Family Cottage Transfers Page 4 Page 5 Cottage LLCs VACATION HOME PLANNING SUMMER 2013 P R I O R I T Y Read Cottage Succession Strategies: Changes on the Horizon By: Kathleen Hogan Aguilar; aguilark@millerjohnson.com; 616.831.1763 For several years, cottage succession planning revolved primarily around avoiding property tax uncapping. Beginning December 31, 2013, a new uncapping exemption takes effect. This new exemption may drastically change cottage transfer strategies by making transfers to certain family members exempt from property tax uncapping. Annual property tax increases on real estate are limited to the lesser of inflation or five percent. When a property is transferred, the taxes uncap and the property is taxed based on its fair market value. For cottage owners, avoiding uncapping is often the single biggest challenge to transferring a cottage to the next generation. Uncapped property taxes can be an unaffordable burden on the new owners. The next generation may have to sell the cottage because they cannot afford to pay the taxes. As a result, cottage succession planning focuses on property tax consequences rather than on solutions that work best for each family s unique needs. The law contains some uncapping exemptions which provide limited ways to transfer property without causing huge tax increases. The popular literature and many cottage succession advisors have focused on avoiding uncapping by creating cottage LLCs. New Exemption When it takes effect on December 31, 2013, the new uncapping exemption may make LLC planning less attractive for many cottage owners. That exemption allows an owner to transfer a cottage by simpler means and avoid uncapping the property taxes. It provides that there is no uncapping on residential real estate if the transfer meets two criteria: 1) The new owner is related to the old owner by blood or affinity in the first degree; and 2) The use of the property does not change following the transfer. Continued on next page.
Cottage Succession Strategies, continued Under the new exemption, an owner can transfer a cottage to certain relatives without uncapping the property taxes. The new owner must be a blood relative in the first degree or a relative by affinity in the first degree. What kinds of relatives qualify? First degree blood relatives are limited to children and parents, including natural and adoptive relatives. Relatives by affinity are related not by blood, but by virtue of a marriage relationship. The new exemption allows transfers to first degree relatives by blood or affinity without triggering uncapping, which would appear to include the following relatives: Parents; Adoptive parents; Children; Adoptive children; Step-mother or step-father; Step-daughter or step-son; Mother-in-law or father-in-law; and Daughter-in-law or son-in-law. Recent guidance from the State Tax Commission indicates that, despite the language of the statute, transfers to step-mothers, step-fathers, daughtersin-law, or sons-in-law will trigger uncapping. (See the related article in this newsletter regarding the State Tax Commission s recent bulletin.) If you want to transfer the cottage to anyone other than a first degree relative by blood or affinity, this exemption will not apply. Grandchildren, siblings, and nieces and nephews are clearly not covered by the new exemption. On the other hand, if you plan to transfer your cottage to the above-listed relatives, this new exemption greatly simplifies cottage succession planning by removing the property tax consequences. Now, many cottage succession plans can focus on what truly works best for the individual family, rather than what approach will minimize taxes. How Will it Work? Questions About the New Exemption Questions remain about what types of transfers the new exemption covers. For example: On Mom s death, she owns the cottage in her name alone and the cottage (along with Mom s other assets) must go through probate. Her three children are the beneficiaries of her probate estate. Does the exemption cover the transfer from Mom s probate estate to her three children? When Dad passes away, the cottage is held in his revocable living trust. Dad s two children and two step-children are the beneficiaries of his trust. Is the transfer from Dad s trust to the beneficiaries (all relatives by blood or affinity in the first degree) exempt? Mom and Dad put the cottage into an LLC and own 100% of the LLC interests at their death. Mom and Dad s LLC interests pass to their son and daughterin-law at their death. Is the transfer of the LLC interests exempt? The exemption is simply too new to answer all the mechanical questions and the State Tax Commission s recent bulletin adds little clarity, if any. New Planning Opportunities The new exemption opens up several planning opportunities. Provided that the cottage will be transferred to the qualifying relatives described above, the following strategies may be better than using the traditional cottage LLC. 1. Ladybird Deed: A ladybird deed is a simple way to transfer property and avoid probate. With a ladybird deed, the current owner retains all the benefits of ownership. In the deed itself, the owner names who will receive the property on the owner s death. You can think of a ladybird deed as a beneficiary designation for real estate. So long as the ladybird deed names first degree relatives by blood or affinity to receive the property on the owner s death, the new exemption will apply. Continued on next page. 2
