Can Creditors Claim a Bankrupt Beneficiary’s Trust Funds?

May 6, 2022
An empty wallet

Written on behalf of Feigenbaum Consulting

A beneficiary’s name being mentioned in a Will or trust might provide some positivity during a difficult time in a person’s life. However, there can be situations where inheriting assets could trigger negative consequences that lead to estate litigation.

A recent decision of the Court of Appeal for Ontario involved an estate beneficiary who was going through bankruptcy. The Court was asked to determine whether the funds he was due to receive from the sale of a house could go to him directly or if the money would have to be used to pay off his creditors.

Beneficiary of trust was due to inherit proceeds from the sale of parents’ house

The case in question, Re Richards, involved the beneficiary of a trust that owned property in Toronto. The beneficiary’s father set up the trust in 2001, and it was structured in a way that allowed the beneficiary’s parents to have a life interest in their home.

The beneficiary’s father died in 2010. His mother continued to live in the home until her death in 2020. The trust called the mother’s death the “Time of Division” and required the trust to sell the home and distribute the funds to the beneficiary. The value of the home’s proceeds was $1,172,120.90.

RBC sought recovery of judgment out of sale proceeds held in trust

At the time of the trial, the beneficiary had an undischarged bankruptcy and was the subject of an outstanding judgment of $987,613 held by the Royal Bank of Canada (RBC). RBC applied under the Bankruptcy and Insolvency Act to make a claim against the sale proceeds of the property, which were held by the beneficiary’s Trustee in Bankruptcy. RBC then brought a motion to the courts to recover the amounts owed to it on the basis that the sale proceeds constituted property owned by the beneficiary.

Trust provisions stated beneficiary’s interest ceases during bankruptcy

The Court noted that the trust contained an “unusual” provision, which stated that the beneficiary’s rights under the trust were only enforceable until he became bankrupt:

“Any right of a Beneficiary to receive any income or capital of the Trust Fund … shall be enforceable only until such Beneficiary shall become bankrupt … the Beneficiary’s Interest shall cease until the cause of the Beneficiary’s Interest becoming vested in or belong to or being payable to a person other than such Beneficiary shall have ceased to exist… and then the Beneficiary’s Interest shall again be allocated to such Beneficiary as aforesaid unless and until a like or similar event shall happen…”

In effect, the trust provided that the beneficiary’s interest in the property would cease any time he went through bankruptcy. His entitlements under the trust would only be reinstated once the situation causing his interest in the trust to become payable to someone else “ceased to exist” (i.e. his bankruptcy was discharged).

Bankruptcy judge found mandatory distribution clause overrode bankruptcy provision

Relying on the terms of the trust, the beneficiary stated that his interest in the property’s sale proceeds was suspended while he went through bankruptcy. He claimed that, as a result, his interest in the funds could only vest once his bankruptcy had been discharged.

In the initial proceedings, the bankruptcy judge disagreed with the beneficiary’s position and pointed instead to the mandatory distribution provision of the trust. That provision provided that, at the Time of Division (i.e. the remaining parent’s death), the trust property shall transfer to the beneficiary if he is alive. The bankruptcy judge found that this requirement overrode the section about bankruptcy. If that had not been the beneficiary’s parents’ intention, the judge stated that clear language to the contrary should have been included in the trust.

As a result, the bankruptcy judge held that the trust property was vested in the beneficiary at the Time of Division. Because the beneficiary was bankrupt, his interests were taken over by his Trustee in Bankruptcy, who transferred that interest to RBC. RBC was then entitled to recover the amounts owing to it from the proceeds of the sale.

Anti-deprivation rule prevents beneficiary from using trust to shield assets from bankruptcy: Court of Appeal

The beneficiary appealed to the Ontario Court of Appeal, which found no error in the bankruptcy judge’s decision. The Court agreed with the bankruptcy judge’s interpretation of the trust, finding it to be consistent with the plain wording of its provisions.

The Court also held that public policy considerations weighed against the beneficiary’s appeal. It pointed to the anti-deprivation rule, which is a legal principle that aims to prevent people from shielding their assets from bankruptcy and is an underlying aim of the Bankruptcy and Insolvency Act. As per the Supreme Court of Canada in the 2020 decision of Chandos Construction Ltd. v. Deloitte Restructuring Inc.:

“… the anti-deprivation rule renders void contractual provisions that, upon insolvency, remove value that would otherwise have been available to an insolvent person’s creditors from their reach.”

As the Court of Appeal found no error in the bankruptcy judge’s interpretation of the trust and based on the anti-deprivation rule, the beneficiary’s appeal was dismissed. He was ordered to pay $17,500 in costs.

Contact Feigenbaum Consulting in Toronto for Comprehensive Estate Planning Services

Effective estate planning and addressing estate tax or inheritance issues requires knowledgeable guidance. Feigenbaum Consulting helps clients avoid legal and financial risks when securing their family’s financial future. As a lawyer and tax professional, Mark Feigenbaum is uniquely positioned to provide this multidisciplinary approach to estate and tax planning. He also has extensive estate litigation experience and advocates for clients when matters are better handled in court. To schedule a consultation, contact the firm online or call (905) 695-1269 (toll-free at (877) 275-4792).

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