Does a Bankrupt Beneficiary's Trust Inheritance Go to Creditors?

If you are heading toward bankruptcy, or already struggling with debt, and a parent or relative has left you something in trust, it is natural to ask whether creditors can reach it. People often assume a trust is a safe box, but the answer is more nuanced.

This article explains the one bankruptcy rule that touches trusts, what it does and does not cover, and how a discretionary trust is treated in a related area, ODSP. Because the outcome depends on exact trust wording and timing, a lawyer or licensed insolvency professional should review your documents.

The basic rule about property held in trust

Section 67(1)(a) of the Bankruptcy and Insolvency Act says that property held by the bankrupt in trust for another person is not divisible among creditors. The key idea is whose property it really is. If you are only the trustee holding assets for someone else, those assets are not yours to be divided up.

That rule is about the bankrupt acting as trustee for others. It does not, on its own, say that your own interest as a beneficiary is out of creditors' reach. Whether a particular beneficial interest is protected depends on its nature and the trust terms, and that is a question for a lawyer.

Why the type of interest matters

Not every interest in a trust is the same. Some beneficiaries are entitled to a share outright. Others can only receive what the trustee decides to pay. Still others only benefit if some future event happens.

We cannot say here how a trustee in bankruptcy would treat each kind of interest in a specific case. The wording of the document, who the trustee is, and when the trust was created all affect the answer.

A useful comparison: discretionary trusts under ODSP

Ontario's ODSP rules show how much trust wording can matter. An absolute discretionary trust, sometimes called a Henson trust, is one where the trustee has absolute and sole discretion over payments to the beneficiary. Under ODSP policy it is not counted as an asset, so its capital may exceed $100,000. Other inheritance or insurance trusts available for maintenance are subject to a $100,000 combined limit, which does not apply to absolute discretionary trusts.

Payments out of the trust are still income in the month received unless exempt, for example up to $10,000 in any 12-month period for any purpose, or approved items such as disability-related items and services, non-reimbursable education or training, a principal residence, an exempt vehicle, or first and last month's rent. These exemptions depend on an annual report of trust transactions.

This is an ODSP rule, not a bankruptcy rule, so do not assume it carries over. It does show that discretion given to a trustee is treated very differently from a right to demand money.

Planning moves that can backfire

ODSP directives say a person entitled to an inheritance cannot put that inheritance into an absolute discretionary trust to avoid the asset test. How any similar step would be treated in a bankruptcy depends on your situation, so it is worth confirming with a lawyer before you take it.

• Do not give away, disclaim or redirect an inheritance without advice.
• Do not assume that a trust you did not create is automatically safe.
• Do not assume a trust you created for yourself is protected.

Tax and trust basics that still apply

Even if the trust itself is respected, tax still follows the money. A trust can deduct income that becomes payable to a beneficiary in the year, and the beneficiary includes that amount in their own income, so tax is paid by the beneficiary on income paid or payable to them and by the trust on income it retains. A beneficiary in financial difficulty may therefore still face a tax bill on trust income paid or payable to them.

What to do next

• Get a complete copy of the will or trust document and any amendments.
• Note who the trustee is and whether the trustee has absolute discretion over payments.
• List your debts and any payments you have received from the trust.
• Speak with a licensed insolvency professional and an estates lawyer before filing or making any transfers.
• Keep records of every distribution and any annual trust report, especially if you receive ODSP.

Frequently asked questions