Protecting Inheritances

If you are considering leaving an inheritance to your adult child, you may be concerned with its protection in the future. It is a reality that even a mature and responsible child may lose control over some of their assets in the face of a relationship breakdown. At present, close to 40% of all marriages will end in divorce – and that figure goes up when also considering common-law marriages. This is not pleasant to think about, but it is important to consider what “worst case scenario” you are willing to live with. Thankfully, there are good strategies for helping your children protect their inheritance depending on your appetite for complexity and the trust you have in your child.

First, a primer on the law regarding division of family property. In Alberta, both spouses and “adult interdependent partners” are entitled to a division of family property upon the breakdown of the relationship. To oversimplify, two people will be adult interdependent partners after living together for 3 years (or less if a child is involved). On the breakdown of a relationship, there is a presumption in law that family property will be divided on a 50/50 split. Some limited exemptions are available, including one for inheritances. However, it is only the original inheritance that is exempt; the increase in value of that property is available for division. To keep its exempt status, the inheritance must be kept separate, kept solely in the name of your child, and traceable. If your child places the property into joint names with their spouse, or uses it to fund family expenses or pay down family debt, then some or all of the exemption is lost.

What can you do to protect your child’s inheritance? To start, you should encourage all of your children to enter into a pre-nuptial, post-nuptial or cohabitation agreement, regardless of how you feel about their spouse. For example, if your child passes away unexpectedly, even a spouse who has every intention of benefiting your grandchildren could end up losing control over the inheritance after they re-partner or re-marry. It is critical that your child seek proper legal advice regarding these types of domestic contracts – they have very strict requirements to be properly executed, and otherwise are not legally binding.

If your child won’t enter into a domestic contract, or you don’t trust your child to protect their own inheritance, then it may be time to consider a fully discretionary testamentary family trust.  These family trusts are complex, both from a tax and a legal perspective. They should never be attempted without the use of an estate planning lawyer.

A fully discretionary family trust set up in your will has certain basic elements. To start, there must be a trustee. This is often the child themselves, together with a trusted family member or friend. If your estates are complex, or if you do not wish to burden a family member with the role, a private trust corporation is a great option which has the added benefit of having a neutral party involved.  There must also be beneficiaries of the trust. This will often be your child and their own children (being your grandchildren). Finally, consideration needs to be given to what type of property to put into the trust, and how you wish for it to be divided upon your child’s death. Your lawyer will help you determine the optimal structure.

As an added benefit, the trust allows your child to income split with their young families. For example, if a child receives their inheritance outright, any income earned would be taxed at their own highest marginal tax rate. However, if income is allocated to a grandchild to pay for expenses (e.g. University tuition), then some income can be taxed in the hands of the grandchild who is likely in a much lower tax bracket. This makes the use of family trusts quite useful from a tax perspective, as the tax paid by your child’s combined family unit is lower than it would otherwise be.

Since the trust is fully discretionary, no single beneficiary is entitled to the income from the trust or capital distributions from the trust until the trustees resolve to distribute. This is the crux of the protection. Since the beneficiary does not own the trust property, nor can control it, it is not typically divisible on the breakdown of a relationship. For example, if a child was going though a divorce, then the trustees would avoid resolving to distribute any property to the child while that property division is being negotiated. This planning strategy is not perfect – there have been instances when the family trust’s assets were divisible – but it adds a very strong level of protection. For that reason, the child should continue to be encouraged to enter into a nuptial or cohabitation agreement even where a family trust is present.

A caution on the choice of trustees. Trustees have a lot of power to handle the trust property and decide how to distribute it. If your child is the sole trustee of the trust, they may, accidentally or purposefully, undo the protection you intended to provide for them by distributing the property immediately to themselves. It is common therefore that a child is not the sole trustee of their own trust. A co-trustee, especially one who is a professional trustee, is a useful tool, not only for the reasons mentioned but also to provide some education to that child. Trusts are flexible – a good estate planning lawyer can tailor each trust for your unique family circumstances. 

Ultimately, it is important for parents and their children to fully understand how an inheritance is to be managed, and what level of protection is desired. At a minimum, you should seek legal advice so that you can make purposeful decisions as to what is best for your family.

Author(s): Michael Klaray, Kayla Thompson, Diane C. Ferrante