Estate planning for blended families

Disclaimer: The content of this post is based on Ontario law. Certain details may not apply in other provinces.

John and Jane are newly remarried. Both in their early 40s, each of them has two children from a previous relationship. Being careful and responsible people, they want to ensure everyone in their new “blended” family will be looked after fairly in the event of their deaths. There are a few options available to them.

In their first marriages, their lawyers helped them prepare “mirror” or “reciprocal” wills. With mirror will planning, each spouse prepares a will leaving his or her whole estate to the other—or, alternatively, should one of them have already died, dividing the estate among the same set of beneficiaries (typically, their children). In John’s case, the effect of this planning was that, if John died before his (now) ex-wife, his assets would pass outright to her; on her death (assuming she did not change her will), her estate (which would have absorbed John’s estate on his death) would be divided as they had agreed during life: among their children.

This was a good plan at the time. John was happy to give his estate to his spouse, with the expectation that their children would become the ultimate beneficiaries of their combined assets. Their lawyer explained to them that this plan relied on trusting one another. She explained that once the first spouse had passed away, his or her assets would be gifted absolutely—it would become the outright property of the survivor. That would mean that the surviving spouse could decide, at any time while he or she had capacity, to write a new will, leaving his or her enlarged estate to someone other than the children. However, both spouses were comfortable trusting one another not to change their wills since they shared an interest in gifting their mutual children their combined estates.

Now, things are different. John and Jane’s relationships with their previous partners have ended and they both need a fresh estate plan. Although John and Jane both want to ensure the comfort of their new partner after they have passed, their interests do not align with regard to the ultimate beneficiaries of their estates. They both have children from their previous relationships and each of the new spouses wants to leave his or her respective estate to them.

They could opt for mirror wills again, naming their collective children as equal ultimate beneficiaries. But now they have less confidence that their new partners will treat all the children equally, instead of favouring his or her own children once widowed. From Jane’s perspective, if John survives her, even if he doesn’t change his will (which he could), he might prefer his own children by making big gifts to them during his life, shrinking their combined estate and ultimately reducing the size of the share available to Jane’s children on his death. Or maybe John remarries again, adding another new spouse and children for whom he wishes to provide—perhaps even using assets inherited from Jane!

Option 1: The mutual wills agreement
One planning strategy available to John and Jane is a mutual wills agreement. This is a contract between two people (typically spouses) to keep certain provisions in their wills in place. Most often, the contract prohibits both people from changing their wills without the consent of the other while they are both alive, and when the first person passes away, the survivor forever loses the right to change his or her will or deplete the estate through extraordinary gifts. Provisions limiting future changes may be written directly into wills or a separate, written contract may be prepared (or both). With this planning, the estate of the first spouse to die is still gifted outright to the survivor, but the mutual wills agreement creates a personal right restricting the future testamentary freedom of the surviving party.

A mutual wills agreement is a useful tool available to prevent a widower from re-gifting a spousal inheritance. If John and Jane elect to enter into one, Jane’s children will have standing to sue John or his estate in the event John breaches the terms of the agreement during his life, either by preferring his own children with extraordinary lifetime gifts or by re-making his will to reduce the entitlement of Jane’s children—perhaps as a result of a new marriage. Indeed, the use of a mutual wills agreement need not be limited to a blended family situation. Spouses in a first marriage may also want an agreement that locks in the distribution they decide on together so as to protect the inheritance of their children from claims by subsequent spouses.

There are disadvantages, though, too. First, depending on the wording of the contract, it may be inflexible. Upon the death of the first to die, provided he has kept his side of the bargain and not changed his will without consent, the agreement becomes irrevocable. This, of course, is the point. But if the surviving spouse goes on to live for many decades more, she may come to resent the loss of testamentary freedom, especially if, through years of work or an inheritance, she has grown the estate well beyond the size it was when the agreement was struck. Drafting an agreement that is flexible enough to permit some later adjustment in planning, but not so flexible as to defeat the purpose of the agreement, is a significant challenge.

Second, a mutual wills agreement is a contract, and therefore only gives a personal right for enforcement. This means that, in principle, the disappointed beneficiaries will have to apply to a court for enforcement—a costly and emotionally difficult way to preserve their inheritance, and not necessarily successful if the assets have already been dissipated. It would also be prudent to inform the expectant beneficiaries of the existence of the agreement and provide a copy to them (or write the terms directly into the will), lest they never learn that this right is afforded them.

Third, the agreement may be difficult to interpret. What, for instance, constitutes an extraordinary gift? This is a factual determination that may be difficult to define—even if the surviving spouse is genuinely attempting to follow the agreement’s terms.

Option 2: The spousal trust
Another planning option available to John and Jane is the settlement of a spousal trust. A trust is an arrangement whereby one person (the “settlor”) gives property to a second person (the “trustee”) to administer for the benefit of a third person (the “beneficiary”)—although, in practice, these need not be different people. A spousal trust is simply a trust to benefit a spouse during his or her lifetime.

John’s will, for instance, could provide that, upon John’s death, his assets are to be held in trust for Jane’s lifetime. Jane would be entitled to receive all the income generated by the assets held in trust for her (investment income from a share portfolio, rents from real estate, etc.) and whatever portion of the sale proceeds of any of the trust assets the trustees of the spousal trust deem necessary to fund care for Jane. On Jane’s death, the assets remaining in the trust could be divided among John’s children.

In this way, John could use his estate to provide for Jane during her lifetime, but since only the income and capital actually paid to Jane from the spousal trust would belong to her outright, John would not need to rely on Jane preparing or maintaining a will that provides for his children (or his children applying to a court to enforce the terms of a mutual wills agreement). The terms of John’s trust would ensure that, on Jane’s death, any assets remaining in the trust would pass to them. A trust drafted in this manner would also preserve the favourable tax treatment that usually accompanies gifts between spouses.

If John uses this strategy, he must be careful that the assets he intends to fund the trust are in his name alone and pass under his will at death. For instance, assets that are held jointly with Jane (where the joint ownership has not been “severed” into a tenancy-in-common) could pass automatically to her outright, and therefore outside of the trust. John must also appoint the trustees of the spousal trust carefully. His children, having a conflict between their duty to care faithfully for their stepmother and their personal interest in maximizing the value of the trust assets for their own eventual benefit, might not be good candidates. If he is comfortable with the fees, John may instead consider appointing a professional trustee to ensure impartiality.

If John and Jane are interested in preparing spousal trusts for each other, they must also consider the implication of family law rules. Legally married spouses are entitled to override a distribution made in a will and instead apply under the Family Law Act to receive an equalization of property on the death of their spouse—essentially preserving the entitlement they would have had in the event of a divorce. This means that, even if a will is drafted to exclude a spouse, the surviving spouse can apply to a court to set aside the distribution under the will and take instead his or her entitlement under family law. Since a spousal trust does not give the spouse an outright entitlement to the trust fund, a surviving spouse may prefer to make an election under the Family Law Act to take his or her share of equalized property instead.

To address this concern, John and Jane should consider entering into a domestic contract prepared with independent legal advice from qualified family law lawyers according to the rules for domestic contracts set out in the Family Law Act. The domestic contract should contain an express waiver of the right to make such an election and a promise to accept the terms of each other’s wills.

Happily ever onward
Members of blended families understand that their affairs are complicated, but they should take advantage of these and other strategies to ensure their loved ones are protected and that their children remain beneficiaries of their estates. The best course is to speak with a lawyer to receive advice tailored to your unique set of circumstances.

Learn more about how KPMG can advise you in your estate and trust planning decisions.