Dan A. Penning

Cubby holes filled with trinkets and treasures
While waving hello to neighboring friends you realize every family cottage and summer home is as different as the memories gathered by families every summer. Each cottage has a special cubby hole filled with trinkets and treasures from sandy beaches and hiking adventures through surrounding woods. Weathered hinges guarantee screen doors will squeak open and slam shut right on cue announcing that this is summer. It’s easy to get caught up in the moment of racing down to the lake and assuming every summer will be just like the last.

My son Casey has been crossing out days on the calendar as the school year winds down into his summer up north. He’s been talking non-stop about everything he wants to do this summer, and spending time with those who are a part of his summer. Without fail, his list includes everything he wants to do each summer. I’ve also been thinking about these excursions and of how to keep our lunch dry during our annual trip down the Crystal River (see photo).

As much as family cottages and memories stay constant, change and different circumstances ultimately visit families over time. Your family cottage is often one of your most valuable legacy assets and attention should be directed to new options and enacted tax laws available to you to protect your family cottage now, and for future generations.

Family goals remain the same
It’s no surprise that in spite of our busy lives some things never change. Family goals remain the same of protecting those you love, the place you love, and protecting the experiences and cottage memories you love.

When your family begins to gather this summer consider talking with them about the future of the family cottage. Now might be the time to begin the discussions about developing a cottage succession plan, if you haven’t already, and looking at short- and long-term strategies and legal structures to avoid the uncapping of your property.

At the minimum, a solid cottage succession plan protects your family cottage from passing outside the family, solves future conflicts between family members about how the family cottage is operated, maintained and improved, and probably most important of all, avoids, through the right to partition governed by real estate laws, the forced sale of your family cottage.

Even a simple plan, which you can easily change and update, is better than the consequence of not having a protective cottage succession plan in place.

Protecting a special place
You know deep in your heart this is where your family memories live, and like a protective mother bear you’ll do whatever you need to do to protect this time, this special place for future generations.

If you have questions or need additional information about planning for your cottage, please call and also visit our Cottage Law website about how to protect the family cottage at www.Cottage-Law.com.

Now if I could just figure out a way to protect my brown-bag lunch during my upcoming water adventures with Casey….

Dan

This is how summers have always been. You enjoy the laughter of denials and finger-pointing about who created the latest mysterious heap of sandy wet towels on the cottage porch floor. The children stand shivering from their latest dip in the lake and you silently wager bets against how long it will take for the lake water drops hanging from ends of clumped wet bangs to land on the table.

It’s almost impossible to imagine this won’t be how you, your children and your grandchildren will spend every summer. Although the idea of family cottage sharing seems like a simple process, the reality of real estate laws and rhythms of life and death, along with divorce laws, could prevent your vision of harmonious sharing of the family cottage by future generations from becoming a reality.

The first obstacle facing the future of the family cottage is knowing how your children view their “legal rights” to the family cottage. Some may not be as emotionally attached to the family cottage and due to their own personal circumstances might not want any part of the family cottage. Your children who live in another state might not want any part of the cottage because they don’t use it, or can’t afford it, or they might want to simply “cash out their inheritance.” The risk always exists that they might lose their portion of the cottage during a divorce. These situations, and the right to partition, can be avoided with a solid cottage succession plan, or as some call it, a vacation property succession plan, from The Penning Group.

Cottage Planning Laws

Protect the Family Cottage using Entity Laws

In 1993 Michigan created the Michigan Limited Liability Company Act (LLC). The creation of this Public Act provides the legal framework, through Entity Laws, to change the relationship of owners. Before Michigan created the Michigan Limited Liability Company Act (LLC), many families relied on partnerships, limited partnerships, joint ownership, or co-tenancy as the structure for owning family cottages or other vacation property. Each of these forms of ownership have drawbacks to ownership that can now be addressed with a Michigan LLC because real estate law surprises put the family cottage at risk.

A Cottage Succession Plan
A Cottage Succession Plan created by The Penning Group will be structured under the laws governed by the Michigan Limited Liability Company Act, to keep your current traditions in place while protecting the family cottage for future generations from disagreements, forced ownership changes, family members failing to pay their fair share of ownership costs, etc. Indirect ownership of the family cottage using entity laws also shields and protects the cottage owner from personal liability in the event a person is injured while at the cottage.

Cottage Sharing – It Is Not Easy
Below are seven common cottage-related concerns of those facing “cottage sharing” within their family – concerns which are addressed and resolved within a Cottage Succession Plan created for you by The Penning Group:

• The possibility that ownership of a part of the cottage will pass into the hands of a non-family member as a consequence of death or a divorce.
• What to do if a family member is not able or not willing to meet any or all financial commitments to the cottage.
• The financial impact on the cottage if a family owner files bankruptcy, or a portion of the cottage’s interest is levied by a creditor of a family member.
• How to solve internal conflicts between family member about how the cottage is operated, maintained and improved.
• A family member wants to “cash out” their interest of the family cottage.
• Disharmony and even possible litigation between siblings when parents are no longer around to mediate a peaceful resolution.
• What happens when a child, or children cannot afford to keep the cottage.

