In establishing a trust, one will inevitably decide whether it should be a revocable trust or an irrevocable one. The primary difference between the two is simple enough.
A revocable trust allows the person making the trust (settlor) to terminate or make changes to the terms of the trust deed if he wishes to do so even after the he signs it. This is done by including a clause within the trust deed which states that the settlor reserves his right to revoke the trust.
In contrast, an irrevocable trust does not afford the settlor the same flexibility. Once the trust deed is executed, it is set in stone.
Hence, although the settlor relinquishes his legal ownership of the relevant assets in both instances to his trustee, in the case of a revocable trust, he has the option of regaining legal ownership of the assets. Not so if the settlor established an irrevocable trust.
This article will address two aspects concerning revocable and irrevocable trusts, namely the degree of creditor protection each affords and how the assets held in them will be treated if the settlor passes away.
1. Asset protection against creditors
As a general rule, where a creditor obtains a judgment against a debtor for monies owed, the debtor’s personal assets (i.e. assets where he has legal ownership) would be at risk of falling in the hands of the creditor to settle the judgment debt.
As highlighted earlier, a person is no longer the legal owner of his assets after he transfers them into a trust. Does this then mean that in a scenario where he becomes a judgment debtor, the assets in his trust are out of reach of his judgment creditors?
If the creditors do not resort to bankruptcy proceedings, the assets within the debtor’s trust, whether it is revocable or irrevocable, are safe. Simply put, for non-bankruptcy proceedings, creditors will only have access to assets owned by their debtors.
However, if the creditor commences bankruptcy proceedings, whether the creditor has access to the assets within the trust depends on the following:
whether the trust is revocable or irrevocable; and
the time period between the settlor’s transfer of assets into the trust fund and when he becomes a bankrupt
Irrevocable Trust
How assets within an irrevocable trust will be treated depends on the following 3 potential scenarios:
Scenario 1: The settlor becomes bankrupt within 2 years from the date he transferred his assets to the trustee
In this scenario, the transfer of assets into the trust shall be absolutely void.
Scenario 2: The settlor becomes bankrupt between 2 to 5 years from the date he transferred his assets to the trustee
In this scenario, the transfer of assets into the trust shall also be void unless the following can be proven:
the settlor was at the time of making the transfer able to pay all his debts without the aid of the property comprised in the transfer; and
the interest of the settlor in such property had passed to the trustee of such transfer on the execution thereof.
Scenario 3: The settlor becomes bankrupt after 5 years from the date he transferred his assets to the trustee
In this scenario, the transfer of assets into the trust is valid. This is where the assets in the trust becomes creditor-proof. As true protection from creditors only takes effect after the 5-year mark, it is advisable for settlors to establish an irrevocable trust when they are steady financially.
Notwithstanding the above, the question remains: Why should a settlor establish an irrevocable trust when he can establish a revocable one instead which affords him the flexibility to revoke or amend the trust?
Revocable Trusts
A convenient way to understand revocable trusts is this:
If a settlor establishes one, two things are involved: The trust itself and the right to revoke or amend the trust.
If a settlor of a revocable trust is made a bankrupt after 5 years had lapsed from the date of the transfer of assets, the assets within the trust is secure in it – similar to an irrevocable trust.
The crucial difference lies in the right of the settlor to revoke or amend the trust.
Section 55 of the Insolvency Act 1967 (previously known as the Bankruptcy Act 1967) states that where a bankrupt’s property consists of “property transferable in the books of any company, office or person”, the Director General of Insolvency may exercise the right to transfer the property to the same extent as the bankrupt might have exercised it if he had not become bankrupt.
“Property transferable in the books of any company, office or person” arguably includes the property that a settlor has transferred to his trustee that the trustee deems to be potentially subject to future transfer (i.e. the scenario of a revocable trust). Hence, where a bankrupt’s property includes his property held by a trustee in a revocable trust, the DGI may step in his shoes and exercise that bankrupt’s right to revoke or amend the trust (i.e. right to transfer the property).
If the DGI does in fact exercise the right to transfer the property within a revocable trust, that property may be used to settle the settlor’s debts to his creditors.
For this reason, revocable trusts may not be creditor-proof. It is then up to the settlor to decide whether this inferior degree of asset protection is worth the flexibility offered by a revocable trust.
2. Avoidance of the lengthy processes of the law
A common consideration in estate planning is how one’s family members will be financially provided for pending the extraction of the documents required to administer the estate, be it the grant of probate (where there is a will) or the letter of administration (where there is no will). As either process can take years depending on circumstances, it is prudent to plan ahead and establish a trust to sustain the needs of one’s loved ones in the meantime.
Despite the differences between revocable and irrevocable trusts highlighted above, the assets placed in either will not be subjected to the lengthy processes of the law. Instead, the settlor’s loved ones may immediately have access to the assets upon his death in accordance to the trust deed.
Conclusion
With the comparison between irrevocable and revocable trusts in mind, careful consideration is necessary in deciding which of the two to elect when preparing a trust deed. While retaining ownership and control through a revocable trust may be more appealing than the inflexibility of an irrevocable trust, it may still be prudent depending on your circumstances and exposure to creditors.
[1] Section 52, Insolvency Act 1967
[2] Section 4, Bankruptcy (Amendment) Act 2017
[3] In the case of Jaya Letchumi a/p KK Kuttan lwn Pengarah Negeri Jabatan Insolvensi Malaysia (cawangan Negeri Sembilan) (No 2) [2015] 10 MLJ 545, the High Court held that pursuant to Section 55 of the Bankruptcy Act 1967 (since then renamed as the Insolvency Act 1967), the DGI may direct any third parties in possession of a bankrupt’s property to surrender the assets to the DGI.
Pacific Trustees Berhad – www.pacifictrustees.com
