Keeping it in the family

“It’s something we’re seeing a lot of,” says Glen Brown, associate vice president of trust businesses, private client services, with TD Waterhouse Canada Inc. in Toronto.

“People are considering it even if their child ostensibly is in a very solid marriage.”

The trend is being driven by the significant level of assets that some clients are accumulating, Brown says, combined with general worries about the relatively high odds that a marriage will break down. According to a Statistics Canada report released in March, some 40.7% of marriages in Canada are projected to end in divorce before the marriage’s 30th year.

“In many cases, it’s the parents themselves who may have experienced a marriage breakdown,” says Christine Van Cauwenberghe, director of tax and estate planning with Investors Group Inc. in Winnipeg, “and they know how devastating it can be.”

A parent who has already seen his or her own personal wealth reduced by a divorce, she adds, may be especially keen to prevent that wealth from being further eroded through a child’s future marriage breakdown.

Fortunately, there are a few key options – both for parents leaving an inheritance and for the child who will be receiving one – that will help protect the assets in the case of the child’s divorce. Here is what you and your clients need to know:

– Separating assets

Legislation covering the calculation of net family property and its division upon divorce is complex and differs from province to province. In Quebec, the rules diverge notably from those in the other provinces.

In the most general terms, however, spouses who are divorcing will divide equally the value of all assets acquired during the marriage, as well as the increase in the value of all assets that were brought into the marriage. Although legislation differs widely among the provinces, the general rule is that spouses are allowed to keep the value of the assets they each brought into the marriage; but, in a number of provinces, marital homes are divisible regardless of when they were purchased.

Any inheritances or gifts spouses receive during the marriage do not have to be included in the shared family property that is divided during a divorce. However, in order to keep these assets excluded from shared property, the spouse receiving the asset must keep that asset in his or her own name – separate from other marital property. If, for instance, the inheritance is used to pay down a mortgage or other family debt, then it may no longer be considered separate and may become part of the marital property. If only part of an inheritance is kept separate, and the remaining part commingled with the marital assets, then it is possible that only the part that was kept separate reasonably can be claimed as excluded assets.

And while the inheritance can be kept separate from marital property, in many cases, any income or growth in its value will be included in the net marital property at divorce.

However, it is possible, in some jurisdictions, for the parents to strengthen their child’s claim to an inheritance, and any income or growth, by adding a clause in their will expressly stating that the inheritance, and any income and growth realized on the asset, is intended to go to their child alone and is not to be shared.

“[Such a clause] would protect the principal and the income or growth before the divorce,” Brown says. “If you did not spell that out, only the principal would be protected.”

However, if the child commingles the inheritance or the interest and growth it generates with marital property, such a clause in your client’s will is rendered ineffective.

Tax and estate specialists suggest that while keeping an inheritance separate from family property is a straightforward solution to protecting assets from a divorce, it may be difficult for a spouse to do so from a practical point of view.

Says Sara Plant, VP and national director of wealth services, BMO Harris Private Banking, at Bank of Montreal and CEO of Toronto-based BMO Trust Co.: “It would be very hard for, say, a 25-year-old who’s newly married and wants to buy a house to: one, remember to keep an inheritance in his or her own name; and, two, say to the other spouse, ‘I have all this money, but we’re not going to put into the house.’ Are you going to say to your spouse, ‘Just in case our marriage doesn’t last, I have to keep this [money] in my own name and separate’?”

As a financial advisor, Plant says, it’s important to let your clients know their options when it comes to protecting inheritances, and then let them make the choices that are right for their situations.

“As long as they know the rules,” she says, “they can make informed decisions.”

– Trusts

Another option available for parents looking to protect an estate from a child’s divorce is to set up the will so that the assets fall into a trust, with the child as the beneficiary, rather than leaving the assets to the child outright in the will.

The advantage of establishing a trust in this case is that the trust, not the beneficiary, is the owner of the assets held in the trust. If the trust is structured properly, the assets in the trust may be protected from the division of property during a divorce.

“The child as the beneficiary could enjoy the assets,” Brown says, “but he or she doesn’t own any of the assets. So, [the trust] protects them in case of marital breakup.”

Trusts offer other advantages that may be appealing from an estate-planning perspective. For example, because a trust is a separate “person” for income-tax purposes, the trust would be taxed separately – often, at a lower marginal rate than the beneficiary is.

