Family vacation homes are more than just tangible assets with money value. They have strong emotional value. They’re places where families build and strengthen their ties around shared joys. They’re supposed to be places that offer a serene respite from daily conflicts.
So the desire of elders to transfer these homes to their children and keep them in the family is understandable. But there are inherent problems when one elder owner wants to transfer a house to what are likely multiple younger co-owners in the junior generation. And these assets then become petri dishes of conflict.
Sources Of Conflict
The unique nature of the cottage as a jointly owned, sentimental family heirloom makes it a very different financial asset. Cottages are costly, for one thing, and children might eventually face creditors (including divorcing spouses). Sibling rivalries are also magnified when it’s time for planning a house transfer. Given the increasing costs of maintenance, repairs and property taxes, vacation homes can agitate and inflame resentments among children who have different amounts of wealth and resources to keep the cottage up.
To ensure peace, the hard work of cottage succession planning must begin before the conflicts do. A successful transfer plan must address the following:
• Who is allowed to use the home? And does that group of users, for example, include adult stepchildren of a divorced spouse? Does it include college friends or close neighborhood friends of minor children?
• Who pays for what? Taxes? Insurance? Maintenance? Improvements or major repairs (such as a new roof)? Other expenses?
• Who chooses and maintains the furnishings and other matters of interior decoration? Who pays for any aesthetic updating unrelated to wear and tear?
• What are the standards of conduct for guests? Are pets allowed? Is smoking?
• How do you determine who gets the prime weeks of the year to use the cottage?
Aside from property management issues, families inheriting cottages are entering a new co-ownership with multiple people. And it’s likely that at least one co-owner will have problems. Such co-owners might simply not want to own property, for financial reasons or otherwise. They may be unable to afford to pay cottage expenses. Or maybe they need money and resent having their inheritance trapped in a piece of property.
If the original planning does not anticipate the economic realities of such inheritors, the parents’ wishes may end up being thwarted, as many joint ownership court decisions demonstrate.
The Form Of Ownership Matters
The usual plan when a widowed spouse leaves a jointly owned family cottage to the kids is to “give” it to them equally. And this is exactly how the problems begin: If the surviving spouse gifts or bequeaths a cottage to multiple children or other beneficiaries, either when she’s still alive or after she dies, the recipients will probably acquire joint ownership of the property as tenants in common unless she designates otherwise.
A tenancy in common is a type of shared ownership of property, where each co-tenant (or co-owner) owns a share—typically, but not necessarily, equal—of the entire property. There are no rights of survivorship in these situations, so if a co-tenant dies, her interest passes according to her will or applicable state laws of intestacy, if she did not have a valid will.
All co-tenants have the right to occupy the property in these cases, regardless of the size of their individual ownership stakes. As tenants in common, each has the right to freely sell, pledge or otherwise dispose of her interest in the cottage to whomever she chooses, for whatever reason she has, without consent from any other co-tenants, either while she’s alive or after she dies. Each co-tenant’s interest in the cottage may be subject to creditors’ claims, divorce claims or even court-ordered partition by one or more disgruntled co-tenants who want to “cash out.” This could lead to a compulsory sale of the cottage. In fact, a court-ordered partition sale can occur even if the remaining co-tenants do not want to sell. It’s not uncommon for a disgruntled or cash-strapped co-tenant to sell her interest to a real estate developer who subsequently files a partition action to force a sale and acquire the entire property for a price below its fair market value.
In short, a tenancy in common by itself is more likely to lead to family conflict than to family harmony. This is surely not a desirable outcome.
Fortunately, there is a succession planning solution that is customizable, flexible and workable, and it can be specifically designed to ensure that the family cottage remains in the family.
Family Cottage LLC
Family limited liability companies (FLLCs) are often used with other family wealth transfer strategies by families conducting their own business or investment enterprise to efficiently transfer value to younger generations. These entities are particularly useful for dividing ownership in family assets among family members when members of the senior generation want to keep a significant management stake or control of transferred interests (even though their retained control may have gift and estate tax implications). For a number of reasons, the FLLC has become one of the preferred legal entities for attorneys specializing in cottage succession planning.
