Fun, Not Friction: LLC Planning for Family Vacation Property

April 3, 2016

Many of my clients own second homes at the beach, or the lake. Less frequently, clients own large properties (often farms) that have deep family and historic significance. In either instance, clients often want to keep these vacation or farm properties “in the family.”

Unfortunately, there are many instances in which these good intentions work out poorly. Usually, this is because the predictable carrying costs for the property (such as property taxes, maintenance, and insurance) don’t overlap well with variability in descendants’ financial situations.

Economic outcomes for children of the lower upper class (i.e., families in which each child will inherit less than $3 million to $5 million, and the class in which there is often one “family property” rather than several that can be parceled out “one to each child”) are characterized by volatility.

Some children tend to end up wealthy (hedge funds, options in venture-funded startups, etc.) while others don’t (boarding school teachers, artists, etc.). Children with the most available time to use the family’s vacation property are often not the ones with the most money available to pay for its upkeep.

Another trend impacting family property ownership is (as we noted previously) the increasing tendency since the ‘60s for adult children of socially and economically prominent families in the “Flyover” to migrate to the coasts in search of greater career opportunity.

(For vignettes illustrating this, read the obituaries published by the alumni magazine of any “fancy” college or boarding school – you’ll note that “Bigglesworth ’52 from Cleveland” returned home to run the family’s widget company and lived there as a pillar of the community for the next 60 years, while his child, Bigglesworth ‘82 never came back to Cleveland, but instead had a great career in software in the Bay Area, or as a “Beltway Bandit” in northern Virginia….)

Geographic dispersion of adult children matters because it reduces the odds that all (or even most) of a pool of descendants will (as a practical matter) be able to use a family’s vacation property.

A third trend families often don’t consider in planning for vacation property (but should) is that after a family’s balance sheet is divided several ways and descendants revert to the economic mean over time, descendants may need money to educate their children, or retire, and may want or need to raise funds by selling their interest in the family’s vacation property.

Even in families in which descendants get along well with each other, failing to plan for these issues can cause missed opportunities.

Yet, as everyone knows, adult children often don’t get along with their siblings. When this is the case, parents creating inheritance situations involving co-ownership of family property can create enormous discord, bitter dissension, and expensive litigation.

I believe the right kind of limited liability company can be a solution for family property ownership that both optimizes outcomes in families that do get along with each other, and substantially improves results when families don’t.

In many situations (subject to family-specific exceptions when it makes sense), some of the features of this type of “vacation property LLC” include:

