Designating IRA and other Qualified Plan Beneficiaries

Please note that this is a very complex area and what follows is generalizations.  This is an area that should be reviewed on a client-by-client, case-by-case basis with a qualified attorney or CPA.

The surge of Estate Planning “experts,” including websites and seminars over the past 20 years has created a surplus of “information” related to estate planning.  Much of this information, while useful in context, is misunderstood and consequently, misapplied.

My “rule of thumb” for the past few years has been to name adult, responsible beneficiaries as direct beneficiaries on IRA and qualified plan assets, unless there is a compelling reason otherwise.

Along with the growth in family Estate Planning Trusts, has come a misunderstanding by many clients and advisors, of the inter-reaction between Trusts and Qualified Retirement Plans.  We tend to think of Trusts as the best solution for all of our Estate Planning clients’ needs.  In a perfect world, this might be true.  From a planner’s perspective, I would like nothing better than to have the flexibility to funnel all of a client’s assets through their Revocable Living Trust.  It would give us ultimate control.  Unfortunately, it doesn't work that way, and while a frustration for planners, it is what we have to work with.

There is no area more fraught with potential economic disaster that so-called, “qualified retirement plans” and IRA’s.  Unfortunately, because our laws are sometimes at odds with each other, there is potentially major income tax peril in linking qualified plans with a Revocable Trust.  While there will be times when the clients’ objectives will require us to do so, such linking is not without pitfalls, and should be undertaken only very carefully.

My “rule of thumb” for the past few years has been to name adult, responsible beneficiaries as direct beneficiaries on IRA and qualified plan assets, unless there is a compelling reason otherwise.

In spite of this advice, we too often find that a client (or their financial advisor) has designated their Trust as beneficiary.

Qualified Plan and IRA Basics

The “idea” of qualified plans was to encourage people to do their own retirement savings.  The “carrot” was the ability to remove a portion of income from taxation when earned, and while it grew (in some cases, it worked “too well”).  Over my years as an Estate Planning Attorney, I have found it more common than not that a client has IRA and qualified plan assets that they are not drawing from, even when well into retirement.  However, the idea was never intended to be an Estate Planning mechanism for passing wealth down to the next generation.

the idea was never intended to be an Estate Planning mechanism for passing wealth down to the next generation

Because of this, the rules eventually require a “forced” withdrawal.  This normally ocurrs when the account holder (participant) reaches retirement age (“the year in which they reach age 70 1/2”).  A second instance is upon the death of the participant.  If the rules simply required a lump sum distribution at the death of the participant, it would be a simple mathematical equation and it would end there.  In that case there would be no issue with Revocable Trust beneficiary designation.  However, the law identifies some different methods of distribution and several of them are very tax-significant.

While an IRA is technically not a “qualified” retirement plan, it is by far the most common form of retirement savings, and shares essentially the attributes of a “qualified” plan.  Indeed once you are in “retirement mode,” the IRA is perhaps the better and more flexible retirement plan vehicle, particularly in terms of estate planning (and for this reason, we often counsel fully retired persons to roll their qualified plan assets into an IRA).  Most of the rules contained within IRS Regulations are specifically directed at IRA accounts.  IRAs are a more or less statutory retirement plan and as, such, are pretty typically similar, from sponsor to sponsor.  However, it is always advisable to read the plan document (be it an IRA or some other plan type), to ensure that it provides for what we think it does.  While we often apply IRA rules to other qualified plan accounts, it is important to understand that the plan documents may differ significantly.

When there is a Surviving Spouse

The Typical Family.

The most significant beneficiary designation involves the surviving spouse.  In the majority of planning situations, I deal with a married couple who have acquired assets together and raised their mutual children for a period of years.  Their typical wishes are to take care of each other in their retirement years and have any remaining assets go on to their children on a relatively equal basis upon their deaths.  In this case we almost never designate anyone but the spouse as the primary beneficiary of a participant’s retirement plan.  The spouse, in most circumstances, can elect to treat the decedent’s plan as their own.

In spite of this advice, we too often find that a client (or their financial advisor) has designated their Trust as beneficiary.  While this is often a cause for angst, there are IRS rulings (in the case of an IRA) that would allow a surviving spouse who was the sole income beneficiary of the trust to remove the IRA and make the favorable spousal election.  It does, however, increase complexity and reduce flexibility.

“Unique” Circumstances.

