30/03/2016

Last month we talked about the basics of asset protection.  This month we're going to discuss related party loans: the good, the bad and the ugly; and why asset protection is necessary for these loan arrangements.

The good
Mum and Dad may want to help their children buy their first house or acquire a business.  If a bank or other third-party financier is not prepared to lend the whole amount needed, a related party loan might seem like a good idea. With a nil interest rate the parents can help the child acquire an asset/business and the child doesn't have any extra interest charges to pay (sounds like a win-win situation).

Mum and Dad also trust their children to pay back any amounts loaned, and with good intentions behind advancing the loan to family, how can anything go wrong?

The bad
With any loan (related party or not) the same risks apply: not getting repaid in part or in full due to the child not being able to pay back the loan, eg financial difficulties and bankruptcy.

The ugly
But that might only be part of the story.  What if the amount advanced to the child as a loan was interpreted by the Family Court to be part of the matrimonial assets of their marriage, so that if they divorced their spouse, that spouse could benefit from 50% or more of the loan amount?

The answer always lies in properly and effectively documenting the loan and the security so that the loan can only ever be interpreted as such and not as a gift by the parent to the child and or their spouse.

Example 1
Parents help a child buy a house, lending $800,000 with no loan agreement in place and no security.  The child is married but later on divorces.

The house is sold for $1 million.  The Family Court rules that the loan was a gift and the ex-spouse is entitled to $500,000 once the house is sold. This leaves the child with only the remaining $500,000 to repay the parents, a shortfall of $300,000.

Let's then say the parents then pass away.  With no formal loan agreement or security the parent’s estate is reduced by $300,000.  If there is a situation where the parents have little or no assets, then effectively there is no money in the estate to distribute to the children.  Had a loan or security been in place the estate could recover the amounts owed.

Loan agreement, no security = UGLY

Example 2
Parents help a child buy a house, with a loan agreement in place but no security.  The child goes on to borrow money from a bank (for some other venture) and grants a mortgage over the house in favour of the bank. If the child goes into bankruptcy the bank, being a secured creditor, would take priority; then any other of the child's secured creditors and what's left (if any) to unsecured creditors.

Parents as unsecured creditors can probably say goodbye to the money they lent in this situation.

Answer
So, how best to protect a related party loan?

Treat the situation as if you were not dealing with a related party.

This means:

1.    having a loan agreement in place (including with the child’s spouse as the joint borrower)

2.     taking the standard security (eg. mortgage over real property, a charge over a company’s assets)

3.     registering the relevant security interest (eg. with the relevant titles office, or on the personal properties and security register)

Think about who you want protection from -  child’s creditors? estranged child’s spouse? estranged parents spouse? parent’s creditors?

Speak to an expert and plan ahead.  Things can get complicated where there are children and their spouses involved.  It's also important to consider the impact of potential deaths and bankruptcy of an individual or a company whilst the loan is still on foot.

It's never too early to start discussing and planning for asset protection before things turn ugly (or extremely ugly). 

For further information, please contact Townsends Business & Corporate Lawyers on (02) 8296 6222.