Ownership. The LLC’s ownership would be split into voting and non-voting units. Only one person in each “branch” of descendants would be allowed to own voting units at any time. No person who was not a descendant (for instance, an ex-spouse) would be allowed to own voting units.
Governance. The LLC would be managed by a board of managers. The persons owning voting units would constitute the board of managers. In instances where there were more than two “branches” of a family, the board of managers would act by majority vote. When there were only two “branches” of a family, the board of managers would act by unanimous vote.
Ordinary Capital Contributions. Especially if a family vacation property isn’t rented to non-family outsiders to defray costs, capital contributions would be necessary from time to time to fund property taxes, maintenance, and insurance. Capital calls for these “ordinary” type of expenses could be made by at least 50% of the LLC’s membership interest (including nonvoting units), or by at least 50% of the LLC’s managers.
Unusual Capital Contributions. Capital calls above a certain inflation-indexed dollar amount (for instance, for major repairs or renovations) could be made by a supermajority of the LLC’s membership interest (including nonvoting units), or a similar supermajority of the LLC’s managers. The supermajority requirement should be set thoughtfully in relation the particular family’s “family tree” of descendants, balancing the risk that one family member or “branch” would be “pushed around” by others, against the offsetting risk that the member or “branch” would be an unreasonable “lone holdout.”
Partial Redemptions of Ownership by Owners Not Meeting Capital Calls. In my experience, few things frustrate high-earning siblings more than having to cross-subsidize co-ownership of a family property by lower-earning siblings who cannot or will not meet their share of a property’s carrying costs.
To address this issue, the LLC’s operating agreement would provide that when an owner didn’t meet a capital call, other owner(s) could. If they did meet another owner’s capital call, a portion of the “deadbeat” owner’s ownership interest in the LLC would be redeemed by the LLC.
This would proportionally increase the LLC’s ownership by the other owner(s) who had met the capital call on behalf of the “deadbeat.”
This feature seems attractive and fair, because over time, a “deadbeat” sibling co-owner’s stake would shrink, but the effect isn’t a punitive “immediate wipeout” of their ownership stake.
Valuation. To avoid fights over the LLC valuation in relation to partial redemptions, the LLC’s operating agreement could provide that the LLC will be valued at the property tax assessed value of its real estate, minus any mortgage debt on the real estate, plus the value of any cash or securities held by the LLC. Admittedly, property tax valuations often lag fair market valuations, but in this instance the convenience of using the property tax appraisal likely exceed any disadvantages.
Pro-Rata Limited Annual Tender Offer. Jane Austen might just as well have begun Pride and Prejudice with the observation that “it is a truth universally acknowledged that sometimes family members need money.”
Because this is a universal truth, the LLC would include a feature to provide limited, periodic opportunities for co-owners to “cash out”: a “pro rata limited annual tender offer.”
With this approach, each year, the LLC would be required to redeem up to, for instance, 3% to 5% of its ownership interest to interested co-owners.
If more than one owner wished to participate in the limited redemption for any particular year, the participation opportunity would be allocated pro rata among the interested co-owners, in proportion to their respective ownership of the LLC.
To raise cash to fund redemptions, the LLC would need to mortgage its property, create more rental income, or receive equity contributions from other owner(s). Limiting the size of the annual redemption right would allow the LLC’s managers to plan for the LLC’s liquidity needs. The annual redemptions permit an orderly exit by a family “branch” that isn’t interested in continuing ownership of the property, or that needs to raise cash.
As above, to avoid valuation controversies in administering the pro rata limited annual tender offers, LLC valuation would rely primarily on property tax assessments of its real property.

Using a thoughtfully designed “vacation property” LLC offers at least two other material advantages.

First, it sidesteps the right each sibling co-owner would otherwise have to seek judicial partition of the property, or a partition/auction sale. This protects siblings who wish to keep using a property, or who highly value keeping a property “in the family” for sentimental and/or historic reasons, against the forced sale of the property caused by different objectives or needs of another co-owner (even only one co-owner among many).

Second, holding property inside an LLC “wrapper” can increase privacy, and is almost always a prudent asset protection approach – no matter how ownership of the property is divided – especially if the property will be rented to outsiders. Property ownership presents all sorts of liability risks, including to trespassers as well as renters. It usually makes sense to “firewall” liability risks presented by the property from other parts of the balance sheets of the property’s owners. Although asset protection may not be the primary purpose of the “vacation property” LLC, it’s a welcome feature.

Another option a family might consider is “endowing” the maintenance and property taxes of their vacation property with a life insurance policy payable to the family LLC, or a bequest to the LLC in their estate plan, to provide initial working capital. This approach is particularly sensible when one or more branches of a family foreseeably won’t be able to meet capital calls, and the older generation bequeathing the property wants to mitigate the property’s cost-of-ownership burden.

Surprisingly, some older clients I work with who plan for their descendants to continue using a vacation property and co-own it together haven’t asked their descendants if that’s the outcome the descendants want. Every situation is different, but in most instances, I don’t think this lack of communication is helpful. If it turns out that enough descendants don’t have an interest in the property, it may be best to skip the vacation property LLC planning altogether, and instead arrange for its devise to the descendant(s) that do want it, or direct its sale in due course during estate administration.

Simply put, with the right planning, a family’s vacation property or farm can be the sort of “gathering place” clients envision, rather than a flash point for controversy, expense, discord, and litigation. The positive outcomes, however, usually don’t happen by accident.

If vacation property is part of your balance sheet, or if you have parents or grandparents with this kind of property, you’re well advised to invest time in thoughtful advance planning, to make sure your family’s one of the success stories, rather than otherwise.