Cottage Plan Consultation

You have worked hard to have a special place for your family to go, and we want to help you preserve your investment for future generations. For further assistance in protecting the family cottage, contact me at 231-271-4500 for a free initial consultation to discuss your family cottage and what you already have in place, and whether it will accomplish the future plans you have for your family’s future use and enjoyment of your family cottage or other vacation property.

Have a great summer at the family cottage!

Dan A. Penning

Water access points along Michigan’s inland lakes
As families begin contemplating vacations up north or weekend getaways to one of Michigan’s many inland lakes, water access points deserve careful consideration as they have become sources of lawsuits regarding the public’s right to access the surface of the water from public roads adjacent to the water. Many of these lakes are bordered by subdivisions that were platted decades ago and depending on the language in the plat and the type of public roads, whether perpendicular or lateral to the lake, will determine whether the surface of the water can be accessed by the public by means of the platted streets.

When the public may use road to access the surface of the water
In Michigan, if a road has been dedicated to public use and essentially runs perpendicular to a body of water and the road ends at the body of water, the public may use the road to access the surface of the water. What has become problematic for nearby property owners, however, is when public water access expands to include parties, picnics, trespassing on neighboring property, etc., which has resulted in some of these access points becoming more like a public park.

Activities allowed at water access points
The Michigan Court of Appeals in 2003 clarified the activities that are allowed at such water access points (where public roads provide access to a lake or other body of water). Absent a contrary intent that can be established by the dedication plat, the permissible activities are limited to accessing the water and the installation of a public dock because it assists in providing access to the water. Other activities, such as those normally conducted at public parks like games and sunbathing, are prohibited, including the anchoring of boats and other watercraft on a nontemporary basis.

Roads that encircle lakes with cottages across the road
An additional water access issue relative to roads involves public roads that encircle all or a part of lake with the property owners’ homes on the opposite side of the road from the lake. At issue in certain locales is the water access rights that the lateral public road may serve to provide to the public. The road severs the portion of the lot adjacent to the water from the lot across the road, commonly with a dwelling on it. In 2009, the Michigan Supreme Court determined that the dedication of the public road does not serve to sever the property owner from their riparian rights and thus, the public is not granted access to the water over the portion of the lots on the waterfront.

Accessing the surface of the water via a public road end
The public can access the surface of the water via a public road end, that is usually laid out perpendicular to the water and a public dock may be installed to aid the public’s access to the water. Other recreational activities are prohibited unless the dedicated plat indicates otherwise. The public cannot access the water via an adjacent lateral road because the dedication of the road to the public does not include the riparian rights associated with the lots separated from the water by the lateral road.

Determining legal rights
So if you are visiting a lake or if your family cottage property is adjacent to a lake with public roads as described above, this information may be useful to aid you in determining the legal rights the public has to access the surface of the water, also being mindful of trespassing violations on private property and what may constitute violations of state law to access the water.

Dan A. Penning

Yes, it’s true when they say, “beauty is in the eye of the beholder,” and it’s especially true when thinking of the family cottage. Whether the family cottage is a family retreat in some stunning mountain region, or a luxurious custom built retirement home on one of the Great Lakes touching Michigan, Illinois, Wisconsin, New York, Ohio, Indiana or even Canada, or a small rustic cabin on a pristine lake or stream, it’s not “economic value” that is the most important factor to protect the family cottage, it’s the “emotional value.”

People make a place special. This is never more true than when it comes to the family cottage, it can be argued “the place” is special, sometimes almost magical, and can transform those who spend time in that place from being stressed out, overworked adults back to their carefree days as a child; skipping rocks on the water, swimming off the dock, nursing a sunburn and eating s’mores by the campfire. For most, the family cottage creates a place for memories and traditions to be formed and a safe haven to retreat to for rest, reflection and reminiscing later in life. The family cottage is a constant in an ever-changing world. It’s where experiences can be shared and passed on to the next generation in their purest form.

Protecting the family cottage requires careful planning, cooperation among family members and a common purpose. It’s those intense family emotions that fuel the desire to protect the family cottage to keep the family cottage in the family to preserve “the place” for future generations of “people” to experience and enjoy.

There are different types of ownership forms that exist and can facilitate preservation of the family cottage, including the positive and negative aspects of each form of ownership.

Outright / Direct Transfers of Ownership

A direct transfer of ownership interest from one generation of owners, (i.e. parents) to the next (i.e. children) can be in the form of joint tenants with rights of survivorship, tenants in common or a life estate for the older generation with the younger generation receiving a “remainder” ownership interest in the family cottage. In summary, these forms of ownership involve transfers by deed of some or all of the current owners’ outright ownership to other individuals such as children, grandchildren or others.

