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LLC - the best choice for cottage succession planning
This article compares the alternatives - trust, partnership, corporation - and concludes that a limited liability company is the best way to keep your cottage in the family for multiple generations.
Question: Our family wants to ensure that our waterfront property stay in family for generations to come, but what is the best way to handle ownership with regard to sharing maintenance and property tax expenses, income tax consequences, etc?
The first decision you must make is whether to use an entity. Without an entity, family members co-own the cottage real property as tenants in common or joint tenants. Their legal relationship is governed by real property law. This is the most common form of cottage ownership but not the best. There are many problems caused by holding title as tenants in common: each owner can force sale of the cottage through an action for partition (a court proceeding); there are no clear rules for sharing use or expense of the cottage; owners may transfer their interests in the cottage outside the family; owners can mortgage their individual interests in the cottage, with a default causing problems for all. Some of these problems can be solved by using a joint owner's agreement. The current owners could sit down and negotiate an arrangement that they believe to be fair. A lawyer would be engaged to formalize the agreement.
Using an entity
The problems caused by shared ownership under real property law are addressed by transferring the title to the cottage to a legal entity, such as a corporation, limited partnership, limited liability company (“LLC”), or an irrevocable trust. The entity provides a legal framework in which the Founders can script how the cottage is to be used, shared, and passed on to future generations. The features of each type of entity is discussed briefly.
Corporations
A corporation is a legal entity formed under state law. Corporations, originally developed to serve as a business enterprise, usually have three layers of control. At the top are the shareholders, who own the entity but have a limited role in management. The shareholders elect directors, who set policy and give overall guidance. Officers handle the day-to-day operation of the corporation. Officers are appointed by, and serve at the pleasure of, the board of directors.
Corporations can be used for cottage planning. The main thing to recommend using a corporation is that many people understand the general roles played in the structure by shareholders, directors, and officers (president, secretary, and treasurer).
The rigidity of the traditional corporate structure is not well-suited to the family cottage, where the people who own the cottage (shareholder role) also operate it (director and officer roles). State laws impose formal requirements on the operation of a corporation: shareholders and directors are required to meet annually (shareholders to elect directors, directors to appoint officers and approve major actions); notices of meetings must be given within a specified period before each meeting; placing family members into the roles of president, secretary, and treasurer seems artificial.
Traditional corporate formalities can be eliminated through clever drafting, but at the cost of losing the familiar structure of the corporation, which I see as the main argument for using the corporate form. Manipulating the 3-tiered structure of the corporation through bylaw provisions, shareholder agreements, or voting trusts results in a complex, unfamiliar arrangement that is not suited to family cottages.
Limited partnerships
The limited partnership is a special form of partnership. Unlike a general partnership, in which each partner’s assets are exposed to creditor claims, the assets of the limited partners of a limited partnership are not so exposed.
A limited partnership must have a general partner. While cottages rarely lead to claims against owners, the fact that the general partner’s assets are subject to such claims makes this type of entity less attractive than others, which do not expose any individual’s assets to creditor claims. The requirement that a limited partnership have a general partner (which cannot be eliminated through drafting) causes the limited partnership to be less attractive than the LLC for cottage planning.
There is nothing to recommend a limited partnership over a limited liability company. While limited partnerships frequently are used to achieve estate planning objectives, these objectives can be met through the use of an LLC.
Limited liability companies
The LLC was developed to have the most desirable characteristic of a corporation (limited liability) without the complexity of a corporation. Wyoming, the first state to authorize LLCs (1977), modeled the LLC upon the German GmbH, which has been used for business in that country since 1892. Most European and Latin American countries permit this type of entity, which is authorized for use in all 50 states now.
Lawyers value LLCs for their flexibility. The ease with which a LLC can be adapted to many forms of enterprise makes them ideal for structuring the relationship among family members with respect to a cottage.
An LLC is formed by filing articles of organization with the state registration office. The state need not be the state in which the cottage is located. Although LLC enabling laws varied considerably as the entity was in its formative stage, state law is converging (in large part due to the promulgation of the Uniform Limited Liability Company Act in 1996 – the Uniform Limited Liability Company Act II was released in 2006), so that most families are best-served by having their company formed under the law of the state in which their property is located.
The articles of organization establish the name of the company (“Smith Cottage, LLC”), identify an agent and office in the state, and whether the company is “member managed” or “manager managed.”
The relationship of the members to one another and to the LLC property is established in an operating agreement (“OA”). The OA determines everything about the cottage: schedule, contribution to expenses, who is a permissible owner, whether a surviving spouse can inherit or use the cottage, and whether the cottage can be changed, mortgaged, or sold.
Once the LLC is organized, the owners of the cottage deed their interests in the cottage real estate to the LLC in exchange for membership units. These units, which function like shares in a corporation, can be given to children during the owner’s lifetime, or passed to children at the owner’s death.
Cottage LLCs normally are “manager managed.” This means that the family designates one or more of its members to perform such functions as paying the bills, coordinating schedules, and hiring contractors to service and maintain the cottage. The manager may have as much, or little, authority as the members wish, as provided in the OA. Decisions beyond the authority of the manager are made by the members. Less significant decisions might be made by a simple majority of members, where the biggest decisions (mortgaging the cottage, permitting renters, adding on to the cottage) normally are made by a greater majority of members (2/3 or 3/4).
The art of cottage planning is in developing an OA that addresses the needs and wishes of your family.
Irrevocable trusts
It also is possible to administer a cottage through an irrevocable trust. An irrevocable trust ordinarily comes into existence under the estate plan of a cottage owner. The trust designates one or more persons who serve as “trustee” of the cottage. The trust instrument specifies how the family members (beneficiaries) share the cottage. The trust may contain cash, in which case the trust might also pay some or all of the costs of operating the cottage.
For cottage purposes the irrevocable trust suffers in comparison to the LLC. Among the reasons: a trust can’t last more than about 90 years (the LLC can last indefinitely); it is not possible to amend an irrevocable trust (the LLC OA can be amended by the members to meet changing circumstances); the trustee can’t be replaced (the members can vote out a manager if the OA permits it); the beneficiaries of a trust can’t be changed, making it impossible to determine who may use the cottage (if granddad’s trust said that all grandchildren could use the cottage, so be it, even if one of the grandchildren is disruptive and awful), whereas the member of an LLC could choose to give an interest in the cottage to some children, and not to others. Some of these problems might be addressed by clever drafting of the trust, but the effort it would take is disproportionate to the ease with which these matters can be handled under the LLC form of ownership.
Stuart J. Hollander (2006) |
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