There are several reasons to consider using an FLLC:
1. It could prevent a forced sale of the family cottage by a partition suit.
2. It could prevent the transfer of cottage ownership interests to non-family members.
3. It could shield owners from the claims of the FLLC’s creditors.
4. It could provide for an endowment to fund cottage expenses or enforce assessments among the members.
5. It could provide for alternative dispute resolution options when legal disagreements about ownership occur.
6. It could allocate future control of the cottage between or among younger generations.
The LLC incorporates many of the best attributes of corporations—limited liability—and the simplicity, flexibility and income taxation of partnerships. They are formed under state law—usually, but not necessarily, in the state where the cottage is located—by filing articles of organization with state regulators. They are treated as separate legal entities for state law purposes. Typically, the articles of organization must provide certain data, including:
• The name of the LLC;
• The purpose for organizing;
• The address of the LLC’s principal place of business and the name and address of its registered agent in the state; and
• The names and addresses of the manager(s) of the entity if manager-managed, or the members’ names and addresses if the LLC is managed by members.
A word of caution: Family LLC planning requires a knowledgeable attorney familiar with business entities and estate planning, since each state has its own LLC statute.
In the articles of organization, the organizer chooses whether the LLC will be member-managed and controlled directly by its owners or, alternatively, manager-managed and primarily controlled by one or more managers appointed or elected by the other members. With a manager-managed LLC, decision-making can be concentrated in one or more of the owners. For example, Mom and Dad could name themselves as managers of the family cottage LLC but transfer significant non-manager LLC interests to their children.
The FLLC can be formed while the original owners, such as the parents, are still alive or when the last one dies. It might be advisable to form the LLC for a family cottage when the original owners are still alive if they want to make gifts to children as part of their ongoing wealth transfer plans. Federal and state income, gift, estate and generation-skipping transfer taxes, as well as applicable state and local property taxes, must be considered in forming the FLLC and in planning for transfers of ownership interests to family members.
Creating the Operating Agreement
The key feature of the LLC for cottage succession is the “operating agreement.” This agreement among the members governs the LLC’s operation and its members’ financial and managerial rights and duties. The agreement defines each member’s or manager’s rights, powers and entitlements, and should set forth the cottage operating rules. Ownership restrictions may be incorporated into the operating agreement to ensure that the ownership remains in the family. Although the articles of incorporation are publicly available, the LLC operating agreement is not, and may be amended at any time as provided in the agreement.
It’s the operating agreement that ultimately determines whether the succession plan will fulfill the intentions of the cottage owners. An effective agreement takes at least two steps by two different groups. First, the property owners and their family must understand, discuss and set out the informal rules that have governed or should govern the ownership and use of the cottage. Second, and perhaps most important, the cottage owners must communicate those agreed upon rules and practices to the estate planning attorneys so that they can formally incorporate the family’s informal agreements and intentions into the FLLC.
Provisions related to the use of the cottage.
The provisions in the operating agreement related to scheduling and use of the house are vital to the smooth and satisfying operation of a shared family cottage. A simple and workable system for home-sharing requires preplanning and the consideration of family traditions, goals and needs. At a minimum, the sharing system must address both how the time is divided and who may use the cottage, including parents, surviving spouses, pets, cousins, renters and guests. A workable and lasting sharing system should be fair and simple, clearly stated, in proportion to ownership and in accord with the family traditions and culture.
Provisions related to the management of the cottage.
In forming your Family Cottage LLC, you have to choose whether to organize as a member-managed or manager-managed LLC. With the former, each member (or member’s representative) has a vote on everything from buying new bathroom towels to whether to sell the cottage. This type of decision-making may work well when there are just a few equal owners, but it will likely be unworkable when there are many owners. If the FLLC is manager-managed instead, members are able to vote or appoint one or more managers with authority to handle routine decisions without consulting the rest of the owners. In the operating agreement, the members can grant the manager or managers as much or as little power as they agree on, while also reserving certain matters in which each member would want a say, such as the ability to amend the operating agreement, mortgage the property, permit rental of the cottage or sell it.
The key consideration in deciding the management structure should be family dynamics. If there are or will be one or more highly involved family members and others that want minimal involvement, it may work out best to have the involved family members be managers of a manager-managed FLLC. If everyone in the family has an equal commitment to and involvement with the cottage, it may be best to use a member-managed FLLC and provide for cottage committees in the operating agreement.
Anytime a family and its trusted legal and tax advisors can engage in candid and focused succession planning, they stand a much better chance of keeping the family vacation home in the family for multiple generations. An FLLC, specifically an FLLC operating agreement, can convert that “candid focus” into a binding legal agreement specifically designed to help families capture traditions and continue creating cherished memories.
Benjamin Lavin is a wealth planner and associate tax strategist at Northern Trust.
Raymond C. Odom is a managing wealth planner and director of wealth transfer services at Northern Trust.
They can be reached at (866) 803-5857.