The benefits of direct transfers of ownership by one generation to the next are as follows:

• The transfer can easily and economically occur by simply drafting and recording a deed reciting the form of ownership interest transferred.
• Fractional interest or “part interest” can be transferred to assist the transferors with estate tax planning objectives. Establishing fractional interests for the family cottage can provide discounts to lower ownership values in the transferors’ estate.
• Transfers whereby the transferors (parents) retain a partial ownership interest can, in most instances, provide a right for the parents’ continued use and enjoyment of the family cottage during their lifetime.
• Direct transfers can, in certain circumstances, be useful as part of a larger overall long-term care or Medicaid planning process to help parents protect the family cottage from having to be sold to raise proceeds to pay for long-term medical or supportive care expenses.

Direct transfers of ownership can also provide negative consequences. They are as follows:

• If the transfers are done without an overall analysis of estate, gift and income and property taxes, the parents can find themselves with unintended tax consequences.
• Direct transfers of ownership interest can create unintended consequences of exposing the family cottage to the claims of their children’s creditors.
• Direct transfers of ownership can expose the family cottage to claims by the spouse of a child in the event of a divorce.
• Direct transfers cannot guarantee that one or more family members will get along in the future. Disputes can arise without accompanying safeguards to transfer ownership that could result in the whole family being in court and a judge ordering the family cottage sold. In addition, an unexpected economic hardship may arise among one or more of the children owning the family cottage and their wanting to sell their interest in the cottage which can also cause complications for the non-selling individual owners and can ultimately lead to an impasse regarding any resolution of the situation ultimately requiring a sale of the family cottage altogether in its entirety to a third party.

Ownership of the Family Cottage in a Trust

Ownership of a family cottage can also be in a lifetime trust. There are two common trusts for this purpose. In both instances, the transfer of ownership is simple in that it is accomplished by the execution and recording of a deed.

The first type of trust is a revocable living trust. The benefits of this type of ownership are as follows:

• Ownership of the family cottage in a revocable trust maintains the parents’ control of the property during their lifetime. The parents can be the current trustees of the trust during their lifetime, thus retaining full authority to make all decisions on the use, management and even disposition of ownership to a third party in the event of an unexpected need or occurrence.
• The revocable trust is a grantor trust for income tax purposes so any transactions for the family cottage such as payment of expenses and property taxes is reported and deductible by the parents/grantors in the same way as if they owned the family cottage in their individual names.
• If a parent/grantor is disabled, usually a successor trustee is appointed in the trust, who then continues to manage the family cottage without interruption or court involvement.
• In the event of either the grantor parents’ disability of death, the family cottage is not subject to probate administration and that the terms of the trust govern the disposition of the family cottage and asset of the trust.

However, placing a family cottage in ownership of a revocable trust can have certain detriments. These are as follows:

• The full fair market value of the family vacation home will be included in the parents/grantors’ taxable estate if the family cottage is titled in the parents’ revocable trust.
• If the transfer of the family cottage was simply made to the trust and there were no provisions for a “succession plan” the family cottage then remains in the grantors’ revocable trust with no specific direction as to its disposition at the parents’ death. Also, any contributions of funds that may be necessary to pay for expenses of the family cottage may prevent gift tax issues if the title of the family cottage remains in the parents’ revocable living trust
• A revocable living trust is generally not a good option in situations where multiple parties are required to make capital contributions for improvements or sharing expenses for maintenance. If a parent/grantor becomes disabled and a successor trustee is appointed, the successor trustee may not have the discretion to keep the family cottage “alive and well”. If the grantor needs funds for other reasons (for example, health, support, medical treatment and so on), the successor trustee may be forced to sell the family cottage to raise funds for those purposes.
• Creditor protection is limited with a revocable living trust based on the fact that it is a “self-settled trust” whereby the grantors/parents simply transfer by deed ownership to the trust and maintains total control during the trust during his/her or their lifetime. In most states, creditors can pierce through the trust ownership of the family cottage and attach it for judgment liens or other liabilities.

A second type of trust that is sometimes used for ownership of family cottages is a qualified personal residence trust (“QPRT”).

The QPRT is a trust where the grantors/parents make a gift of the family cottage to the trust while essentially retaining an interest similar to a life estate for the term of years of the QPRT. As a result, the parents maintain the use and enjoyment of the family cottage during the QPRT’s term of years. A gift of the interest in the family cottage using a QPRT is less than if the gift were made outright by the parents to their children. The QPRT allows for gifts of fractional interest, thereby reducing the gift tax clause. The QPRT is also a grantor trust for income tax purposes so all deductible costs (i.e., real estate taxes) continue to be deductible by the grantor parents for income tax purposes during the term of the trust. The QPRT can also be a useful tool in minimizing the grantors/parents estate tax liability. Basically, a complete gift of the family cottage from the parents to the QPRT, based on the parents’ retaining the use and enjoyment of the family cottage during the term of the QPRT, allows for a reduction of the amount actually counted as a gift for gift tax purposes. As a result, a complete gift of the family cottage can be made for much less than the fair market value of the cottage and all future appreciation of the cottage can be excluded from the parents’ estate.

