Planning for blended families using trusts

It’s estimated that 41% of marriages in Canada will end in divorce within 30 years. With such a high divorce rate, you’ll likely have clients who are part of a blended family.

In particular, a complex stepfamily is one where each spouse brings one child or more to the relationship, or where a child is born from the new union. Almost 40% of Canadian stepfamilies are complex, and proper planning is important as their needs will likely be different from those of clients with different family structures.

Often, planning for blended families requires the use of trusts.

Case study

Michael and Julie each had two children already when they married five years ago. After their wedding, they prepared mirror wills. Essentially, if Michael passes away, Julie inherits his entire estate and vice versa.

This works well in a first marriage but, in a blended family, the deceased would likely want to ensure their children from a previous relationship are taken care of as well.

When Michael passes, Julie inherits his entire estate and there’s no guarantee that Julie would, on her passing, leave anything to Michael’s two children (and vice versa). He may want a plan that explicitly provides for Julie as well as his children.

As a result, he may consider setting up a spousal trust for Julie with his children as the residual or secondary beneficiaries of the trust. This strategy is commonly used in blended family situations. It would ensure that Julie is provided for during her lifetime and that the children inherit any assets remaining in the trust when Julie passes away.

The Income Tax Act sets out conditions for a spousal trust. To begin, Michael must have been a Canadian resident immediately prior to his death, and the trust created by his will must be resident in Canada. Also, Julie must be entitled to receive all income from the trust during her lifetime, and she’s the only one who can receive income or capital from the trust while she’s alive. It is only upon her death that Michael’s children would be entitled to income and capital from the trust.

If Julie is an income beneficiary, she can receive only income from the trust and not capital gains. This causes confusion for many people because they believe income includes capital gains, but that is not the case in trust law.

When a spousal trust is established as a result of death, the property being transferred can generally be rolled into the trust on a tax-deferred basis, except for registered plans.

Other applications

Trusts also work well in other blended family situations. For example, Julie’s mother recently passed away and Julie inherited the family cottage, which has been in her family for generations. She would like her children to eventually inherit it.

As per the terms of Julie’s current (mirror) will, Michael would inherit the cottage, and he could choose to sell it once inherited or leave the cottage to his own children — likely not what Julie would want.

Since Julie recently inherited the property, there’s no capital gain on the property since her adjusted cost base would be equal to the fair market value at the time of her mother’s death. Now may be a good time to set up a family trust and transfer the cottage to it, with Julie and her daughters as beneficiaries.

When property is transferred to a trust, it’s deemed disposed, and tax would have to be paid on any gains. Also, it generally makes sense to have additional money in the trust to pay for the upkeep of the property, including maintenance and property taxes.

The family trust could also be set up upon Julie’s death. Capital gains tax would apply, and could be significant if the property has appreciated in value when it’s transferred to the trust, and, as above, Julie’s daughters could be beneficiaries of the trust.

When working with trusts, it’s important to be aware of the 21-year rule, whereby most personal trusts in Canada are subject to a deemed disposition of capital property every 21 years. That means any unrealized capital gains will be taxed at the top marginal tax rate in the trust every 21 years, requiring planning to ensure money is available in the trust to pay the capital gains tax. With proper planning, the trustee could roll the property out of the trust into the hands of the capital beneficiaries on a tax-deferred basis prior to the trust’s 21-year anniversary. Capital gains tax would then apply to the beneficiaries personally when the property is sold.

As you can see, there’s a lot to consider when planning for blended families, and this article scratches the surface with its discussion of trusts. There are several other areas to consider as well, and every situation is different. If you have clients who are part of a blended family, you may want to speak with them to see how their estate plans are structured and whether their wishes and objectives are being met.