There may be circumstances where a direct beneficiary designation to a is not the desired result, such as where there is a second marriage, blended families, non-resident spouse, or perhaps just a concern that the surviving spouse may not appropriately manage the assets.  In this case, we may still want to designate a Trust as beneficiary.  For example, in a second marriage situation, the participant may wish to have the spouse have the annual income from the retirement plan, but ensure that any remaining plan assets go to their own children.  However, to use a common advertising disclaimer; "Do not try this at home."

While Congress has provided that it is permissible to designate a Trust as an IRA beneficiary (and, presumably, by analogy, other “qualified” plans); and the IRS has provided us with guidance on how to safely do so, that guidance is a proverbial minefield of danger.  Any misstep will likely not only result in a deemed lump-sum distribution (and therefore immediate income taxation) of the entire remaining balance, but will also very possibly result in taxation at the highest percentage brackets.

And, even if done properly, the appropriate administration of such accounts in a Trust guarantees long-term ongoing trust administration and lack of ultimate flexibility for the surviving spouse.

There may be circumstances where a direct beneficiary designation to a is not the desired result, such as where there is a second marriage, blended families, non-resident spouse, or perhaps just a concern that the surviving spouse may not appropriately manage the assets

Contingent Beneficiaries and When there is no Surviving Spouse

The concerns are even more compelling when there is no surviving spouse, or when, because of a prior death, the contingent beneficiary designation becomes effective.  Only the spouse is entitled the “treat-the-account-as-is-it-were-my-own” (referred to as a spousal rollover) election.  However, an individual beneficiary may still have some ability to reduce the effects of taxation on the account.

An individually designated beneficiary may elect “beneficiary IRA” treatment (sometimes called a “stretchout” IRA by financial advisors).  The rules here are pretty clear when the beneficiary is an identifiable individual.  The beneficiary may use his or her life expectancy (in accordance with published IRS tables), to calculate an annual required minimum distribution.  Distributions must commence shortly after the death of the participant, regardless of the age of the beneficiary.  But obviously, there is significant value in the continued tax deferral of the balance of the plan assets during the lifetime of the beneficiary.

“pass-through” language must comply with some very technical IRS Regulations requirements that attempt to match trust fiduciary accounting rules with IRA distribution rules.

Unpredictable Beneficiaries

What if our intended beneficiaries are minor children, or children with special needs or other “disabilities?”  These are instances in which we might wish to use a Trust, even in light of all the pitfalls.  These might be one of the “compelling” reasons my “rule of thumb” acknowledges.

The IRS rules, as noted earlier, do allow for a Trust to be the designated beneficiary of an IRA.  But as also noted, not without complexity and inflexibility.  The Trustee may “step into the shoes” of the trust beneficiaries in only a couple of instances.  First, if all of the trust beneficiaries are identifiable persons and the trust provides for immediate distribution of all of their shares to them; or second, if the trust contains specific “pass-through” (sometimes called “see-through”) language.  If there is a class of beneficiaries (like “children” or “grandchildren”), the distribution rules will be keyed to the oldest person in the class (with the effect of forcing the taxable income out in the fastest manner).

In each case, the IRA custodian will likely be somewhat inflexible.  Typically, this means that a trust “beneficiary” IRA is set up and the Trustee is charged with calculating the annual minimum distribution amount, requesting it from the custodian, and distributing it to the beneficiary, in accordance with the trust language.  This will likely continue on a yearly basis for the lifetime of the youngest beneficiary or until assets have been exhausted.  While this gives the “stretchout” benefit, it must be balanced with the economic and emotional costs of maintaining the trust.

And, the “pass-through” language must comply with some very technical IRS Regulations requirements that attempt to match trust fiduciary accounting rules with IRA distribution rules.

What about Charitable Beneficiaries?

The IRS regulations are also clear about who may be a designated beneficiary for purposes of the “stretchout” election.  They must be identifiable individual beneficiaries.  So what if the trust (or the IRA by direct designation) provides for a charitable beneficiary?  The purpose behind the individual requirement appears to be so the life expectancy calculations may be accurately made.  Obviously, an entity cannot have a life expectancy.

But the IRS has acknowledged that charitable beneficiaries are common, and has given us a planning “out.”  As long as the charity’s portion can be determined and is paid out within a year after the death of the participant, the IRS will essentially ignore it.