The detriments of transferring a family cottage to a QPRT is if a grantor/parent dies during the QPRT term, the fair market value of the family cottage is then accountable in the grantor/parent’s estate for estate tax purposes. That could result in a waste of the gift tax credit. In addition, at the end of a QPRT term, if a grantor/parent survives and continues to occupy the family cottage, the grantor/parent must rent the family vacation home from the QPRT continuation trust or the QPRT individual beneficiaries (i.e., children) at fair rental value. This can also be a benefit in that parents seeking to transfer wealth from their estates to their children can do so by the amount of the rental payments over time. If the family cottage is sold during the QPRT term, the net proceeds of the sale must be reinvested in a qualifying replacement home or an arrangement must be converted to a grantor retained annuity trust whereby the income of the principal of the trust would be paid to the grantors/parents. In addition, similar to a grantor trust, there is little, if any, creditor protection in most states with respect to the family cottage being owned by a QPRT.

Ownership of Family Cottage in an “Entity”

The ownership of the family cottage can also be transferred in an entity such as a general partnership, limited partnership or limited liability company. For purposes of ease of explanation, all references to an entity in this writing will be to a Limited Liability Company (“LLC”). Most of the concepts discussed herein are equally applicable to other types of entities, such as Family Limited Partnerships (“FLP”) or General Partnerships. One caveat is there may be some additional requirements in different nuances relating to ownership of the family cottage in a different entity, but for purposes of this article, reference to an entity as an LLC should suffice for the concepts to be explained below.

In transferring a family cottage to an LLC, there are a number of non-tax and tax reasons usually motivating such a transfer. One consideration in placing a family cottage in an entity is whether or not the formation of the entity was limited in its purpose to establish ownership of a single “personal” asset such as the family cottage fulfills the “business purpose” requirements under some states LLC laws. In addition, another consideration is whether because the nature of the LLC is a personal use of a family cottage is a problem with respect to the inclusion of the family cottage in the grantors/parents estate under IRS Code Section 2036. In the event that transfer of a family cottage to an entity is being done for tax planning purposes, individuals should consult with an attorney to draft the LLC operating agreement in such a way to try and maximize the tax benefits of the transfer.

Another issue affecting the transfer of the family cottage to an entity, such as an LLC, is the management or control of the family cottage. Usually, where grantors/parents transfer the family cottage to an LLC during his/her or their lifetime, the parents maintain management positions of the LLC to make decisions regarding the maintenance, use and other matters affecting the family cottage. If gifts of ownership interest in the LLC are made by the parents to children, the appointment of the parents as managers of the LLC usually avoids a problem with respect to the use and maintenance of the LLC while the parents are living.

In addition, a significant benefit of an entity, such as an LLC, owning the family cottage is creditor protection. The only remedy, for instance, in the state of Michigan and many other states, is that outside creditors can only receive a charging order against the LLC owner’s interest in the LLC and, therefore, cannot become a member of the LLC or force any asset within the LLC to be sold to satisfy any liability of an individual member (owner). A charging order on behalf of a creditor of a member/owner does not give the creditor any management rights, voting rights or other participation rights with respect to the asset of the LLC.

Another consideration in owning a family cottage in an entity, such as an LLC, is protection of ownership with respect to divorced spouses. If gifts of ownership interest of the LLC are made by parents to children, a child can usually keep ownership of the LLC interest separate and distinct from commingling any ownership of the asset with his or her spouse. This fact, together with the fact the LLC operating agreement can make special provisions regarding what happens when a divorced spouse, through court order, attains certain rights against, in the form of a lien, a spouse’s family LLC interest. The LLC operating agreement can be helpful in creating an organized formula with respect to how the interest will be paid for to a divorcing spouse and ultimately extinguish the divorced spouse from the entity.

An extremely important non-tax issue surrounding the transfer of the family cottage to an entity and, ultimately, a succession plan for distribution of ownership interest to succeeding generations, is the operation and maintenance of the family cottage, for instance, who pays, who works, and who does what. Although, regardless of the care taken by an individual to draft a carefully thought-out operating agreement to govern these types of issues for future generations, ultimately cooperation between the individuals will either make such an agreement tenable or, in the event of un-cooperating owners, it becomes more difficult to enforce.

The operation and maintenance of the family cottage usually consists of addressing the following areas:

• Duties, responsibilities and payment for routine, regular maintenance.
• Duties, responsibilities and payment for extraordinary maintenance, such as more capital intensive things such as structural, mechanical or other significant expense.
• Responsibility for payment of regular operating expenses.
• Schedule or personal and rental use of the family cottage.
• Sale of the family cottage and division of tangible personal property.

