Legal Tip 318: An Individual Lending Money to a Trust of Which they are the Trustee

Discussion in 'Legal Issues' started by Terry_w, 4th Dec, 2020.

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  1. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    A trust is not a legal entity so can’t borrow money. What happens is that the trustee of the trust borrows the money in their capacity as trustee or as trustee for the trust.

    When borrowing from a bank, the trust loan documents will be the trustee as the borrower, but make note that they are doing so in their capacity as trustee. They will have a personal obligation to pay the lender and their personal assets will be at risk – but they will be entitled to be indemnified out of the trust assets.



    But how this this work when the individual is borrowing and onlending to ‘the trust’ and they are the trustee?

    Example

    Homer has a home loan with Combank. The loan is in his sole name.

    Homer wants to debt $100,000 into a trust and have the trust to borrow to buy shares. But to do this he will need to split the loan, pay it down to $1, and then redraw the loan and ‘lend’ himself $100,000 as trustee to buy shares.



    What’s the problem with this?

    Well, a person cannot contract with themselves. Homer cannot legally lend money to himself, even when he is acting in different capacities. So at law Homer cannot lend to Homer as Trustee. Homer couldn’t sue himself if he stopped paying the loan as trustee for example



    Here are 3 potential solutions

    a) Homer redraws the money, in his capacity as trustee

    When Homer pays the Combank loan down he plans to redraw the money out again. The ATO treat this as new borrowings for tax purposes. Homer can resolve to draw the money as trustee and the trust can use it as if Homer had applied to the bank as trustee.

    Homer could also potentially document this with a deed poll – a deed with one party, instead of a contract.

    b) Homer enters into a loan agreement with himself

    Homer knows it won’t be legally enforceable. But it shows the intention that Homer is acting in 2 different capacities and it might keep the ATO happy. A court of equity might still enforce this agreement if things go sour.



    c) Homer and spouse can lend Homer

    You cannot contract with yourself, but you and another could contract with you.

    Homer and Marge could lend money to Homer as trustee.



    I am about to lodge a private binding ruling with the ATO to find out what they think (for this particular client). I think either one could be fine and the simplest would be to just do a written onlending agreement – the ATO doesn’t always understand the legal implications.



    But the legal implications are important for other reasons too.

    Imagine Homer died. Marge became the executor and Bart became trustee. Could Marge recover the money from the trust for the estate? Could Bart argue that the loan was not legally enforceable? Will the courts assist?

    Note that where the trustee is a company, these issues don’t arrive.
     
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  2. Paul@PAS

    Paul@PAS Tax, Accounting + SMSF + All things Property Tax Business Plus Member

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    It can be effective to change the trustee to address the loan problem. Extra complications ie deed of amendment, process for how to change trustee etc all need legal advice. on top of the loan agreement

    I once had a wise barrister explain the human trustee issue as this can also apply to a beneficiary. eg Fred is trustee for the Fred Family Trust. Fred resolves to distribution $100 of income as 50% each to Fred and Barney. So the trustee owes $50 to Fred. So Fred has resolved to pay Fred and still owes Fred.....So Fred can sue Fred for breach of trust if Fred pays the $100 to Barney.

    A company trustee would avoid this alter ego issue for sure. Fred may be appointor and retain right appoint a new trustee company he controls to terminate Fred Pty Ltd as trustee.
     
  3. Paul@PAS

    Paul@PAS Tax, Accounting + SMSF + All things Property Tax Business Plus Member

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    Human trustees tend to be a poor choice when :
    - There is a related party loan
    - There is a distribution
    - There is a lease to a partnership or sole trader
    or when the ATO initiates audit actions or someone sues the trustee.

    One of the very few instances where I dont see major issues with a human trustee is where a trustee ONLY acts as shareholder to a company that produces profits. The sole acts of the trust maybe to facilitate a share of dividend income in a discretionary manner rather than a fixed basis which would otherwise be the case for a company.
     
  4. Ian87

    Ian87 Well-Known Member

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    Hi Terry, did you get your private ruling on part C?

    I am exploring the idea of withdrawing equity from ppor then onlending to trust that I may set up. If PPOR is in both names could we withdraw money and either have wife only lend to trust if I am the trustee. Or myself and my wife elnd to the trust? All at market rates and I realise I would also need loan contracts drawn up.

    I 100% need to seek specific advice, I just want to know what may be possible.

    As always thank, learned so much from your posts over the years.

     
  5. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    Yes received a positive private ruling.
     
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  6. Baker

    Baker Well-Known Member

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    Should money taken from redraw go straight to the bank account used for trust activities?
    Or can it first sit in a completely untainted/new offset account before being moved to the trust bank account?
     