Different types of trusts allow parents the option of attaching conditions to the way beneficiaries receive the assets in the trust. In a non-discretionary trust, the client can dictate exactly when the trustee is to transfer the assets to the beneficiary. For example, portions of the assets could be transferred when the client’s child reaches age 21, 25 and 30.

In a discretionary trust, the trustee, who is sometimes also the beneficiary, has full control of the timing of the transfer of assets.

Your clients can arrange to have more than one trust set up through their wills, or have one trust with multiple beneficiaries. This is often done when parents wish to have both children and grandchildren as beneficiaries of the estate, a scenario that is becoming more common in this age of blended families.

“If you’re trying to work through generations,” Plant says, “and attach certain terms and conditions, you do it through trusts.”

Says Brown: “Having an estate set up so that it falls into a trust allows you to spell out much more clearly what you would like to do.”

Your clients should keep in mind that trusts undergo a “deemed disposition” upon their 21st anniversary – meaning any capital gains on the assets in the trusts would be taxable as if they had been sold. Steps are usually taken to address this issue before the anniversary date, such as making sure all the assets have been transferred out.

When assets come out of the trust and are received by the beneficiary, it will then be up to him or her to keep those assets separate. Commingling the assets is likely to mean those assets would be considered part of marital property in a divorce.

– Marriage contracts

A contract between the spouses, agreed upon before marriage, may be the strongest way to protect specific assets. A marriage contract allows the spouses to opt out of the division of property rules in divorce legislation, agreeing instead to a predetermined division of property (within certain legal limits) should the marriage break down.

Marriage contracts often are employed in cases in which the intention is to exclude a specific asset from the shared marital property in a divorce.

“You see marriage contracts when you have an asset that is really important to keep in the family, such as a vacation property or a family business,” says Elaine Blades, director of fiduciary products and services with Bank of Nova Scotia’s private client group in Toronto. “If there’s a divorce, you don’t want an ex-spouse ending up getting a piece of a family business.”

And although the topic of a marriage contract is a sensitive one to discuss with a child, parents might feel more comfortable doing so when a specific asset is involved, Blades says. Specifying an asset (such as shares in the family business) may help the child understand why a marriage contract might be needed.

However, it’s vital that any discussion about a marriage contract be conducted before the marriage, to see whether the prospective spouse would be willing to waive his or her entitlement to a particular asset or assets. After the marriage, any leverage that may have existed is lost.

– Common-law relationships

Parents might be similarly concerned if a child is in a common-law relationship, says Van Cauwenberghe.

The rules governing common-law relationships vary widely among jurisdictions. In some provinces, common-law partners have rights to family property that are similar to those of married couples. In others, they have little claim to family property.

Some provinces enable common-law couples to enter into a more formal civil union-type of relationship, which may or may not give the respective partners a greater claim to family property upon the relationship’s dissolution.

Common-law partners always can draw up wills and estate plans that name the other partner as a beneficiary to certain, or all, property. But in provinces that allow only limited claim to family property, courts are increasingly granting ex-partners a greater claim, particularly if the relationship was long-term and if the couple had been raising children together.

– Family communication

Estate-planning specialists say that, overall, there is too little communication between the generations regarding clients’ estate wishes and concerns – starting with a reluctance to address the issue at all.

“A lot of people don’t want to face their own mortality,” Brown says, “so they don’t do the planning needed.”

In order for your clients to ensure their estate assets end up in the hands of their intended heirs, it’s vital that at least some discussion takes place between generations. If a beneficiary doesn’t understand why certain estate-planning decisions were made, he or she can easily and unwittingly render them ineffective.

Hurt feelings and family conflict can occur if there is no communication between those leaving an estate and those who will receive the benefits of it.

“You can let beneficiaries know [about the estate plan] in general, without necessarily going into the dollar values involved,” Blades says. “But we need to be conscious of giving estate advice to the next generation.”

A key step for you as an advisor, Brown says, is to determine your client’s wishes and ensure he or she receives good legal advice. And, he adds, make sure the estate plan is reviewed every time there is a major change in your client’s life.

You can play an important role, Van Cauwenberghe adds, as a neutral third party in conversations between the generations about estate plans: “It doesn’t have to be personal. A client can say to their child, ‘I’m meeting with my planner next week to discuss my estate plan. Do you want to come along? I want to discuss the best way of structuring it’.”IE

© 2012 Investment Executive. All rights reserved.