Ring fencing has nothing to do with jewelry, but everything to do with protecting the assets that are most important to you – or mitigating risk in a volatile business.
Ring fencing describes the act of separating, isolating, and insulating select assets or business dealings through some form of legal arrangement. There are no formal systems in place for creating a ring fence, nor is there an established template. There are, however, multiple different common tools that are associated with ring fencing. A living trust is one of them.
In the context of a living trust, a ring fence is a form of trust established to protect assets from the risk of bankruptcy, or from creditors. Because trusts can exist as independent legal entities (controlled by third party called a trustee, with a fiduciary duty towards the trust’s beneficiaries), they become the perfect means to place a safe distance between yourself and the assets that matter most to you.
Understanding Ring Fencing
Liability is crucial to understanding ring fencing. Whether it is legal liability, a financial obligation, or a debt, liability represents financial sacrifice. Certain individuals and businesses will be more prone to liability due to the nature of their work. Perhaps you are in an industry that is especially prone to litigation, or perhaps your business dealings invoked a great deal of personal risk on your part. Or, perhaps, you need a way to keep key business assets or operations functioning should your company incur bankruptcy in the future.
Ring fences are not just workarounds for legal liability. They are, in fact, a necessary part of business in many industries. In the UK, for example, large banks are required by law to ring fence their retail banking units from other parts of the banking organization, in the aftermath of the financial crisis. This is to ensure that people’s money would not be tied up in speculative investments and the bank’s other financial dealings.
In business, a ring fence usually takes the form of an independent and highly limited subsidiary. These must be carefully structured to ensure that they are legally independent, meaning that you cannot siphon money to or from your subsidiary. Such subsidiaries are sometimes called special purpose vehicles. The benefit of setting up an independent subsidiary is that companies can avoid having all their eggs in one basket – so in the event of a financial downturn for the parent company, the subsidiary will be able to sustain the business and maintain crucial assets.
Individuals can choose to utilize ring fences as well. This is where a living trust comes into play.
A Living Trust as a Ring Fence
Trusts are legal entities defined and created through an agreement between three parties: the grantor, the trustee, and the beneficiary. Sometimes, one person can play several or all of these roles.
But when a trust is created to isolate and protect assets from a grantor’s personal liabilities, it’s in their best interest to pick a trustee that can work independently, and act in the beneficiary’s best interests. Most trusts are established ultimately for estate planning purposes, to provide a greater degree of control and flexibility over the management and distribution of estate assets, and to allow for a more complex gameplan regarding the bequeathment of assets after death.
For example, whereas a will would only allow someone to bequeath the remainder of a checking account to a loved one in a single transfer, a trust puts that money in the hands of a trustee, to be managed, invested, and paid out as monthly income over a set period, before the principal (initial amount) is bequeathed in full.
Use the Right Kind of Trust
Trusts are either living or testamentary. Most trusts are living, meaning that they are established and put into action while the grantor (creator) of the trust is still alive. At that point, the main distinction between most trusts is whether they are revocable or irrevocable. Revocable trusts are more flexible, as they allow greater involvement on the grantor’s part, and can be amended endlessly. However, because they allow revisions and remain under the grantor’s control, they offer poor protection against creditors or other liabilities.
Irrevocable trusts are as close to permanent as you can get and can be difficult to reverse. But they also offer a much greater degree of separation between a grantor and their former assets, granting a trust the degree of independence needed to cut itself off from the grantor’s liabilities, including tax liabilities. Irrevocable living trusts are often used to reduce a grantor’s taxable estate, and thus avoid federal estate taxes.
An irrevocable trust created as ring fence also offers a degree of protection for the beneficiaries. Because the trust is a separate legal entity, the assets held therein belong to neither the creator of the trust (the previous owner), nor the beneficiaries (the future owner). So long as the trustee does not transfer ownership rights of the assets held within over to the beneficiaries, their liability does not affect the contents of the trust. However, any income paid out to the beneficiaries may be claimed by a creditor, or used to pay off a debt in the event that the creditor employs a bank levy.
Ring Fencing Requires Forethought
However, readers should beware that setting up a trust as a ring fence requires forethought. If you set up a trust after incurring a debt with the explicit intent of protecting assets from that debt, for example, a court may reverse the trust. If you are in a risky position and want to protect key non-exempt assets from creditors, be sure to set up your ring fence well before you begin accumulating debt.
Again, it should be treated as a precaution.
Setting Up Your Own Trust Ring Fence
Put simply, the key features of a trust ring fence include:
- The trust must have a single purpose (to protect key assets for beneficiaries)
- The trust must be independent (it cannot merge with other entities)
- The trust incurs no debt (it should not assume risk on its own)
Furthermore, the best type of trust for the job will usually be an irrevocable living trust.
Trust agreements are crucially designed to suit the circumstances for which they are created. Avoid DIY solutions or templates online and use the services of an experienced law firm.