Cottage Succession Strategies, continued 2. Revocable Living Trust: For some families, holding the cottage in their revocable living trust may be an appropriate planning strategy. A trust can direct who receives the cottage when the current owners die or can keep the cottage in trust for the beneficiaries use. Like an LLC operating agreement, the trust may contain provisions relating to the use, management and disposition of the property. A trust also provides for management and decision-making through the trustee. 3. Qualified Personal Residence Trust (QPRT): A QPRT is a tax-advantaged way to transfer a cottage. QPRTs may be appropriate for people who expect to pay federal estate tax on death. In a QPRT, the current owners give the cottage to the next generation, but retain the right to use the cottage for a set number of years. If their right to use the cottage expires before they die, the cottage is removed from their taxable estate. The owners are assessed gift tax on a discounted value of the cottage based on their retained right to use the cottage. 4. Co-Ownership Agreements: If cottages are jointly owned or will be jointly owned when the cottage passes to multiple beneficiaries, co-ownership agreements are an important means of providing structure and management for the cottage. A co-ownership agreement can cover many of the same subjects as an LLC operating agreement, including personal rights to use the cottage, management of rentals, obligations to contribute to expenses and upkeep, and decision-making rules. One of the great benefits of the new exemption is that families can plan to transfer their cottage not only to avoid large property tax increases, but also to fit what works best for the family. No single plan can work for every family and every circumstance. Every family has unique family dynamics, history, relationships and goals. The legal solutions for transferring the cottage need to work with the family s distinctive situation. Contact Us If you have any questions about keeping the cottage in the family for multiple generations please contact the authors or any member of Miller Johnson s Vacation Home Planning practice. If you would like to schedule a speaker for your association, we are available to come to your meeting and cover a range of legal topics. Send us an e-mail at info@millerjohnson.com. Please forward this e-mail to neighbors, family, friends and fellow cottage owners so that they may sign up to receive future newsletters. Sign up at www.millerjohnson.com. 3
Family Cottage Transfers: The State Tax Commission Speaks By: Jeffrey S. Ammon; ammonj@millerjohnson.com; 616.831.1703 We told you in January about a new law that will allow you to transfer your family cottage to the next generation without uncapping its property tax base. See http://www.millerjohnson.com/pubs/xprpubdetail. aspx?xpst=pubdetail&pub=2005 and the related article in this newsletter. Michigan s State Tax Commission (STC) just issued a bulletin on May 13, 2013 listing who may use this new exemption. Unfortunately, that bulletin adds only uncertainty. The new law will exempt transfers to someone related by blood or affinity to the first degree. The STC bulletin interprets affinity to the first degree to mean the transferor s: Spouse Father or mother Father or mother of the spouse (transferor s mother-in-law and father in-law) Son or daughter (including adopted children) Son or daughter of the spouse (transferor s step-son or step-daughter) A few observations on this bulletin are in order: The STC includes step-children, but not step-father or step-mother. Nothing in the statute suggests this difference. So why did the STC include step relations only in the descendant direction and not in the ancestor direction? The STC bulletin does not include a son-in-law or daughter-in-law. So, the STC believes you can transfer to the kid of a spouse, but not to the spouse of a kid. Nothing in the statue supports the exclusion of sons- and daughters-in-law. These STC omissions can be worked around if family members agree to make two-step transfers. For example, to exempt a transfer to your son-inlaw, first transfer to your son (exempt under this new law), then have your son transfer to his spouse (transfers to spouses are exempt under existing law). Remember: STC bulletins and similar informal pronouncements by the STC (or any other state agency) are unenforceable. State law says plainly that a bulletin is not enforceable by an agency, is considered merely advisory, and shall not be given the force and effective law. An agency shall not rely upon a bulletin A court shall not rely upon a bulletin MCLA 15.232. How much clearer can the Legislature say it? Remember this new exemption s other key features: It is not effective until December 31, 2013. Successive generations may use this exemption, which can t be done with the joint tenancy exception. It applies only to property classified as residential. Classification is not the same as zoning. The assessment notice you receive each January lists your property s classification. That classification may include your principal residence, a second home, a cottage, or other structures on property used for residential purposes. Despite the uncertainty created by the STC bulletin, we believe this new exemption will expand opportunities for cottage succession planning. As the nearby article explains, this exemption may also make other traditional planning tools less attractive or even obsolete, such as cottage LLCs and joint tenancies. If you have questions about this new law, please contact the author or any other member of Miller Johnson s Vacation Home Planning Practice Group. 4