One significant benefit to using an entity to hold ownership of a family cottage is imposing certain “buy sell provisions” in an operating agreement to govern how, and to whom, individuals sell their ownership interest in the family cottage. These types of buy sell agreements are essentially the same types of buy sell agreements governing the buying and selling of ownership interest in corporations that have been employed by applicable owners of closely held businesses for years. The benefit of buy sell provisions is that various provisions can be inserted into the operating agreement to provide a methodical and fair system in which individuals can offer, and ultimately obtain, the sale of their ownership interest to other LLC owners or, in some instances depending on the terms of the operating agreement, to third parties.

Conclusion

Planning for cottage ownership and succession should not be taken lightly. Without adequate planning various taxes and family disagreements can destroy the future enjoyment of the family cottage. Unfortunately, there is no “cookie cutter” to planning. A family’s goals and personal relationship will influence the ultimate decisions to be made; however, consulting with an expert in cottage law and engaging in careful consideration and a planning process will keep generations of family’s memories intact, and protect the family’s most important asset, the family cottage.

The Supreme Court’s decision in the Klooster case provides that certain types of joint ownership of real estate in Michigan can prevent property taxes increasing at the time of a joint owner’s death. While the decision is generally favorable to the taxpayer, there are various rules and contingencies that must be satisfied in order to achieve property tax savings.

Historical Perspective on Michigan’s Property Tax System

In 1994, voters passed a law (Proposal A) amending a portion of the Michigan Constitution to limit the annual increase in property tax assessments. The purpose of the law was to limit taxes on property as long as it remained owned by the same party, even though the actual market value of the property may have risen at a greater rate. The Michigan Legislature was then instructed to determine the specific rules needed to implement the effect of the law on Michigan property taxes.

The Legislature passed law that fixed the cap on assessment increases at the lesser amount of either 5% of the assessed value of the property for the previous year or the increase in the rate of inflation from the previous year (usually less than 2%). However, after certain transfers of ownership occur, property becomes uncapped and thus subject to reassessment based on actual property value. In the event of a “transfer of ownership” of property after new law took effect in 1995, the property’s taxable value for each calendar year following the year of the transfer is the property’s state equalized valuation for the calendar year following the transfer.

From the definition of “transfer of ownership” set forth by the Legislature in the law, there were 17 specific transfers and conveyances that were exemptions (exceptions), including the creation and termination of certain joint tenancies (transfers creating a joint ownership of property or the death of a joint owner). In the event an exemption applies, the property does not become uncapped and is not then subject to reassessment based on actual property value.

The Joint Tenancy Exemption

In order to avoid an uncapping of property taxes at the death of a joint owner, the first element that must be satisfied is that when the joint ownership was established, at least one of the joint owners was an “original owner”. An “original owner” to satisfy this provision of the joint tenancy exception would be a person who owned the property at the time that the last “uncapping occurrence” occurred. For example, if a husband and wife, or the survivor of them, purchased property in 1998 resulting in the uncapping of the property at the time of their purchase, then either of them would be an “original owner” and satisfy this element of the joint tenancy exception.

The next element that must be satisfied in order for the joint tenancy exception to apply is the form of joint ownership must be “joint ownership with rights of survivorship.” This type of joint ownership means that all of the joint owners have a current ownership interest in the property; however, at the time of one of their deaths, the deceased individual’s interest then, by operation of law, transfers to the remaining joint owner(s). A type of joint ownership that does not satisfy the test is joint owners as “tenants in common”. This type of joint ownership indicates that a joint owner and undivided fractional share of the property and in the event of a joint owner as a tenant in common’s death, the deceased individual’s share is then part of his or her estate and can transfer to their heirs.

As a result, a parent who is an “original owner” pursuant to the aforementioned definition can now transfer real estate to his or her children as joint tenants with rights of survivorship. In the event the parent predeceases the children, there would be no uncapping of the property for property tax purposes at the time of the parent’s death. Neither the initial transfer by the parent to the children or the subsequent death of the parent would constitute a “transfer of ownership” and result in an uncapping of the property for property tax purposes. This scenario can be attractive to certain real estate owners who wish to transfer their property to their children without a significant increase in the property taxes resulting at the parent’s death.

Potential Problem

The potential problem with creating joint tenancies to avoid an increase in property taxes is that the time of the death of an original owner, the surviving owner must maintain joint ownership of the property as “joint tenants with rights of survivorship”. A requirement of continuing to own the property as joint tenants with rights of survivorship means that if ownership is maintained that way, then at the death of one child, the remaining children would receive that deceased child’s ownership share. That result is not usually keeping with parent’s goal that children often times be treated equally with respect to the assets in the parents’ estate. The solution, in order to achieve the parents’ intended goal would be to change the ownership of the property after the parents’ death from joint tenants with rights of survivorship to joint tenants as tenants in common. However, that change of ownership would be deemed to be a transfer of ownership and the property would uncap for property tax purposes at that time.