What this does tell us is how important the details in planning are.  I often find it fits client’s objectives more closely to designate a specific portion of the IRA to charity, or event to split off a separate account and designate it entirely to charity.

As with all Estate Planning, we need to remember that it is a “moving target.”  Regular period review of designations and of your goals are important to making sure this all works.

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Should You Have a "Ladybird Deed" ?

With all the competition for customers (from lawyers and non-lawyers alike) in the estate planning field, it is easy to see why the consuming public has the perception that an estate plan merely consists of a pre-printed form, or a set of forms, and that there is a “standard” method of planning.  And it seems like there is always some hot, new technique for estate planning being advocated, often by marketers.  It is nearly impossible these days to find an article, or attend a presentation on Estate Planning these days without hearing about the virtues of  the “Ladybird Deed,” and why everybody should have one.  It is common to have a client call or come in for an appointment, already convinced that they “need” a ladybird deed.

  it seems like there is always some hot, new technique for estate planning being advocated, often by marketers.

The reality is that these are actually somewhat complicated real property conveyancing tools.  And like all tools, I have often said over the course of my career that estate planning is not a “one-size-fits-all,” proposition.  And there is perhaps no better example of this than the “Ladybird Deed.”  The truth is that some people may benefit from the technique and many may find it a detriment.  In order to appreciate this, we need to discuss what a “Ladybird Deed” is and what it does.

Ladybird: What’s In a Name?

"Ladybird" is a name that caught on from use by a Florida attorney and lecturer whose favorite fictional spouse reference was “Ladybird,” in his examples.  The technically correct name is “Enhanced Life Estate Deed."

The reality is that these are actually somewhat complicated real property conveyancing tools.  And they are not a “one-size-fits-all,” proposition

Attorneys learn early in law school that property rights in the most of the U.S. can be divided up into different interests, and that the interests can be defined in different ways.  The sum total of all the rights held together, is known as the fee title.  It is not uncommon to see specific rights be divided (such as mineral, water and wind rights) and conveyed or reserved when the underlying land is conveyed.  It is also possible to convey rights that can be measured by the duration of ownership.  One such division and conveyance is the traditional “life estate.”  Like it sounds, a life estate is measure by the lifetime of the owner of the life estate.  Usually.

There is a very real temptation (often by persons unqualified to give estate planning advice) to indiscriminately use Ladybird Deeds

An Enhanced Life Estate reserves or conveys the traditional duration (life of the owner), but also adds an element (usually reserved by the transferor) to in effect, “change their mind,” and convey the fee title of the property away to someone else (or back to themselves).

Ladybird deeds can be very powerful, versatile, estate planning tools.  But like any tool, they can be misapplied.  Estate Planning is a process involving the careful application and combination of available tools.  There is a very real temptation (often by persons unqualified to give estate planning advice) to indiscriminately use Ladybird Deeds.  But the deed is just a tool, not a process!

Why Shouldn’t You Use a Ladybird Deed?

The danger in casual use of these deeds lies in viewing real estate conveyances as on-dimensional.  There are numerous related risks.

“Uncapping."

Michigan’s ad valorem real property tax scheme is based on complex valuation rules.  In the late 1990’s Michigan’s Constitution was amended to impose a “cap” on how much real property tax assessments could be increased.  This capped value is known as “Taxable Value,” and is subject to a cost of living – based formula, limiting increases.  Like so many laws, over time a series of exceptions and exemptions have emerged. Taxable Value, for example, may be “uncapped” when the property is conveyed (remember that there is a conveyance – or perhaps multiple conveyances – involved when a “Ladybird Deed” is created).  While there are certain exemptions to this “uncapping” rule when Estate Planning and Family transfers of residential real estate are involved, current Michigan law does not appear to apply such exemptions to the end conveyance accomplished by the Ladybird Deed.  So beware!

In order to track the changes of ownership (and therefore “uncapping” opportunities), Michigan has an affidavit filing process (MI Department of Treasury Form L4620 – Property Transfer Affidavit) with local assessors.  There is a relatively nominal fine for failure to file the affidavit and perhaps a temptation to ignore filing it.  One significant concern is that if the time period between the recording of the conveyance and the automatic conveyance by termination of the life estate is substantial, will this cause issues.  The affidavit should be filed, and one of the exemptions invoked, in my view.

Indiscriminate use of a Ladybird Deed may have unintended and undesirable results

Probate Avoidance.

