Choose The Right Legal Entity For Your Family Cottage Plan.

Understanding the options of legal entities to transfer indirect ownership of the family cottage is important to make sure your family’s particular goals and needs are met by the type of entity chosen.

The various aspects of each legal entity provides the general framework for a cottage plan which is then specifically described and implemented through the governance documentation which apply to that particular legal entity. Some entities have different rules so depending on the goals, one entity might be more preferable than another. It’s not one size or type fits all.

The following are the different forms of legal entities for indirect ownership of the family cottage.

Cottage Trusts

A trust is not a legal entity established with a State (unlike a corporate entity) but is rather an entity formed by contract by the cottage owner(s).Trusts historically have not been the most attractive entity by which to establish a cottage plan. 

First,trusts do not establish liability protection from judgement creditors like a corporation: however, with that risk in place the trust can purchase increased and more comprehensive premises liability insurance to insure against liability risks.

Second, management in a trust is established in “trustees” which if not structured properly can result in important decisions being made by the trustees without input from all the family members as beneficiaries. This problem can be addressed through careful drafting whereby a more democratic decision making process is imposed on the trustees.

While a cottage trust has not in the past been the preferred entity with which to establish a cottage plan, in States like Michigan, property tax rules have made the trust a the preferred planning entity based on the significant property tax savings that a trust can accomplish for future generations of trust beneficiaries.

In Michigan and some other states, property taxes are “capped” meaning that by law, property taxes can only be increased by a small percentage based on a capped value of the cottage. In summary, as long as a person owns the cottage, the property taxes cannot be significantly increased from year to year. This results in the value of the cottage on which the taxes can be calculated/assessed being limited in comparison to what the actual fair market value of the cottage might be if it were sold on the open market.

For example, parents who may have owned the cottage for 30 years may be paying property tax based on a cottage value that is one quarter of the actual value. (i.e.  a cottage owned for 30 years might be taxed at a value of 100,000 when the actual value of the cottage is 400,000).

The problem comes when the title to property is “transferred” at the death of the parents which historically resulted in the cottage value being “uncapped” and the taxes would then be recalculated/re-assessed on the then current value (the 400,000 in the above example and that resulted in the next generation taking title getting a tax increase of 4 times the amount the parents were paying. So, using the above example, if the parents were paying 5,000 a year in taxes, the new tax bill to the next generation on transfer could be raised to 20,000 a year

In Michigan like some other States, the rules changed in 2014 and the new rules allow the transfer of a cottage to the next generation to occur as an exemption to the uncapping as long as the transfer is to a family member(s) as defined by the law. As a result, a simple transfer from parents to their children under the new law in the above example could save 15,000 a year in property taxes. 

By using a trust, the transfer of ownership initially from parents or current owners into a trust is an exempt transfer keeping the taxes the same and then when the benefits of the trust (i.e. the use of the cottage transfers to the next generation at death) the transfer of the beneficial interests of the trust in the cottage to the next generation is also an exempt transfer which allows the terms of the cottage plan in the trust to apply without triggering an increase in the tax.

As a result, cottage trusts are the preferred tool for implementing a cottage plan and in other States with similar rules to Michigan. The tax savings usually far outweigh any downside the trust may have as referenced above.

Standard Corporation

A corporation is a legal entity formed by filing articles of incorporation with a State. A corporation protects its shareholders (owners) from liability. The shareholder owners exercise ultimate control of the corporation and it’s assets by appointing a board of directors and the board appoints officers to manage and deal with the corporation's assets.

The corporation may adopt various rules to reflect a cottage plan for the current and all future owners to address all the potential problems and pitfalls that can threaten the future ownership and enjoyment of the family cottage.

While the corporation as an entity has advantages for cottage planning over simply passing ownership to the next generation members with no plan, this entity can be cumbersome for future generation owners.

In order to perfect a workable cottage plan,the corporation must adopt various terms that are drafted into the corporation's articles, by-laws and other agreements such as a shareholder agreement. This can be difficult to coordinate all the various working parts. Obviously, if it is hard to draft a plan into this system, it may also be difficult for the future generations of the family to work with the plan reflected in the various documents.

Also, the property tax exemption referenced above does not apply to ownership of the corporation passing from the parents or current owners down to their children and then onto future generations.

Limited Liability Company

A limited liability company was designed to combine all of the advantages of a corporation like limited liability to its owners with various other advantages like simple low cost formation, flow through tax treatment and a flexible format for a cottage plan to be drafted and implemented.

The fact that an LLC is probably the most popular corporate entity for small business operations and things like cottage planning is proof positive that it is the best entity to utilize for families seeking to protect their cottages.

However, as referenced above, in 2014 in Michigan the property tax rules made the use of an LLC to implement a cottage plan musch less attractive given the fact that transfers of ownership of the LLC interests at the death of current owners does not qualify for the exemption keeping the property value capped and the resulting tax the same. The positive attributes of the LLC most often do not warrant the significant increase in taxes and thus families in Michigan typically opt for using the cottage trust for planning.

However, I want to at least provide an explanation of the entity to give a full picture of the various entities available for cottage planning.

Limited liability companies are formed by filing a document-articles of organization with the appointed State agency where corporations are registered within a State. The State the LLC is formed need not be the State where the cottage is physically located.

The key benefit to an LLC is that the entity and its owners are governed by a document called “The Operating Agreement”. The operating agreement spells out all of the rights and responsibilities of the LLC owners/members. Typically, these rights and responsibilities are focused on the management of the cottage, the payment of financial obligations, the use of the cottage and matters concerning how, when and for what price ownership can be sold by a member to another member.

Conclusion

In order for a cottage plan to be enforceable and guide the future generation of owners, one of the above referenced entities should be considered within which to structure a plan. The above information is only meant to be an introduction to the concepts involved with each entity. Any family considering a cottage plan should consult with an experienced professional who can assist in identifying the families goals and then recommending the entity best suited to accomplish the goals in a detailed plan.

I am available at no obligation to discuss your family cottage and your thoughts about implementing a cottage plan. Please call me at 248-752-6480.

Dan Penning.