Blended families have long been familiar features of the Canadian landscape. But they are often a challenge for estate planners.

One of the most common challenges is how to balance the interests of a new partner with the interests of children from a prior relationship. Consider the example of recently married Rebekah, 50, and Mansur, 56. Rebekah divorced her former husband three years ago. Mansur divorced his former wife two years ago and has a daughter and a son from the previous marriage: Sarah, 23, attends law school, and Jibril, 24, recently began a promising career in business. Mansur and Rebekah want to ensure both spouses are provided for, but Mansur also wants to leave something to his children.

It would be a mistake to approach this type of situation as being, primarily, a technical or tax planning one. Good estate planning is mainly an exercise in understanding human needs, and then using technical expertise to meet them.

For instance, a tax-effective option for Mansur would be to make a will directing the residue of his estate to a spousal trust for Rebekah’s lifetime, with his two children named as the remainder beneficiaries. That would defer capital gains tax that would otherwise arise on his death until the death of Rebekah (assuming she survives him). It would also ensure that whatever capital remains in the spousal trust on Rebekah’s death goes to Mansur’s children.

But is this the right solution? To answer that question, you need to know a lot more about the relationships at play. It’s not always easy to ask clients about personal matters, but planning requires it. In the case of Mansur and Rebekah, you need to understand something about how they met and how their marriages ended. Were the breakups acrimonious, amicable, or somewhere in between? Did the new relationship begin before or after Rebekah and Mansur separated from their former spouses? How do Sarah and Jibril see Rebekah?

The answers will help you spot potential trouble spots in the planning process. A spousal trust for the entire residue of Mansur’s estate may be an effective way of deferring capital gains tax while providing for his children; but it could also spark expensive, time-consuming and emotionally damaging litigation.

The reason for these divergent outcomes is straightforward. To qualify for a deferral of capital gains tax, a spousal trust must provide that the spouse receive all the net annual income. In addition, if the trust permits capital encroachments, only the spouse can receive the benefit of the capital. In other words, the remaining beneficiaries cannot receive any income or capital from the spousal trust until the spouse dies. Thus, the interests of the spouse and the children are opposed: to the extent that capital encroachments are made in favour of the spouse during her lifetime, there will be less to distribute among the children when the spouse dies.

Relationship dynamics matter

These conflicting interests may not be an issue if Sarah and Jibril have a good, or even just a cordial relationship with Rebekah. The same is true if the spousal trust has enough capital so that even if Rebekah draws a generous sum, there’s still enough for the children.

But suppose Jibril blames Rebekah for the breakdown of his parents’ marriage, or that Sarah believes Rebekah’s out for her father’s money. If they feel this way, every decision of the trustees will almost certainly be closely scrutinized. Resolutions in these cases can take years.

There are options for mitigating such conflicts. Mansur could consider including cash legacies in his will for his two children. They would provide an immediate benefit to Sarah and Jibril, which may help avoid, or at least diffuse, confrontations concerning the size of Rebekah’s capital encroachments.

Alternatively, Mansur could divide the residue of his estate between Rebekah, Sarah and Jibril. The children would get their shares outright; Rebekah’s would either be held in a spousal trust or distributed outright. If the entire residue’s distributed outright, it eliminates the conflicting interests that a spousal trust creates between Rebekah and the children.

But this solution isn’t perfect. Since the deferral of capital gains tax on death only applies to assets transferred to a spouse or a spousal trust, there will be no deferral for the residue given to Sarah and Jibril. But Mansur may decide that the goal of maintaining peace within the family is more valuable than the tax savings.

Consider provincial law

Whether or not he goes the spousal trust route, Mansur will need to consider Ontario’s Family Law Act. It says that when one spouse in a married couple dies, the surviving spouse may choose to get an equalization of net family property rather than gifts given in the will (rules of intestate succession apply where there’s no will). This is the same calculation, with some modifications, that married couples go through when there’s a marriage breakdown. It aims to equalize the respective growth in each spouse’s net worth during the course of
the marriage.

In general, the effect of the Family Law Act is that whenever a spouse does not receive at least half of the residue, there’s a possibility that the equalization payment will be greater than the gift under the will. For example, suppose Mansur decides to make specific gifts of his personal property and several cash legacies to named beneficiaries. He then leaves one-third of the residue of his estate to each of Rebekah, Sarah and Jibril. In that case, it’s possible Rebekah will receive more through an equalization payment than under the will. The outcome will depend on a number of factors, including whether Rebekah is named as a beneficiary under a life insurance policy or plan, or whether Mansur and Rebekah own property as joint tenants.

It’s much more common for a spouse to receive less than the entire residue in the case of a blended family. That increases the potential for a spouse to advance an equalization claim, which can overturn an otherwise well-planned estate. If Rebekah advances such a claim, Sarah and Jibril could be left feeling—justifiably or not—that part of their inheritance had been taken from them. To avoid this outcome, Mansur and Rebekah could enter into a marriage contract for the limited purpose of mutually waiving the right to make an equalization claim.

Darren Lund is an associate in the Toronto office of Borden Ladner Gervais LLP. His practice is focused on estate planning and administration. He can be reached at (416) 367-6358 or dlund@blg.com.

Originally published in Advisor's Edge Report

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