Our modern society has evolved with the ability to structure “pay on death” direct beneficiary designations with nearly every type of asset people own today.  Michigan is one state where such transfer techniques are plentiful and easy to accomplish.  The Ladybird Deed, is such a technique.  It is relatively easy to create, and may well result in a probate--avoided transfer.  Again, indiscriminate application however, may create undesirable results.  This is particularly true where the intended recipients are multiple children.  “Joint” ownership of real property may create a whole set of unintended problems of its own.

Medicaid Planning.    

The so-called Elderlaw planning industry really thrust the use of the Ladybird Deeds into the forefront.  They have been a very powerful tool for Elderlaw planning.  But a lack of understanding of the tool and the process may well create unintended consequences.  The filing of a Medicaid Application is very timing specific.  Whether to convey property by Ladybird Deed, directly to a trust, by JTWROS designation, or not to convey at all, should be carefully considered by the planner, in light of all of the client’s circumstances.

What State are You In?

Not all States recognize Ladybird Deeds.  Since the real estate laws and rules vary by State to State it is wise to consult a knowledgeable specialist in the State where the property is.  Some States recognize a "pay on death," or "transfer on death" conveyance.

Ladybird Deeds are a powerful and often desirable planning tool.  My objection to them is when they are used in an unconsidered, “knee-jerk” one-size-fits all approach to the planning process as a whole.

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Welcome Clarification on Family Transfers of Residential Real Property and “Uncapping”

The new law now provides that transfers of property into and out of a trust, and via an estate, to these family members, are exempt, in addition to direct transfers.

Beginning December 31, there is yet another beneficial new exception to “uncapping” of transfers of residential real property between certain family members.

In the early 1990’s the Michigan Legislature passed legislation that “capped” the ability of local taxing bodies to increase the “taxable value” of real property to a the lesser of (currently 1.05%) and the rate of inflation for the year.  The statute attempted to define “transfer,” and also set out a series of exceptions to “transfers.”  Over the ensuing years, other exceptions (notably the Agriculture Exception) were added.  But also during this period, some disagreements arose over the meaning and intent of this legislation.  The was a particularly important issue for family cottages and recreational properties that were passed down from generation to generation.

In 2011, the Michigan Supreme Court interpreted one of these disagreements, in Klooster v. City of Charlevoix, holding among other things, that if at the time all owners at one generation died, but there was also a surviving joint tenant in the next generation (most commonly one or more children), that the survivorship conveyance of title by operation of law was not a “transfer” as the Legislature intended that term.  While I have never been persuaded by the Klooster analysis, who am I to rock the boat – particularly when the decision is basically favorable to the taxpayer?  See my blog, “Michigan Supreme Court Buys Us Another Generation on Real Property Taxes,” from March, 2011.  The Klooster case gave us some new, limited planning opportunities to preserve the “cap” on family transfer of property.  But it wasn’t enough.

It wasn’t enough

In December of 2012, Governor Snyder signed new Legislation aimed at this problem.  See, New Michigan Law Avoids “Uncapping” in Family Transfers.”  But as we will see, the aim was not as accurate as it might have been.  The new legislation (effective December 31, 2013, and on), provided that a direct transfer or conveyance of residential real property to a person related to the transferor “by blood or affinity to the first degree,” where the residential use continued, was not deemed a transfer for “uncapping” purposes.  This rather archaic definition seemed reasonably clear to those of us who took the basic Wills and Estates course in law school, but it left way to much uncertainty on the table.

It remained unclear whether these transfers among family members only applied to direct transfers (which would exclude transfers using Trusts, Wills, Estates and Limited Liability Companies).  If they did, it was – though a welcome forward step – still not enough.

It was still not enough

My own view was that given the history of interpretation of similar issues by local governments and by the Michigan Department of Treasury, combined with the near-bankrupt condition of our state government, they were going to take a very literal interpretation of the statutory language.  In Michigan State Tax Commission Bulletin number 23 dated December 16, 2013, my supposition was confirmed.  They would view this as only applying to direct transfers:  “Due to the blood relationship clause, the Commission has defined the transferee and transferor as a ‘person.’  Therefore, this exception to uncapping does not apply to a trust, a limited liability company, or a distribution from probate.”  Transfers to and from estate planning devices like trusts would not come within the exception.  Nor would transfers from an estate, whether by Will or intestate succession.  Again, while there were some additional planning opportunities (the “Ladybird” Deed, for example would work), they were still too limited.  One of the benefits of estate planning – and particularly the trust as a planning tool – is the ability to maintain some management and control where the beneficiaries are either not sufficiently mature to manage, or where there are multiple beneficiaries.  The trust allows ownership and management of assets for the benefit of children, including family legacy real estate (like the family cottage).