  7. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    If you lent me money I wouldn't want you to keep it in your offset
     
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  8. Baker

    Baker Well-Known Member

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    Thanks @Terry_w , if I may I will rephrase:

    Using option B) from above, does it matter where money first lives before being loaned to the trust?

    Homer already has fully paid down investment loan, ready to redraw cleanly for the next investing adventure. The redraw can only be transferred into an account with the same bank. This loan has an offset account attached with $0 balance, so he can park the money there to begin with and not accrue interest.

    Homer wants his next investments to be held in his discretionary trust, so Homer enters into a loan agreement with himself at the Trustee. Homer loans the money from that offset account into an account with another bank used for Trust activities, and income-producing investments are purchased in trust.

    The interest charged monthly to the trust is equal to the interest charged on the investment redraw.

    Does that work?
     
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  9. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    Yes it matters because if you are onlending the money you want to be able to claim the interest on that loan. The trust can only claim interest if it has borrowed to buy an income producing asset. Homer wouldn't want to do what you propose.
     
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  10. K168

    K168 Well-Known Member

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    Is there a tax and commercial benefit to doing this, or is it mainly legal and protection purposes?
     
  11. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    If a trustee is buying trust property the deposit has to come from somewhere. DIscretionary trusts are usually started with just $10
     
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  12. mr_alex

    mr_alex Well-Known Member

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    Hi Terry

    Let's say Homer had on-lent money to a trust under a written loan agreement and the trust has been making monthly interest payments to Homer which match homers payments to the bank. Homer actually had an offset account linked to the loan account which was on-lent.

    Since no offset facility exists between Homer and trust,

    1) Would Homer need to calculate what the interest charged would have been without the offset benefit, and charge the difference to the trust?

    2) could the above be achieved as simple as subtracting the already received trust interest payments from the calculated interest (without offset) and have the trust make an additional loan payment with the description along the lines of 'interest adjustment for period x'
     
  13. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    1. Yes
    2. Yes but consequences
     
  14. mr_alex

    mr_alex Well-Known Member

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    Thanks Terry, can you please elaborate on what the consequences may be? For the above, are there other ways to rectify an incorrect trust payment without consequences?
     
  15. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    is it the type of contract that 2 strangers would enter into?

    If you lent me $100,000 at 5% pa I would pay you $5,000 in interest and you would pay say $4,000 to the bank.

    If you suddenly win $50,000 and put it in the offset against your loan your interest would drop to $2,000 pa. Why would my interest to you drop by an equal amount?

    It would be an artificial arrangement if you dropped my interest to you

    Would the ATO then allow you to claim any interest from on your loan?
     
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  16. Paul@PAS

    Paul@PAS Tax, Accounting + SMSF + All things Property Tax Business Plus Member

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    It also depends on the perspective
    - Is there a tax benefit to be obtained ?
    - Is there a arms length maintenance of the loan ?
    - Commercial charecter of the arrangement ?

    And the timing
    - Many tax schemes seek to accrue and interest cost being incurred and to defer a taxing point so one taxpayer may benefit. That said deferral is not in itself a concern. eg Fred may lend to Fred Pty Ltd which is doing a property dev and Fred only seeks his cashout when all sales are realised. Deferral is a normal issue.

    Care should be taken to avoid the "money lending" rule. This means "accrued interst" may be considered income even thought its not physically received.
    https://www.ato.gov.au/law/view/view.htm?docid=EV/1051347801962&PiT=99991231235958
     
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  17. mr_alex

    mr_alex Well-Known Member

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    Thanks for this example Terry. I mean if the mistake was realised after the fact.
    Following from your eg. If say, the last 2 repayments you made to me were affected and the amounts were less than they should have been due to me having an offset and quoting you the wrong amount.

    In an attempt to restore the arm's length situation, could the correct amount of interest be calculated and an 'out of cycle' payment be made by you as a 'correction' in order to get things on track again? - wasn't sure if you meant doing this would have consequences.

    I didn't know this, so the shortfall in the above example could be considered as a deferral and be made up with an extra payment? And I guess the terms of the agreement would come into play but assume it's drawn up as like a revolving loan facility.
     
  18. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    It would depend on the contract terms. If you haven't met the minimum repayment it might be a breach of contract with penalties. The way I generally draft loan contracts is so they are like a LOC and if a minimum payment has been missed the loan capitalises.
     
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  19. ChrisP73

    ChrisP73 Well-Known Member

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    Has it been published by the ATO?
     
  20. Terry_w

    Terry_w Lawyer, Tax Adviser and Mortgage broker in Sydney Business Member

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    not sure, should be
     
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