Before setting up a trust, it’s important to understand the strict requirements for the validity of a trust, keeping in mind that there may be serious consequences if the trust is found to be invalid. In the context of trusts, the words ‘sham’ and ‘alter ego’ are often used interchangeably, although they are in fact two separate concepts that should be fully understood to ensure that your trust can withstand legal scrutiny.
In simple terms, a sham trust is a bogus or pretence arrangement where the trust founder had no intention to set up a trust even though on paper a trust appears to have been formed. On the other hand, an alter-ego trust can be described as an extension of the trust founder who continues to manage the trust assets as if they were his/her own. Let’s take a closer look.
Alter-ego trusts
The term ‘alter-ego’ can be described as ‘an alternative self, believed to be distinct from a person’s true original personality’. In the context of trusts, the term applies in circumstances where the trust founder uses the trust as an extension of himself by failing to relinquish control of the trust assets and by continuing to treat the trust assets as his own. While the trust may meet the requirements of a valid trust, the trust founder fails to act with the necessary care, diligence and skill required in terms of the Trust Property Control Act (TPCA). Where a trust is found to be an alter-ego trust, SARS, the trust’s creditors or even a spouse can attack the trust by requesting the courts to look beneath the veneer of the trust. In doing so, the courts may disregard the trust and treat some or all of the assets as if they belong to the trust founder in his personal capacity.
By way of example, the trust founder could set up a family trust but continue to exercise control over the trust assets for his own benefit without allowing the other trustees to exercise decision-making powers. In such a circumstance, while a valid trust still exists and the trustees and beneficiaries will acquire rights in respect of the trust assets, the courts may determine that certain trust assets be used to settle the personality liabilities of the trust founder. A hallmark of an alter-ego trust is the failure of the trustees to adhere to the requirements of trust administration, including the requirements to exercise independent discretion, give effect to the trust deed, exercise their fiduciary duty towards the trust beneficiaries, and act jointly at all times with the other trustees.
In determining whether an alter-ego trust exists, one would need to look for signs of abuse and/or mismanagement by the trust founder and/or trustees. The absence of an independent trustee can be a warning sign as, without independent oversight, the trust founder may be able to manage the trust assets for his personal benefit. The trust deed should also be examined to determine whether the trust founder has retained a level of control over the trust assets or whether he has given himself the power to amend the trust deed without the consent of the other trustees. That said, it is not sufficient that the trust deed provides the trust founder with control over the assets. The trust founder must actually exercise control over those assets and treat them as his own in order for the trust to be an alter-ego one. Another indicator of an alter-ego trust is where the trust founder or trustee acts contrary to the trust deed, uses the other trustees as puppets in that they do not form part of the decision-making process, or influences the other trustees in the exercise of their discretion. Remember, all trustees are required to act together with due care, diligence and skill to manage the trust assets for the benefit of the beneficiaries – and any indication that this is not happening could be seen as a warning sign that the trust is an alter-ego of the donor or trustee. That said, keep in mind that a trust is not voided on the finding that it is an alter ego trust, but it can be used to justify the courts looking through the veil and holding the founder or trustees personally liable.
Sham trusts
While alter-ego trusts may be valid, ‘sham’ trusts fail to meet the requirements for validity in that they are essentially fake trusts designed to deceive others. As such, the test for determining whether a trust is a sham one is to establish whether the requirements for validity were met at the outset, particularly in relation to the intentions of the trust founder. Suppose it is found that the trust founder had no intention of setting up a trust or intended to create something different. In that case, the courts may rule that no trust ever existed – and the trust can be voided on the basis that the parties contracting with the trust were oblivious to the true nature of the trust and can therefore not be contractually bound to it. Where the trust is voided, no transfer of assets would be deemed to have taken place between the trust founder and the trustees, and the assets will be deemed to have formed part of the trust founder’s personal estate from the outset.
The modus operandi of the trust founder in the case of a sham trust is to create the perception that a trust relationship has been formed whereas, in fact, it has not. As such, it is important to first look at the intention of the trust founder to determine whether he intended to create a trust relationship between himself, the trustees and the beneficiaries. In the process, the courts would look at the trust deed to determine whether the trust property was clearly identified and whether the legal rights and obligations of the parties were documented. They would also consider whether the objectives of the trust were lawful, whether there was an independent trustee with fiduciary experience was appointed, and whether the trust administration process was clearly set out and adhered to.
Where the court finds the trust to be a sham one, any transactions entered into by the trust may be found invalid and the trust beneficiaries will acquire no rights in respect of the trust assets. Further, the trust assets would lose their protective status against SARS, creditors and even divorcing spouses, and the trust founder could face criminal prosecution. As such, SARS remains on the lookout for signs of sham trusts which include the absence of a paper trail when it comes to trust administration, lack of recordkeeping, lack of separation between the founder’s assets and the trust assets, or where the founder and trustees are also beneficiaries of a trust, such as where a husband and wife are both the trust founders and the beneficiaries.
If you have a trust and are unsure whether it meets the stringent legal requirements for validity in terms of the Trust Property Control Act, be sure to have it checked by a fiduciary expert to put your mind at ease keeping in mind the potentially onerous legal and financial consequences of your trust being successfully challenged.
Have a fabulous day.
Sue