Now there is good news

The title of the blog promised good news.  And there is.  On October 10, the Legislature passed still more legislation, clarifying the “uncapping” rules.  Effective December 31, the law now defines those family members within the no uncapping exception more specifically as transfers to “a mother, father, brother, sister, child, adopted child, or grandchild.  And even better, the new law now provides that transfers of property into and out of a trust, and via an estate, to these family members, are exempt, in addition to direct transfers.

We now can breathe easier as estate planners and clients, knowing that we can continue to plan for estates using tried and true techniques.  Like any new law, there will be a period study and analysis and inevitably, questions about clarity of certain provisions and interpretation.

All in all:  I think this is a great development.

Thanks to my Law Partner and fellow Estate Planner, Elian Fichtner for her research and help on this article and topic.  See more about both of us on our website link at the top of the Blog 

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The Michigan Property Tax Personal Residence Exemption

The Michigan General Property Tax Act authorizes municipal entities, including cities, townships, villages, schools, and municipal "authorities" to levy taxes real and personal property in Michigan. There are two principal exemptions from part of the taxes that routinely impact our clients. The most commonly invoked exemption is the "personal residence exemption" (a/k/a "homestead exemption). The second important exemption is the "qualified agricultural property" exemption (see, Navigating The Michigan General Property Tax Qualified Agricultural Property Exemption). Both exempt the subject property from the school tax. The mechanics of their application differs somewhat.

There is a lot of misinformation out there, much of it by word of mouth. This is an important exemption, as the school tax tends to be one of the highest taxes levied. So, understanding its applicability is worth a few moments' reading.

The personal residence exemption applies to property which is classified by the tax assessor as "residential property." Classification as "residential," does not by itself qualify the property for the exemption. The owner must demonstrate, to the satisfaction of the taxing authority (or – ultimately – the Michigan Department of Treasury), that the property for which they are seeking the exemption is their one, true personal residence.

Obtaining the Exemption

In order to qualify for the principal residence exemption, a homeowner must file an Affidavit of Personal Residence, (Form 2368), which may be obtained on line at the Michigan Government Website (www.michigan.gov/treasury). The affidavit must be filed – in most cases – not later than May 1 of the year the exemption is sought. The Affidavit is filed with the Local Assessor, not with the Treasury Department.

There are instances when a "late" filing can be sought by appearing before the tax board of review (which convenes in most municipalities in July and again in December). It probably makes sense to seek some professional assistance at that point, as there are rules and deadlines that must be carefully observed.

The greatest area of concern is when a residence is purchased after the May 1 deadline. In most instances, the prior homeowner has already filed the affidavit and qualified and the exemption will remain in effect until December 31, after which you may file to meet the May 1 deadline for the following year. The Affidavit need only be filed once and the exemption remains in effect as long as the residence continues to qualify for that owner.

Qualifying For the Exemption

This is the area where the most confusion (and frankly, a fair amount of "license" with the rules) usually arises. This exemption is intended to apply to one personal residence where a resident of Michigan intends to permanently use as their primary home. There are certain indicia that the Department of Treasury (or the local assessor) uses as "proof" of residency. The statutory provision makes clear that it is a matter of intent on the part of the owner. But proof of such intent is sometimes difficult. The authorities will look at things like voter registration address, address on Michigan Driver's License or other Michigan I.D., where the applicant has his or her mail sent, where bills are mailed and the address they use on official tax filing. None of these items alone will be determinative, but they will be used as evidence of intent.

The Michigan Department of Treasury publishes a pdf pamphlet called "Guidelines for Michigan Principal Residence Exemption Program." It is worth noting that in the guidelines, they specifically address the vacation home or cottage issue. Up until just recently, most lakefront vacation property in Michigan was appreciating much more rapidly than suburban or urban residential property. The tax pressure on owners of these properties was enough that many such owners have attempted to make them their personal residence in order to have the exemption apply to their higher value property. Some even attempted to claim both residences as their principal residence. About 10 years back, there was a strong push by taxing authorities to seek out these "transgressors."

