The stringent legal requirements of a valid trust

If you plan to set up a trust to achieve your estate planning goals, it is essential that the trust is appropriately formed because, if scrutinised and the trust is found to be invalid, you may face serious financial consequences. A recent Supreme Court of Appeal judgement regarding the misuse of trusts in a divorce matter has brought to light the importance of correctly setting up trusts and ensuring that they are fit for purpose.

In this SCA matter, a husband set up a trust shortly before his divorce was to be finalised, with his brother named as the trustee and his minor child as the beneficiary. He transferred a substantial amount of assets to the trust and claimed that he set up the trust to provide maintenance for the minor child. His wife argued that he had set up the trust for the purpose of hiding assets from the divorce proceedings and to frustrate her accrual claim. Taking the facts of the case into account, the court ruled that the veneer of the trust could be pierced and that the trust assets should be included when calculating the accrual, meaning that the trust was essentially set up as a sham to deceive his wife.

The words ‘sham’ and ‘alter ego’ are often used interchangeably when dealing with trusts, but they are actually two separate concepts that need to be fully understood to ensure that your trust is valid and can withstand the scrutiny of the courts. In simple terms, a sham trust can be considered a bogus or pretence set-up where the trust founder did not actually intend 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 considered an extension of the trust founder who continues to manage the trust assets as if they were his own.

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’. Similarly, the term can be applied in circumstances where the trust founder uses the trust as an extension of himself by failing to relinquish control of the trust assets and continuing to treat the trust assets as his own. What is important to note in the case of an alter-ego trust is that, while the trust meets all requirements in respect of being valid, the trust founder or trustee does not act with the necessary care, diligence and skill required in terms of the Trust Property Control Act (TPCA). In terms of legal remedy, if a trust is found to be an alter-ego trust, the trust creditors, SARS or even a spouse (in the case of divorce) can attack the trust by requesting that the courts ‘pierce the veil’ of the trust or going behind the surface of the trust. In doing so, while recognising that the trust is a valid one, the courts can disregard the trust and treat some or all of the assets as if they belong to the trust founder in his personal capacity. This could happen where, for instance, the trust founder sets up a family trust but continues to exercise control over the trust assets for his own benefit without allowing the other trustees to exercise decision-making powers. In such circumstances, a valid trust still exists, and the trustees and beneficiaries will acquire rights in respect of the trust assets, although the courts may determine that certain trust assets be used to settle the personality liabilities of the trust founder. Generally speaking, 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 to act jointly at all times with the other trustees.

Sham trusts

On the other hand, the term ‘sham’ refers to something which is fake or bogus and which is designed to deceive others. The test for determining whether a trust is a ‘sham’ is to establish whether the requirements for validity were met in the first instance, particularly in relation to the trust founder’s intention. If it can be found that the trust founder did not intend to set up a trust, or had the intention to create something different, then the courts can rule that no trust ever existed. The effects of this would be that the trust is void on the basis that the parties contracting with the trust were oblivious to the true nature of the trust and therefore not contractually bound to it. 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 all along. As such, it is important to note that ‘piercing the veil’ or looking behind the veneer of the trust is not a legal remedy in the case of sham trusts because no trust is deemed to have ever existed and there is effectively nothing to ‘look behind’.

Identifying an alter-ego trust

Remember, an alter-ego trust is valid in that it is the trust founder’s clear intention to form a trust, and all the requirements for the formation of a valid trust have been met. As such, 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. One should also look to the trust deed to determine whether the trust founder has retained a level of control over the trust assets, or if he has given himself power to amend the trust deed without the consent of the other trustees. Keep in mind, however, that 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 the trust 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 if 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 where he 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. In doing so, they are required to meet regularly, keep records of their discussions, maintain accurate financial records, and sign resolutions – 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. However, the fact remains 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.

Identifying a sham trust

Keeping in mind that a ‘sham’ trust is intended to deceive others, the key to identifying whether a trust is a sham is to question whether a valid trust was created in the first instance. Generally speaking, the founder of a sham trust aims to give third parties or the court the appearance of creating a trust relationship but where the founder actually has no intention of doing so. It is therefore important to first look at the intention of the trust founder to determine whether his intention was to create a trust relationship between himself, the trustees and the beneficiaries. Does the trust deed clearly identify the trust property? Does the trust deed clearly set out the legal rights and obligations of the parties to the trust? Are the objectives of the trust lawful? Is the trust administration process clearly set out and is it adhered to? Is there an independent trustee with fiduciary experience appointed to the trust? Remember, the legal remedy that can be sought in the case of a sham trust is for the trust to be found void, and any transactions entered into may be found invalid. This would mean that the trust assets would lose their protective status against SARS, creditors and even divorcing spouses, and the trust founder could face criminal prosecution. Further, the beneficiaries will acquire no rights in respect of the trust assets. 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/or 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 TPCA, our advice is 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 great day.


Let's talk

For a free consultation with no obligations, please fill in your details and we will contact you to set up a meeting.