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When contemplating their estate plan, a common concern for many people is how they can protect the inheritances they leave to their adult children from being accessed by their son-in-law or daughter-in-law in the event of a marriage breakdown.

As discussed in another blog I wrote on this topic, there are provisions in the Family Law Act which protect an inheritance received after the date of the marriage from forming part of a spouse’s net family property (“NFP”). There are also provisions that protect the income earned on such inheritances from forming part of a spouse’s NFP if this is expressly stated in the Will. However, if a testator (person making a Will) leaves his or her children’s inheritances to them outright and any children comingle their inheritances with marital property, any comingled property will form part of that child’s NFP absent being able to trace the comingled property back to the inheritance or the child having a marriage contract in place to protect against this result.

Essentially, if a child receives his or her inheritance outright, the onus to keep the inheritance separate and apart from marital property remains with the child. Some testators are satisfied discussing this with their children and trusting that they will keep their inheritances separate and apart from marital property. However, if a testator wants to put in place additional protections against an inheritance forming part of his or her child’s NFP, the testator should consider leaving his or her children’s inheritances to them in trust rather than outright.

An advantage of establishing trusts for the inheritances of children is that a testator can exercise a certain degree of control over the future use of the trust funds through their choice of trustee(s) and/or through stipulating how much of the income and capital a child can access from his or her trust. There are several factors that need to be considered when determining the terms of the Trusts and choice of trustee(s). A testator can appoint his or her child as sole trustee of his or her own trust, and if the trust allows for payment of all income and capital to each child, each child will have full control over the use of his or her trust funds. Even if a child chooses to use trust funds for payment of marital expenses that may put the funds at risk of being comingled, an advantage of having the funds held in trust is that the inheritance funds will be increasingly traceable, as payments would be made in the child’s capacity as trustee of the trust rather than his or her personal capacity. This makes it easier to establish that the funds used were derived from the inheritance and therefore should be excluded from NFP.

A potential disadvantage of making a child the sole trustee of his or her trust and allowing for payment of all income and capital to the child is that it would allow that child to essentially pay all of his or her trust funds to himself or herself. This could be an issue if there is any concern a child would use his or her power to encroach on the capital of the trust to abandon the trust structure altogether (i.e. simply take funds from the trust and put them in a personal account). This may be a concern if a child doesn’t believe in keeping assets separate from his or her spouse for whatever reason (i.e. feels “what’s mine is ours” and/or that he or she will never separate from his or her spouse). This may also be a problem if there is any pressure from the child’s spouse to abandon the trust structure and, for example, take the funds out of trust and simply deposit them into a joint account which both of them can access.

If there were any concerns that a child may abandon the trust structure altogether as sole trustee by encroaching fully on the capital of the trust and choosing to hold the funds personally or in a joint account with his or her spouse, a testator could put limits on the ability of the trustee to encroach on the capital of the trust. The disadvantage of limiting capital encroachments is that the testator would have to speculate to what extent capital encroachments may be needed or appropriate in the future, which does not leave flexibility for encroachment in situations where the testator may have otherwise wanted his or her child to be able to access the capital of his or her trust.

A possible solution for this limitation would be for the testator to appoint a trustee other than his or her child (a “Third Party Trustee”) to act as sole trustee or as joint trustee with the child. In this event the testator could leave discretion regarding payment of income and capital. An advantage of this approach is that it leaves flexibility for the Third Party Trustee to approve payments from the trust based on the child’s needs (flexibility that is not available where capital encroachments are limited). At the same time, a testator may not like the idea of involving another trustee, as this would result in another party weighing in on and approving when the testator’s children could access their trust funds rather than the children having full control over how they use their inheritances for their own benefit.

Other factors to take into account when considering establishing a trust for children is the ongoing work and costs that are involved in managing a trust, such as the following:

  1. filing tax returns for the trust;
  2. paying taxes at the highest marginal rate on the income earned in the trust;
  3. paying trustee compensation if there is a Third Party Trustee;
  4. paying investment management fees;
  5. ongoing meetings between the trustee(s) and investment management team to ensure the written investment strategy is being adhered to;
  6. planning for potential wind up of the trust within 21 years from the date of death, as the Income Tax Act provides that all of the assets in the trust will be deemed to be disposed of every 21 years, meaning the capital gain on any assets in the trust with an unrealized capital gain will be triggered on the 21st anniversary of the creation of the trust (being the testator’s date of death).

Ultimately, there are various considerations that need to be weighed when deciding whether including a trust for your adult child’s inheritance is right for your estate plan. If it is, there are a number of additional decisions that need to be made regarding the terms of the trust. You should consult an estates lawyer to assist you in this regard. If you would like to discuss this further with a member of our estates law group, please reach out to us at 416-863-0125 or contact us online.

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