As a result, the joint ownership exception for purposes of avoiding an uncapping of the property at one joint owner’s death is most attractive where a parent(s) intends to leave ownership of real estate to a single child. That being said, there is an advantage to transferring property jointly to more than one child in that the children can always own the property for an indefinite period of time before changing ownership to “joint ownership as tenants in common” which would uncap the property but, in the mean time, children as joint owners would enjoy the tax savings.

Conclusion

While the Supreme Court’s decision presents a benefit to Michigan taxpayers who are real estate owners, everyone should keep in mind that the Legislature could amend the current law to remove the joint ownership exception which has been recognized by the Supreme Court in the Klooster case. Whether or not legislative action in the future would be retroactively applied to those joint ownership situations that existed prior to any legislative action taking place is unclear. If you are considering a transfer of real estate to possibly take advantage of the joint tenancy exemption, please contact us to discuss the specific facts of your situation and your goals to make sure your proposed action is best for you and your family.

Dan A. Penning

Some would argue that a place is just a place but the people make it special. When it comes to the family cottage, it can be argued “the place” is special, sometimes almost magical, and can transform those who spend time in that place from stressed out, overworked adults back to their carefree days as a child; skipping rocks on the water, swimming off the dock, nursing a sunburn and eating s’mores by the campfire. For most, the family cottage creates a place for memories and traditions to be formed and a safe haven to retreat to for rest, reflection and reminiscing later in life. The family cottage is a constant in an ever-changing world. It’s where experiences can be shared and passed on to the next generation in their purest form.

It’s those intense emotions that fuel the desire to keep the family cottage in the family to preserve “the place” for future generations of “people” to experience and enjoy. Keeping the family cottage requires careful planning, cooperation among family members and a common purpose.

The focus of this writing is to identify the types of ownership forms that exist and can facilitate preservation of the family cottage, including the positive and negative aspects of each form of ownership.

Outright / Direct Transfers of Ownership

A direct transfer of ownership interest from one generation of owners, (i.e. parents) to the next (i.e. children) can be in the form of joint tenants with rights of survivorship, tenants in common or a life estate for the older generation with the younger generation receiving a “remainder” ownership interest in the family cottage. In summary, these forms of ownership involve transfers by deed of some or all of the current owners’ outright ownership to other individuals such as children, grandchildren or others.

The benefits of direct transfers of ownership by one generation to the next are as follows:

• The transfer can easily and economically occur by simply drafting and recording a deed reciting the form of ownership interest transferred.
• Fractional interest or “part interest” can be transferred to assist the transferors with estate tax planning objectives. Establishing fractional interests for the family cottage can provide discounts to lower ownership values in the transferors’ estate.
• Transfers whereby the transferors (parents) retain a partial ownership interest can, in most instances, provide a right for the parents’ continued use and enjoyment of the family cottage during their lifetime.
• Direct transfers can, in certain circumstances, be useful as part of a larger overall long-term care or Medicaid planning process to help parents protect the family cottage from having to be sold to raise proceeds to pay for long-term medical or supportive care expenses.

Direct transfers of ownership can also provide negative consequences. They are as follows:

• If the transfers are done without an overall analysis of estate, gift and income and property taxes, the parents can find themselves with unintended tax consequences.
• Direct transfers of ownership interest can create unintended consequences of exposing the family cottage to the claims of their children’s creditors.
• Direct transfers of ownership can expose the family cottage to claims by the spouse of a child in the event of a divorce.
• Direct transfers cannot guarantee that one or more family members will get along in the future. Disputes can arise without accompanying safeguards to transfer ownership that could result in the whole family being in court and a judge ordering the family cottage sold. In addition, an unexpected economic hardship may arise among one or more of the children owning the family cottage and their wanting to sell their interest in the cottage which can also cause complications for the non-selling individual owners and can ultimately lead to an impasse regarding any resolution of the situation ultimately requiring a sale of the family cottage altogether in its entirety to a third party.

Ownership of the Family Cottage in a Trust

Ownership of a family cottage can also be in a lifetime trust. There are two common trusts for this purpose. In both instances, the transfer of ownership is simple in that it is accomplished by the execution and recording of a deed.

The first type of trust is a revocable living trust. The benefits of this type of ownership are as follows:

• Ownership of the family cottage in a revocable trust maintains the parents’ control of the property during their lifetime. The parents can be the current trustees of the trust during their lifetime, thus retaining full authority to make all decisions on the use, management and even disposition of ownership to a third party in the event of an unexpected need or occurrence.
• The revocable trust is a grantor trust for income tax purposes so any transactions for the family cottage such as payment of expenses and property taxes is reported and deductible by the parents/grantors in the same way as if they owned the family cottage in their individual names.
• If a parent/grantor is disabled, usually a successor trustee is appointed in the trust, who then continues to manage the family cottage without interruption or court involvement.
• In the event of either the grantor parents’ disability of death, the family cottage is not subject to probate administration and that the terms of the trust govern the disposition of the family cottage and asset of the trust.