Cottage LLCs: The Five Traps By: Jeffrey S. Ammon; ammonj@millerjohnson.com; 616.831.1703 Some advisors promote cottage limited liability companies ( LLCs ) as the near-perfect tool for cottage and vacation home ownership and succession planning. (See the related articles in this newsletter on how a new law may affect the usefulness of LLCs.) But if an LLC is warranted, beware: the cottage LLC has traps for the inexperienced. This article explains five of the most common traps and how to avoid them. Trap #1: Believing That The LLC s Limited Liability Protection Is Broader Than It Really Is Much cottage LLC literature touts their so-called limited liability as an advantage over owning the cottage personally, in a trust, or in common ownership under a joint tenancy or tenancy-in-common. That literature cites the rule correctly that LLC members are not personally liable for LLC obligations. Here s the trap: an LLC will not protect you from the most common and most expensive forms of personal liability. Consider this example. You and your sister are equal members in an LLC that owns a family cottage on an inland lake. You and your sister have noticed that the dock is showing its age: a couple of the boards are soft, due to cracks and dry rot. You ve been telling each other for a couple of seasons that you really should replace those boards. But before you get around to it, one of your cottage guests suffers severe injuries when she walks onto the dock and steps through one of those weak boards. She and her family sue the LLC. And, to your surprise, they also sue you and your sister individually. But weren t you protected from this personal liability by having the cottage owned by the LLC? No. You cannot escape responsibility for your personal negligence. You remain responsible even if you were acting on your LLC s behalf. In this example, the LLC s ownership of the dock didn t limit your liability at all. Nor would the LLC s ownership of a cottage protect you from other kinds of cottage mishaps involving your carelessness: A child is seriously hurt playing with tools it found in your unlocked tool shed. A guest sustains severe burns after falling into your beach bonfire while being chased during a beach game of tag that you realized was getting out of hand. A neighbor is seriously injured when your friend, chainsaw in hand, fells a tree onto your neighbor. In some situations, only one of you might be personally liable. Assume the same LLC described above. While your sister is out of town, you throw a big party at the cottage. The party combines an excess of adult beverages with speed boats, jet skis, and other motorized watercraft. One of your guests is seriously injured during horseplay that you are participating in. The injured person sues the LLC, of course, because it owns the cottage. The injured person could also sue you personally if your carelessness contributed to the injury. But that person would not be able to sue your sister. She was not careless at all. In fact, she didn t even know the party was going to happen. The solution to this trap? Since you can never escape responsibility for your personal negligence, the only real solution is to be careful. You, your sister, and the LLC should also carry appropriate levels of liability insurance and consider whether other asset protection planning makes sense. Continued on next page. 5
Cottage LLCs, continued Trap #2: Believing That An LLC Interest Transfer Also Transfers Voting Rights Transfers of LLC interests are not like transfers of corporate shares. If you sell General Motors shares to me, I have the right to vote those shares. Not so, however, if you transfer your LLC interest to me. The LLC Act gives me no voting rights. These opposite conclusions create much confusion among clients and LLC operating agreement drafters. Consider an example. Assume that you, your sister and your brother each own a one-third interest in an LLC. Your LLC operating agreement gives voting rights in accordance with ownership percentages. You decide to sell your interest to your sister, a transfer the operating agreement allows if your brother consents. Assume that he consents. Now your sister owns two-thirds of the LLC, but does she have a two-thirds vote? No. Transferring all of your interest terminated your LLC membership and your voting rights evaporated. Your brother s consent allowed your sister to receive your one-third LLC interest, but it did not transfer your voting rights. So your brother and your sister are now the two remaining members of the LLC, each with 50% of the voting power. Is this what you, your sister, and your brother intended? Your brother might be pleased, since his voting power (50%) is greater than his ownership (1/3). Your sister might be correspondingly unhappy, because she has two-thirds of the interest but only a 50% vote. The trap in this case was the operating agreement s failure to state that certain transfers also transfer voting rights automatically, like corporate shares. The solution? Make sure your cottage LLC addresses which transfers also transfer voting rights. Should this occur only in transfers to children? What about transfers to anyone who is already a member? And don t be reluctant to put examples into the operating agreement so that your family understands exactly how this works. Contact the author of this article if you want to see some sample examples. Trap #3: Principal Residence Exemption A primary residence owned entirely by an LLC does not qualify for the principal residence exemption. Do not transfer your primary residence into an LLC and expect to retain that exemption. Trap #4: Inadvertently Triggering Real Estate Transfer Tax When Contributing Property To Your LLC When you create an LLC to own your cottage, you might plan to deed the property to the LLC in exchange for receiving an LLC membership interest. The trap: this form of transfer could trigger application of Michigan s real estate transfer tax. And this tax would apply even though the LLC didn t pay any money for the transfer. How can this be, if the transfer is a gift and no money changes hands? The transfer tax statute looks to the value you received in exchange for deeding the property. In the example above, you received an LLC membership interest in exchange for the deed. Since that LLC membership interest gave you complete control over the LLC, a taxing authority could argue that you received value in the form of an LLC interest in exchange for the cottage. You would owe a $4,300 tax on your transfer of a $500,000 vacation home into your new LLC. You must pay the tax when the deed is recorded. The solution to this trap: become an LLC member before you deed the property. Then, when you deed the property later as a gift, you receive nothing in exchange since you already own the LLC membership interest. Trap #5: Believing That A Form Of LLC Business Operating Agreement Is A Good Form For A Cottage LLC Operating Agreement The key cottage LLC document is its operating agreement: the private agreement among the LLC members that addresses voting rights; cottage use; inheritance of interests; funding for taxes, insurance and Continued on next page. 6