The Guidelines make it clear that the state will view this as a matter of reality. In other words, you cannot simply change your driver's license, voter registration and other "indicators," and automatically have the property qualify. You have to demonstrate in a meaningful way that you indeed intend to reside in the property as your principal residence. While there are obviously grey areas (e.g., the "snowbirds," who may spend 6 or more months in a warmer climate), this means that you "live" there – you spend the bulk of your time there.

Multiple Exemptions

It is clear that a homeowner is only entitled to one principal residence exemption. You must be a resident of the State of Michigan and you may not have claimed a similar personal residence exemption in another state, country or territory. You cannot have dual residency, for purposes of the exemption.

What if you are husband and wife? State and Federal laws are nothing if not unclear about this distinction. The general approach is that we treat married couples as a single unit. However there are exceptions. For purposes of the principal residence exemption, if a husband and wife file a joint income tax return, they are entitle to one exemption for their "marital unit." However, if they file separately, they may each claim an exemption. Beware, however, that they will still have to demonstrate the "intent" reality discussed above. In most cases, unless the parties are separated, that will be pretty difficult to do.

Much will depend upon the diligence of the local taxing authorities on all of the above issues.

The Ownership Requirement

This requirement may be among the most elusive – and confusing. Like much legislation, the language is not necessarily consistent, nor clear. For example, the General Property Tax Act refers to the term "person." Yet they don't necessarily consistently apply their interpretation. For purposes of the principal residence exemption, "person" is interpreted as its plain meaning, a "human." A residence that has been transferred into a Limited Liability Company, a Partnership, or some other legal entity will cease to be qualified for the principal residence exemption. While this may seem harsh, it is the law in Michigan. Where we see this application cause the most problems is in the family farm arena, where we are often structuring land-holding entities and family limited liability companies and partnerships. Because there are other complex rules and programs affecting farmland, and because the farmstead and family home are often part of a larger tract of land, family estate and succession planning can become problematic and complex, and attention to detail is important in that context.

You do not, however, need to be a 100% owner of the property. The law says a partial owner may claim the exemption (again, subject to demonstrating that it is their one true personal residence). This means joint owners, and holders of life estates may still claim the exemption.

The law does not specify the amount of ownership. This opens the door to some creative tax and estate planning. For example, a child, parent or sibling could legally own a fractional interest (as little as a 1% joint tenancy interest), but reside in the home and claim the exemption. This, combined with the "uncapping" protections we learned about in the Klooster case (see, "Some Family Cottage Strategies In Light of The Klooster Case") may present some very enticing family property succession strategies.


A residence that has been transferred to a grantor-revocable trust also qualifies for the exemption.  In that case, the grantor (in most cases) is deemed the "person" who is the owner and entitled to the exemption.

Finally, note that you may claim the exemption if you are a Land Contract purchaser. This makes sense because Michigan Law sees such a purchaser as the "equitable" owner of the property, subject to the security interest of the Land Contract Vendor (the so-called "legal owner").

What Property is Covered?

This is another area which is sometimes susceptible to confusion. Adjacent land parcels are often arbitrarily separated by legal description (e.g., by the way they are acquired by deed) or by tax parcel identification code. They may be separated by roads, ditches, waterways, or other natural or man-made obstructions.

The exemption covers all contiguous property to the occupied residence, as long as it is: (1) classified residential, (2) is vacant, and (3) is not used for non-residential purposes. The Guidelines provide several examples of what qualifies as contiguous. Essentially, it is property which is "touching" the property the primary residence is on. A road, ditch, stream, etc., does not destroy contiguity. Another parcel owned by another that is in between does (there is some thought that the state views a corner-to –corner touching as not contiguous, though I fail to see the logic in that view) .

Separately described or deeded parcels or parcels with separate tax code parcel identification numbers, will all still qualify, as long as they satisfy the contiguity requirement. You need not combine parcels in order to have the exemption. You do, however, need to file separate exemption Affidavits for each separate tax code parcel.

The state is dead-serious about the 3 limitations above. If a contiguous parcel has a separate structure on it, it is not "vacant" and does not qualify for the exemption. If any business use is occurring on the contiguous parcel, at least a portion of it will not qualify. The most common example of this latter occurrence is vacant farmland, which is being farmed for rent. In most cases, it will or can be classified as qualified farmland, which will solve the problem. In other cases, it will be important to seek qualified professional assistance.