However, placing a family cottage in ownership of a revocable trust can have certain detriments. These are as follows:

• The full fair market value of the family vacation home will be included in the parents/grantors’ taxable estate if the family cottage is titled in the parents’ revocable trust.
• If the transfer of the family cottage was simply made to the trust and there were no provisions for a “succession plan” the family cottage then remains in the grantors’ revocable trust with no specific direction as to its disposition at the parents’ death. Also, any contributions of funds that may be necessary to pay for expenses of the family cottage may prevent gift tax issues if the title of the family cottage remains in the parents’ revocable living trust
• A revocable living trust is generally not a good option in situations where multiple parties are required to make capital contributions for improvements or sharing expenses for maintenance. If a parent/grantor becomes disabled and a successor trustee is appointed, the successor trustee may not have the discretion to keep the family cottage “alive and well”. If the grantor needs funds for other reasons (for example, health, support, medical treatment and so on), the successor trustee may be forced to sell the family cottage to raise funds for those purposes.
• Creditor protection is limited with a revocable living trust based on the fact that it is a “self-settled trust” whereby the grantors/parents simply transfer by deed ownership to the trust and maintains total control during the trust during his/her or their lifetime. In most states, creditors can pierce through the trust ownership of the family cottage and attach it for judgment liens or other liabilities.

A second type of trust that is sometimes used for ownership of family cottages is a qualified personal residence trust (“QPRT”).

The QPRT is a trust where the grantors/parents make a gift of the family cottage to the trust while essentially retaining an interest similar to a life estate for the term of years of the QPRT. As a result, the parents maintain the use and enjoyment of the family cottage during the QPRT’s term of years. A gift of the interest in the family cottage using a QPRT is less than if the gift were made outright by the parents to their children. The QPRT allows for gifts of fractional interest, thereby reducing the gift tax clause. The QPRT is also a grantor trust for income tax purposes so all deductible costs (i.e., real estate taxes) continue to be deductible by the grantor parents for income tax purposes during the term of the trust. The QPRT can also be a useful tool in minimizing the grantors/parents estate tax liability. Basically, a complete gift of the family cottage from the parents to the QPRT, based on the parents’ retaining the use and enjoyment of the family cottage during the term of the QPRT, allows for a reduction of the amount actually counted as a gift for gift tax purposes. As a result, a complete gift of the family cottage can be made for much less than the fair market value of the cottage and all future appreciation of the cottage can be excluded from the parents’ estate.

The detriments of transferring a family cottage to a QPRT is if a grantor/parent dies during the QPRT term, the fair market value of the family cottage is then accountable in the grantor/parent’s estate for estate tax purposes. That could result in a waste of the gift tax credit. In addition, at the end of a QPRT term, if a grantor/parent survives and continues to occupy the family cottage, the grantor/parent must rent the family vacation home from the QPRT continuation trust or the QPRT individual beneficiaries (i.e., children) at fair rental value. This can also be a benefit in that parents seeking to transfer wealth from their estates to their children can do so by the amount of the rental payments over time. If the family cottage is sold during the QPRT term, the net proceeds of the sale must be reinvested in a qualifying replacement home or an arrangement must be converted to a grantor retained annuity trust whereby the income of the principal of the trust would be paid to the grantors/parents. In addition, similar to a grantor trust, there is little, if any, creditor protection in most states with respect to the family cottage being owned by a QPRT.

Ownership of Family Cottage in an “Entity”

The ownership of the family cottage can also be transferred in an entity such as a general partnership, limited partnership or limited liability company. For purposes of ease of explanation, all references to an entity in this writing will be to a Limited Liability Company (“LLC”). Most of the concepts discussed herein are equally applicable to other types of entities, such as Family Limited Partnerships (“FLP”) or General Partnerships. One caveat is there may be some additional requirements in different nuances relating to ownership of the family cottage in a different entity, but for purposes of this article, reference to an entity as an LLC should suffice for the concepts to be explained below.

In transferring a family cottage to an LLC, there are a number of non-tax and tax reasons usually motivating such a transfer. One consideration in placing a family cottage in an entity is whether or not the formation of the entity was limited in its purpose to establish ownership of a single “personal” asset such as the family cottage fulfills the “business purpose” requirements under some states LLC laws. In addition, another consideration is whether because the nature of the LLC is a personal use of a family cottage is a problem with respect to the inclusion of the family cottage in the grantors/parents estate under IRS Code Section 2036. In the event that transfer of a family cottage to an entity is being done for tax planning purposes, individuals should consult with an attorney to draft the LLC operating agreement in such a way to try and maximize the tax benefits of the transfer.

