged, the court can assume that a genuine request for the exercise of such discretion would probably be met by a favourable response.”
Further examples can be found in Charman v Charman (No 4) [2007] 1 FLR 1246, and Whaley v Whaley [2012] 1 FLR 735.
The ‘judicious encouragement’ principle may therefore be used to coax the trustees into exercising their discretion where this is considered to be fair. Furthermore, they can treat the trust assets as a potential resource available to a divorcing beneficiary by awarding a greater proportion of the assets held outside the trust to the other spouse.
On the other hand, if the trust has a very wide class of beneficiaries, a court is likely to be reluctant to press this rule, especially where the beneficiaries represent future generations of the settlor’s family but specifically exclude their children’s prospective spouses.
Some conclusions
Discretionary settlements – particularly long-standing family trusts – can offer an important degree of protection for family company owners. They should therefore be considered an important succession planning tool for passing down shares to the next generation. In contrast, transferring shares into a discretionary trust will often prove more effective than gifting them outright, where they might easily be comprised in a future divorce settlement.
However, trusts are not impregnable to divorce-related claims, since the courts have generally sought to ensure that the existence of a trust should not interfere with the principle of fairness in resolving divorce settlements. However, as Lord Justice Waite articulated in Thomas v Thomas (see above), the courts must not cross the line between ‘judicious encouragement’ and ‘improper pressure’.
Practical tip
The courts normally find it more difficult to ‘attack’ long-standing family discretionary settlements that are designed to protect wealth for future generations, especially where they have a wide class of family beneficiaries.
