This is part two of a two-part blog post series on cottage succession planning in Michigan.
As summer winds down, the second-home market continues to heat up in Michigan. One of the issues many second-home owners face is determining the best way to keep a family cottage in the family for generations to come. In this series on cottage planning in Michigan, we are addressing that very issue.
In part one, we discussed the reasons why a cottage owner may want to develop a cottage plan (including Michigan’s complicated real estate tax framework). This article deals with the mechanics of cottage succession planning in Michigan—specifically, utilizing a limited liability company or trust structure to allow a cottage to be used and enjoyed by future generations in an organized way that helps reduce the risk of family disputes, thereby increasing the likelihood that the cottage will be part of the family for years to come.
What is a Cottage Plan?
A cottage plan is an agreement that describes how a cottage will be shared, managed and passed on to future generations of family members. Cottage plans typically cover a range of issues that can impede the succession of a cottage if left unaddressed, including:
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- Who should own the cottage?
- Who should manage it?
- Who should pay for it?
- What if an owner wants/needs out?
- Who gets to use it?
- How should use be scheduled?
By working through these issues in a cottage plan, an owner (or “founder” in cottage-planning lingo) can achieve various goals that are commonly shared by those who desire to keep the cottage in the family. Those goals include:
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- Keeping the cottage in the family for future generations so that it can continue to serve as a gathering place for extended family
- Giving children equal shares of the cottage (while avoiding “trapping” an inheritance in the cottage)
- Keeping interests in the cottage out of hands of in-laws and creditors
- Reinforcing family interests versus any one individual’s interests
An effective cottage plan can and should also address the objectives of the family members (or “heirs”) who will enjoy the cottage beyond the owner’s lifetime. Such objectives include:
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- Protecting the cottage from a divorce
- Developing decision-making structures and control mechanisms
- Developing consequences for failure to abide by rules—financial and behavioral
- Developing a fair, flexible scheduling system
- Provide an exit strategy where desired or necessary by providing the ability to sell interests back to family
Cottage Planning Solutions
Most husbands and wives who own a cottage hold title as joint tenants with rights of survivorship, which means that title to the property automatically passes to the survivor on the death of the first co-owner regardless of any provision in a will or trust. Upon the death of the survivor, and in the absence of a cottage plan, the cottage will pass to heirs as tenants in common.
A tenancy in common can be problematic for a number of reasons, including:
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- Each tenant in common (“TIC”) has a right to partition
- Each TIC may use the cottage at any time
- A TIC may transfer his interest to any person at any time – including his/her spouse.
- A TIC does not owe rent to the other owners for using the cottage.
A better approach, which helps avoid the issues that often arise when heirs are tenants in common, is to have title to the cottage held either by a limited liability company (“LLC”) or a trust. Under an LLC structure, a management committee, which serves a function similar to a board of directors, is formed to manage the cottage’s affairs. With a trust, co-trustees are appointed to make decisions. In either case, if the family and entity is structured by branches, it is advisable to have one representative from each branch of the family involved in decision making.
Through the cottage planning process, the founders decide who may be a “member” (under an LLC) or beneficiary (under a trust). Virtually all cottage plans restrict participation to lineal descendants of founders, which ensures the cottage remains in the family—in other words, preventing in-laws from becoming members or beneficiaries.
One of the primary advantages of having a cottage plan utilizing an LLC or trust structure is that it provides a mechanism for transferring membership or beneficial ownership interests. Plans typically include a “put option” which requires the LLC or trust to purchase the interests of members or beneficiaries who want to sell their stake, and a “call option” that allows for the forced buy-out of difficult members or beneficiaries. Valuation and payment term guidelines for purchases are defined in the plan. This provides a predetermined exist strategy for those who do not wish to participate in the cottage or those who do not or are unable to contribute their fair share to cottage costs and expenses. The predetermined terms established for the buy-out provisions offer the opportunity for a graceful exit.
Plans also address issues related to expenses, such as taxes and maintenance, for the cottage. Expenses are typically allocated according to a predetermined sharing ratio among the members and beneficiaries. Often, an annual budget is prepared and an annual assessment is determined at the beginning of each year or season. Failure to pay expenses can be dealt with through an escalating series of sanctions, from the imposition of late fees and interest all the way to the forced buy-out of the delinquent member or beneficiary.
In many instances, founders choose to offset the ongoing expenses of a cottage by establishing an endowment, which is a dedicated sum of money for a specific use. For example, a $500,000 endowment invested at a five percent rate of return will create a pre-tax return of $25,000 per year, which is a sum sufficient to operate many cottages. The endowment may be held and managed by a bank trustee or by the LLC. If a cottage is sold, the endowment distributes to the founder’s descendants. One way to fund the endowment is to purchase a “second-to-die” life insurance policy.
Finally, a cottage plan typically addresses issues related to the use of the cottage—that is, who can use the cottage at any given time. Two common approaches include a “rooming house” structure in which any member or beneficiary can use it any time, and a “time share” structure in which members and beneficiaries are allocated specific time slots for use.
Take Action to Create a Cottage Plan
There are significant advantages to having a cottage plan that utilizes an LLC or trust structure. There is no single option that is best for all families, so it’s important to consult with an experienced cottage law attorney to determine what option is right for you. With a bit of planning, you can help ensure that your cottage will be a source of enjoyment for your family for generations to come.
If you have any questions about planning issues for your cottage in Michigan, please contact Fraser Trebilcock shareholder Mark Kellogg.
This alert serves as a general summary and does not constitute legal guidance. Please contact us with any specific questions.
Fraser Trebilcock attorney Mark E. Kellogg is a certified public accountant, and has devoted over 30 years of practice to the needs of family and closely-held businesses and enterprises, business succession, commercial lending, and estate planning. You can reach him at 517.377.0890 or mkellogg@fraserlawfirm.com.