Another issue affecting the transfer of the family cottage to an entity, such as an LLC, is the management or control of the family cottage. Usually, where grantors/parents transfer the family cottage to an LLC during his/her or their lifetime, the parents maintain management positions of the LLC to make decisions regarding the maintenance, use and other matters affecting the family cottage. If gifts of ownership interest in the LLC are made by the parents to children, the appointment of the parents as managers of the LLC usually avoids a problem with respect to the use and maintenance of the LLC while the parents are living.

In addition, a significant benefit of an entity, such as an LLC, owning the family cottage is creditor protection. The only remedy, for instance, in the state of Michigan and many other states, is that outside creditors can only receive a charging order against the LLC owner’s interest in the LLC and, therefore, cannot become a member of the LLC or force any asset within the LLC to be sold to satisfy any liability of an individual member (owner). A charging order on behalf of a creditor of a member/owner does not give the creditor any management rights, voting rights or other participation rights with respect to the asset of the LLC.

Another consideration in owning a family cottage in an entity, such as an LLC, is protection of ownership with respect to divorced spouses. If gifts of ownership interest of the LLC are made by parents to children, a child can usually keep ownership of the LLC interest separate and distinct from commingling any ownership of the asset with his or her spouse. This fact, together with the fact the LLC operating agreement can make special provisions regarding what happens when a divorced spouse, through court order, attains certain rights against, in the form of a lien, a spouse’s family LLC interest. The LLC operating agreement can be helpful in creating an organized formula with respect to how the interest will be paid for to a divorcing spouse and ultimately extinguish the divorced spouse from the entity.

An extremely important non-tax issue surrounding the transfer of the family cottage to an entity and, ultimately, a succession plan for distribution of ownership interest to succeeding generations, is the operation and maintenance of the family cottage, for instance, who pays, who works, and who does what. Although, regardless of the care taken by an individual to draft a carefully thought-out operating agreement to govern these types of issues for future generations, ultimately cooperation between the individuals will either make such an agreement tenable or, in the event of un-cooperating owners, it becomes more difficult to enforce.

The operation and maintenance of the family cottage usually consists of addressing the following areas:

• Duties, responsibilities and payment for routine, regular maintenance.
• Duties, responsibilities and payment for extraordinary maintenance, such as more capital intensive things such as structural, mechanical or other significant expense.
• Responsibility for payment of regular operating expenses.
• Schedule or personal and rental use of the family cottage.
• Sale of the family cottage and division of tangible personal property.

One significant benefit to using an entity to hold ownership of a family cottage is imposing certain “buy sell provisions” in an operating agreement to govern how, and to whom, individuals sell their ownership interest in the family cottage. These types of buy sell agreements are essentially the same types of buy sell agreements governing the buying and selling of ownership interest in corporations that have been employed by applicable owners of closely held businesses for years. The benefit of buy sell provisions is that various provisions can be inserted into the operating agreement to provide a methodical and fair system in which individuals can offer, and ultimately obtain, the sale of their ownership interest to other LLC owners or, in some instances depending on the terms of the operating agreement, to third parties.

Conclusion

Planning for cottage ownership and succession should not be taken lightly. Without adequate planning various taxes and family disagreements can destroy the future enjoyment of the family cottage. Unfortunately, there is no “cookie cutter” to planning. A family’s goals and personal relationship will influence the ultimate decisions to be made; however, consulting with an expert in cottage law and engaging in careful consideration and a planning process will keep generations of family’s memories intact, and protect the family’s most important asset, the family cottage.

Michigan Governor Rick Snyder called the consideration of his proposed Executive Budget a “defining moment” for the state this week as the Executive Budget was submitted to state legislators for the 2011-2012 fiscal year. Snyder commented on his budget as an opportunity to “stop living in the past and start looking to the future.”

As expected, the lynch pins of Snyder’s plan call for the reduction of business taxes by in excess of 1.8 billion and a significant reduction in spending on public schools, universities, local governments and prisons. If passed, the plan will have an immediate impact on the state’s businesses by providing a replacement of the existing Michigan Business Tax with a 6% flat tax on corporate income with some exemptions for designated small businesses. Other parts of the proposed Executive Budget call for an elimination of various business tax credits and replacing the credits with grants from the Michigan Development Corporation.

The Executive Budget also provides for maintaining the already scheduled reduction in the state’s individual income tax rate from 4.35% to 4.25% which is set to go into effect October 1, 2011. Further scheduled reductions to the individual tax rate would be eliminated. In addition, the proposal calls for the elimination of many other existing credits, deductions and exemptions.

While the proposed Executive Budget is far from being a reality and enacted into law, the stage has been set for the debate of how the new administration in Michigan will seek to solve the state’s economic difficulties.

Please stay tuned for more updates on these matters as the debate and ultimate actions to be taken unfold.

Dan Penning