Family Trust and Bankruptcy: Legal Risks in Australia

Insolvency often raises urgent questions about whether family trust assets are exposed to creditors. In Australia, family trusts (typically discretionary trusts) are widely used for wealth management, tax planning, and intergenerational asset protection. Under the Bankruptcy Act 1966 (Cth), trust assets are generally insulated from a bankrupt’s personal creditors. However, this protection is not absolute. Statutory clawback provisions, judicial interpretation, and the structure of the trust deed can significantly affect outcomes.

This article examines how family trusts operate under bankruptcy law, highlighting leading cases, statutory provisions, and best practice strategies.

Statutory Framework: Bankruptcy Act 1966

Section 58 of the Bankruptcy Act 1966 (Cth) provides that, upon a sequestration order, a bankrupt’s property vests in the trustee in bankruptcy. However, section 116(2)(a) expressly excludes from divisible property any asset “held by the bankrupt in trust for another person.” This statutory carve-out forms the foundation of trust asset protection.

Nevertheless, sections 120 and 121 permit the clawback of transfers into a trust made for less than market value or with the intent to defeat creditors. Division 4A further extends recovery powers where a bankrupt has effectively transferred their personal exertion or capital into a trust structure.

Case Law Guidance

Case law plays a decisive role in clarifying how far family trusts can protect assets in bankruptcy. Australian courts consistently weigh the legitimate use of trusts against the rights of creditors. Key judgments illustrate the balance struck by the judiciary:

• Lewis v Condon [2013] NSWCA 204 – The NSW Court of Appeal confirmed that assets held under a valid family trust did not vest in the bankruptcy trustee of the appointor.
• Boensch v Pascoe [2019] HCA 49 – The High Court held that property legally owned by a bankrupt as trustee does not automatically vest in the trustee in bankruptcy, unless the trust is invalid or the bankrupt has a beneficial interest.
• Cummins v Cummins (2006) 227 CLR 278 – Demonstrated the court’s willingness to scrutinise asset transfers to trusts where creditors’ interests are prejudiced.

These authorities collectively reinforce that while trust structures offer robust protection, courts will not permit them to be used as instruments of creditor avoidance.

Trustees and Beneficiaries: Legal Position in Bankruptcy

When bankruptcy arises, the legal status of both trustees and beneficiaries determines whether trust assets remain protected or become vulnerable. The law draws clear distinctions:

Trustees

If a trustee becomes bankrupt, they are disqualified from acting under most trust deeds. A new trustee is typically appointed. Importantly, the trust itself remains intact.

Beneficiaries

For discretionary trusts, a beneficiary holds only a mere expectancy until a distribution is resolved. This interest does not constitute property divisible among creditors. Once a distribution is declared or paid, however, it becomes available to the trustee in bankruptcy.

Creditor Remedies Against Trust Assets

While creditors cannot seize trust property directly, bankruptcy trustees may:

• Set aside transfers: Sections 120–121 BA enable reversal of undervalued or fraudulent transfers.
• Apply Division 4A: Where personal exertion or capital has been diverted into the trust.
• Plead sham trust: Courts may disregard a trust if not properly constituted or administered.
• Examine records: Section 77A allows inspection of documents from associated entities, including family trusts.

Common Legal Pitfalls in Trust Structuring

Although family trusts are powerful asset-protection tools, errors in drafting or administration can undermine their effectiveness. Frequent pitfalls include:

• Appointing individual trustees rather than a corporate trustee.
• Naming default beneficiaries with vested interests.
• Poor record-keeping or mixing trust and personal funds.
• Outdated deeds lacking provisions to remove bankrupt trustees or appointors.
• Failure to document loans, gifts, or transfers properly.

Best Practice Legal Strategies

To maximise protection, legal advisers should ensure:

• Corporate trustee structure is used to separate liability.
• Deeds exclude default beneficiaries, reducing vested entitlements.
• Automatic disqualification clauses for bankrupt trustees or appointors.
• Proper documentation of all trust transactions.
• Regular deed reviews in light of evolving case law and legislative amendments.

FAQs on Family Trusts and Bankruptcy

Many trustees, advisers, and family members ask similar questions about how bankruptcy affects trusts. Below are some of the most common concerns and their legal answers under Australian law:

What happens if a trustee or appointor is declared bankrupt?

The trust continues. A new trustee is usually appointed under the deed, and trust assets remain protected.

Can creditors access family trust assets?

Generally no. However, clawback provisions under the Bankruptcy Act and sham trust arguments may allow access.

What if a beneficiary becomes bankrupt?

They cannot compel distributions. Any actual distribution during bankruptcy will vest in the trustee in bankruptcy.

Do distributions made before bankruptcy stand?

Not always. Transfers made at undervalue or to defeat creditors may be reversed.

Conclusion

Family trusts remain a cornerstone of asset protection in Australian law, but their effectiveness during bankruptcy depends on sound legal structuring and vigilant compliance. Courts have consistently upheld valid trust structures, while simultaneously exercising powers to prevent misuse. For trustees, advisers, and families, the lesson is clear: proactive legal advice and meticulous trust administration are essential to ensure protection holds when financial pressure arises.