Loans versus Gifts - Bankruptcy and Death Why Should a Loan be Documented?
During the twenty-five (25) years experience and counting that I have had in administering bankruptcy matters, the issues in identifying whether monies provided to a bankrupt by a family member or friend are a loan or a gift will largely be determined by the facts and importantly documentation at hand (collectively called the evidence). Much like watching a CSI program, the Bankruptcy Trustee will be guided in making their decision with reference to the evidence.
In a bankruptcy matter that I am presently administering, an issue arose where the Bankrupt was claiming that his father was an unsecured creditor of the Bankrupt Estate for about $50,000. Whilst on the face of it, that sounds straight forward, it was then complicated by the following facts:
- The Bankrupt was declared bankrupt by an Order made in the Federal Circuit Court of Australia. His main liabilities related to unpaid credit cards and tax debts.
- The Bankrupt was a director of a number of companies. These companies experienced financial difficulties and were placed into Liquidation.
- The Bankrupt had not listed his father as a creditor in the Statement of Affairs (“SOA”) when submitted to me. The SOA is a document that a bankrupt is required to complete and details amongst other information, the bankrupt’s assets and liabilities. Whilst this was not fatal, it was an important factor in considering whether the Bankrupt actually believed the monies provided were a gift as opposed to a loan.
- The father passed away shortly after the bankruptcy commenced and the Bankrupt’s mother had pre-deceased his father.
- The Bankrupt was one of three siblings named in the Will of the father as a beneficiary. The main assets of the Deceased Estate of the father were a residential property worth about $650,000 and monies in a bank account totalling about $20,000. Consequently, the assets of the Deceased Estate totalled $670,000 of which the Bankrupt Estate’s share was one-third or approximately about $223,000. The Bankrupt was initially the Executor of the Deceased Estate, however due to the bankruptcy he renounced his role as Executor and his two remaining siblings assumed the executorial role in a joint and several capacity.
- Such purported loan had not been disclosed in the application for Probate.
- The Bankrupt Estate’s share in the Deceased Estate arose by virtue of Section 116(1)(a) of the Bankruptcy Act, 1966 (“the Act”) which says, “all property that belonged to, or was vested in, a bankrupt at the commencement of the bankruptcy, or has been acquired or is acquired by him or her, or has devolved or devolves on him or her, after the commencement of the bankruptcy and before his or her discharge". As the father passed away after the commencement of bankruptcy and before the Bankrupt’s discharge it therefore becomes an asset of the bankruptcy.
- During the course of the assets of the Deceased Estate being realised, the Executors also asserted that the Deceased Estate was owed an amount of $50,000 from the Bankrupt. The Executors were also seeking to offset the amount asserted to be owed from any distribution to the Bankrupt Estate under Section 86 of the Act.
- In terms of dealing with the above, we sought to determine:
- Why the Bankrupt did not disclose the amount asserted to be owed in his SOA? He said that he didn’t expect his father to pass away this early and that he wanted to “keep it quiet” or just between the two of them and further that he still intended to pay his father back after discharge from bankruptcy anyway.
- Why the amount indicated to be owing wasn’t disclosed in the application for Probate. We were informed that the Bankrupt had not told his brothers about the amount owed.
- As the father was deceased we were not able to corroborate any of the Bankrupt’s version of events.
- Of relevance was that further investigation showed that the Bankrupt has been involved in a company that had been placed into external administration shortly after the monies were provided. Consequently, a concern we had was whether the monies were provided to the company or the Bankrupt directly. This is important because if the monies had been provided to the company, then the Deceased Estate needed to look to the external administrators of the company for any redress.
- No bank records were able to be produced by the Executors to show that the monies were in fact paid directly to the Bankrupt. Equally, the Bankrupt was not able to produce documentation confirming that the monies had been received into his bank account. Even if however, such bank records could have been provided, it still would not have been definitive as to whether the monies provided were a loan as opposed to a gift.
On this score, the Bankrupt confirmed that there was never any formalisation by way of a letter or agreement that the monies were to be treated as a loan.
- The above evidence led us to reject the claim of the Deceased Estate in the bankruptcy and therefore it will not receive any dividend distribution. So, it isn’t an ideal outcome for the family.
Some readers may think that the ability of a bankrupt estate to have an interest in a deceased estate to be unfair. Whilst this is understandable, the Act under Section 116 does provide for it as at the commencement of the bankruptcy and at any time before the bankrupt is discharged from bankruptcy (which is typically three (3) years from the time their SOA is filed). It should be noted that the reduction in the period of bankruptcy is presently before the Senate whereby it is quite likely to be reduced from 3 to 1 year (refer to my previous articles).
The lack of documentation is critical if there is to be a strong argument in support of the fact that the monies provided were a loan as opposed to a gift. Whilst this may sound obvious, it is about ensuring that expectations are clear and that there is an education process in advance of such need. It doesn’t only absolutely clarify the lender’s position in a bankruptcy scenario, but also contemplates the case of relationship breakdowns of family members – if it can’t reasonably be concluded that it is a loan, then it will be considered as part of the couple’s assets and assessed accordingly for settlement purposes. So, a loan document is vital as is evidence that the monies have actually been advanced and received. As to the precise form such document should take, there are varied opinions, however, it should at a minimum set out the total monies advanced, term of the loan (i.e. interest rate and period) and repayment terms / schedule.
As we appear to be entering a period where there may be increasing calls on parents for funding (think pre-payment of school fees and is it a loan or some part of a future inheritance), we need to be prepared to properly discuss it and document it. In certain situations, the lenders may need to check with their financial advisor about any other potential impacts.
I have seen circumstances where parents have agreed to provide a limited guarantee secured against their home for borrowings of their son/daughter for use in their business. In these circumstances, not only is there no documentation about the loan/security position, but just as importantly the parents have absolutely no idea about the financial position of their son/daughter/the business. What happens if the business is already in a precarious financial position when the monies are advanced? Whilst some may conclude it will go to them eventually anyway, given the reasons mentioned above and with people living longer it is equally important for us to not leave parents potentially stranded in circumstances that could otherwise be avoided entirely or certainly significantly mitigated.
Whilst the main part of this article has discussed the perils of loans and gifts in the context of a bankruptcy, it is worthy of a much broader discussion as noted and when the subject comes up next within families we should not shy away from having a sensible discussion about it and how it all gets documented.
by Bruce Gleeson