Cottage LLCs, continued repairs, etc. Michigan lawyers have much experience drafting LLC operating agreements for businesses ever since 1994 when Michigan s LLC law was enacted. These business LLC operating agreements have only recently been adapted to cottage LLCs. Here is the trap: those business agreements are poor models for cottage LLC operating agreements, because cottage LLCs function exactly the opposite of business LLCs in many ways. Here are some of those opposites. In a business LLC, transfers of LLC interests almost never include an automatic transfer of voting rights. The opposite is true in a cottage LLC: when family members receive LLC interests, the other members typically intend that voting rights automatically transfer at the same time. So cottage LLC agreements must identify who gets voting rights automatically and who doesn t. Methods of seeking permission to make transfers are also treated in opposite ways. In a business LLC, the remaining members rarely want a deceased member s spouse or children to inherit that deceased member s interest. So the agreement will either prohibit those transfers altogether, or permit them only if the other business members consent. Those members would also typically have an option to purchase the interest that would otherwise be transferred. In a cottage LLC, the opposite is true. In fact, family members fully expect that the children (and in some cases surviving spouses) will inherit the interest without needing anyone else s consent. ongoing contributions. And they should address what consequences befall a family member who cannot afford the contributions. In a business LLC, members have no right to personal use of the LLC s assets. The opposite is true in a cottage LLC: the family members expect to use the cottage personally. In fact, they wouldn t have deeded the cottage to the LLC in the first place if they couldn t continue to use it! So the cottage LLC operating agreement must address issues not found in a business LLC operating agreement, namely, how use of the cottage is shared, whether the LLC may be rented, etc. So trap #5 is the failure of your cottage LLC agreement to adequately address subjects that are either insignificant or irrelevant to business LLCs. These unique cottage LLC terms should be drafted by legal counsel experienced in cottage LLC operating agreements. In summary, a cottage LLC can be a wonderful vehicle for enjoying the family cottage or vacation home. But structuring the LLC should be done by legal counsel experienced in cottage LLCs, as there are many traps to be avoided. If you are interested in learning more about cottage LLCs, please contact the author or any member of Miller Johnson s Vacation Home Planning Practice Group. Ongoing cash contributions to the LLC are also treated differently in cottage and business LLCs. In a business LLC, members typically do not expect to contribute additional cash to the LLC after they make their initial contributions. In a cottage LLC, the opposite is true: family members know they must contribute additional cash each year for cottage taxes, insurance, utilities, and maintenance. So cottage LLC agreements need to address the timing, amount, and limitations on these Jeff Ammon and Katie Hogan Aguilar presented at the 2013 Cottage & Lakefront Living Show at DeVos Place 7
Grand Rapids p 616.831.1700 f 616.831.1701 Kalamazoo p 269.226.2950 f 269.226.2951 www.millerjohnson.com Managing Member Craig A. Mutch 616.831.1735 mutchc@millerjohnson.com vacation home planning Kathleen Hogan Aguilar 616.831.1763 aguilark@millerjohnson.com Jeffrey S. Ammon 616.831.1703 ammonj@millerjohnson.com Karen J. Custer 616.831.1771 custerk@millerjohnson.com Christopher L. Edgar 616.831.1784 edgarc@millerjohnson.com Carol J. Karr 616.831.1723 karrc@millerjohnson.com If you received this from someone else and wish to receive your own copy or future copies of Priority Read - Vacation Home Planning, please send your name and e-mail address to info@millerjohnson.com or go to Publication Sign Up on our homepage. Keep an eye out for workshops and presentations our group offers throughout the seasons at www.millerjohnson.com. Miller Johnson is a member of Meritas, a global alliance of over 7,000 lawyers serving in more than 170 fullservice law firms across more than 70 countries. For direct access to locally-based legal expertise worldwide, please visit the Meritas website at www.meritas.org. U.S. News Media Group and Best Lawyers awarded Miller Johnson with high rankings for 34 practice areas in Grand Rapids and 11 in Kalamazoo as part of their 2013 Best Law Firms report. Achieving a high ranking is a special distinction that signals a unique combination of excellence and breadth of expertise according to the report. Services ranked as Tier 1 include employee benefits, bankruptcy and creditor/debtor rights, corporate law, labor and employment, mergers and acquisitions, banking and finance, commercial litigation, mediation, real estate, tax law, trusts and estates, and family law. This newsletter is a periodic publication of MILLER JOHNSON and should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only, and you are urged to consult your lawyer concerning your own situation and any specific legal questions you may have. For further information about these contents, please contact us. 2013 MILLER JOHNSON. All rights reserved. Priority Read is a federally registered service mark of MILLER JOHNSON.