It is very common for people to transfer assets to a spouse (or family trust) before embarking on a ‘risky’ activity. For example, before going into business, starting work as a medical professional, becoming a partner in an accounting or law practice, or undertaking a development. But is this really effective?
The case of Wallace v Wallace (Wallace’s Case) suggests that transferring an asset to a spouse may not always be an effective strategy, especially if the transferor is about to embark on a ‘hazardous financial venture’. In Wallace’s Case, the transferor transferred the family home to his spouse prior to starting up a motor vehicle retail business. Ten years later the business failed. The Court found that the transfer failed to protect the asset by applying a ‘hazardous financial venture’ test and concluding that motor vehicle retailing was such a hazardous financial venture that it justified accepting a ten year gap between the transfer and ultimate insolvency.
Effectively, the Court said that because Wallace was embarking on motor vehicle retailing, which is a very hazardous industry, it could be expected that some time in the future things may turn bad. Therefore, any transfer at the outset must be to defeat future creditors – even if those creditors are not currently on the horizon.
Notwithstanding Wallace’s case, our modern economy is based on the premise that people should be able to choose how much they risk when they go into business or undertake a speculative investment. Essentially, creditors must take some responsibility for ensuring they get paid (i.e. contractually and through the Personal Property Securities Register), rather than relying on blanket laws that personally expose business owners to unlimited liability.
So, what can you do to protect your home (or another asset)? Some obvious (yet often overlooked) strategies are:
Adopt a business structure that affords you a good level of limited liability. Most obviously, a company structure. Importantly, you should then operate the company effectively (with proper policies and procedures in place) to ensure you do not fall foul of the various laws that can make you personally liable as a director.
Limit the number of people who become a director, ideally, to just one person – and a person with few personal assets. There is no reason to unnecessarily expose any more people to potential personal liability. Many people appoint their spouse as a director ‘to involve them in the enterprise’. This is folly.
Carefully read the terms of all documentation you enter into, e.g. the terms of any loans, mortgages, leases and supply agreements, that may seek to make you personally liable. Then negotiate.
Be very reluctant to agree to personal guarantees and keep a register of those you do agree to. Avoiding personal guarantees will be difficult with professional creditors, like banks. However, you do have choice among suppliers.
But if a liability does arise…
You must accept that moving an asset after a liability is on the horizon will not be effective. Wallace’s Case suggests that simply starting a business is enough to create relevant contingent liabilities. Therefore, you should divest yourself of the asset as soon as possible, and well before taking on any actual or contingent liabilities.
Ideally, never own the asset. For example, if you are going into a genuinely risky venture or business, then selling your current home and buying a new one solely in your spouse’s name or in a trust may be a good long-term financial decision. The relevant sections of the Bankruptcy Act require a ‘transfer‘ to have taken place. Time for an upgrade?
Be careful not to make any obvious direct financial contributions to the asset. For example, avoid making any direct contributions to the initial equity or ongoing mortgage repayments. Have these come directly from your spouse’s account or the bank account of the trust. You should meet recurrent and wasting expenses, such as household expenses, rather than contributions acquiring or preserving the asset.
Do not use ‘journal entries’ to record contributions and transfers. Ensure that your spouse or trust makes actual contributions. If using a trust, ensure that the trust has its own bank account and keeps financial records.
Make any asset transfers for full market value. It may be that this takes the form of a corresponding debt obligation (i.e. $1m of debt to acquire an asset worth $1m), but this should cap the amount that may be clawed-back to the face value of the debt ($1m) rather than the increased asset value in 10+ years’ time.
Importantly, you must never represent to an actual or potential creditor that you have any interest in the asset. In fact, you should explicitly state to creditors that you do not hold any interest in, nor make contributions to, such assets.
If you earn income through a trust, then consider distributing the bulk of any residual income to your spouse holding the asset, so that your spouse has the financial resources to sustain the asset without your direct or indirect assistance.
Follow the terms of whatever documentation you put in place. For example, related-party loan agreements, mortgages, leases, etc. If the terms are not followed, then the Court is likely to ignore the legal significance of the documentation.
If possible, have a good reason for the transfer other than asset protection. This can be difficult, and in our view, should not be necessary. It should be reasonable for someone to say, “I’m not prepared to risk this asset, and I’m taking precautions to put it out of harm’s way,” but the Court in Wallace’s Case thought otherwise.
To get a clear understanding of your personal exposure or to better structure your affairs, seek your lawyer’s advice.