 

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Some Family Cottage Strategies in Light of the Klooster Case

Nothing triggers emotions more than the family cottage. You may have raised children who spent all their vacations there. You may have grown up there yourself. All the best memories are often there. Yet this family "heirloom" often becomes the most difficult asset to pass to the next generation; and sometimes the most contentious.

As an owner-family, one of the first questions I have clients consider is whether they should even go down that proverbial road? There is simply no legal "GPS" for finding the right mix of ownership and management of multiply-owned family recreational property. Much has been written about this subject over the years, including "Saving the Family Cottage," by Stuart Hollander, a Northern Michigan Attorney who lived and practiced in Leelanau County; and "The Cottage Rules" by Nikki Koski. These books purport to help "solve" the problems arising in trying to pass a cottage from one generation to the next. Yet they admit that it is more of an art than a science. In the end, I usually counsel my clients that their own family "chemistry" will make or break the succession, no matter how good or clever our written documents and plans may be. And, a continuing problem is how, even after passing to the second generation, successive generations will be treated. This article is not really a piece addressing whether the family cottage should be passed. Nor is it really a road map illustrating how it should be done. Rather, it addresses some of the pros and cons of different ownership methods and when they might be considered, in light of the real property taxation.

In 2010, the Michigan Supreme Court decided Klooster v City of Charlevoix, defining under what circumstances a "transfer" resulting in "uncapping" for purposes of the Michigan ad valorem real property tax. "Capping" refers to a limitation placed on the ability of the taxing municipality to raise the "taxable value" of real property as its fair market value increases. The intent of the act was to keep current owners from being unfairly taxed in relation to increase and development of surrounding properties, during their tenure of ownership. It imposes a formulaic limit on tax increases. However, when the ownership is transferred, this "cap" comes off and the taxing authority is free to make a one-time (for each transfer) adjustment to reflect fair market value in the hands of the new owner. The Klooster decision put an interesting (and for some of us, unexpected) twist on the meaning of "transfer" of ownership for purposes of the act. See, Michigan Buys Supreme Court Buys Us Another Generation on Real Property Taxes.

Before addressing the pros and cons, it is appropriate to review ownership options for family cottage properties. Over the years, some different methods of ownership by the next generation have been prevalent.

Joint Ownership

Perhaps the most common (and the most fraught with problems) is joint ownership of property. Michigan law observes several different types of joint ownership. Among non-married owners, the most common and often presumed type is as tenants-in-common. In tenancy-in-common, each owner owns an "undivided" fractional interest in the property. The interest can be sold, or transferred freely. In the event a problem arises in co-ownership, a tenant-in-common may ultimately petition the Circuit Court for an action to partition. The court may, alternatively, order a sale or physical division of the property. A second type of concurrent ownership is as joint-tenants. This type of ownership presumes that on your death, your interest passes, automatically, to the surviving owner. But during lifetime, between non-married owners, the interests may be sold or transferred freely. Such a transfer converts the joint tenancy to tenancy-in-common. A third type of joint ownership is known as joint tenancy with full rights of survivorship (JTWROS). Here, the decedent's interest also automatically passes to the survivor(s). However, these interests may not be transferred or sold without the concurrence of all joint owners. The JTWROS tenancy may not be severed, even by a court.

You may note that I have prefaced each of these with "among non-married owners." In Michigan, when a husband and wife take title to real property, it is presumed that they do so as tenants-by-the-entireties (a special type of JTWROS ownership reserved for married couples). It should be easy to see that, depending upon the makeup of owners and their ability to (and perhaps live) together, each of these owner methods may have potential significant disadvantages.

It is permissible, and in my view, strongly recommended, that the parties have a separate, recordable and enforceable written agreement providing for use, management and succession issues.

A separate, written agreement providing for use, management and succession issues is strongly recommended

Trusts

Another ownership method is a Trust. Most often, a parent-owner will create a Trust for ownership during their lifetime which provides for "rules" and management of the property following their death. Trusts can create complexities and difficulties that may have been completely anticipated by the client and/or drafter. Someone or some entity must act as the Trustee, with the significant responsibilities impose by both the Trust Agreement and the Michigan Trust Code. Tax reporting at both the federal and state level is required. The allocation of the taxable (and deductible) attributes is not always simple. There are annual reporting and accounting requirements, sometimes to more "remote" individuals who may have no current involvement, but have a possible future interest. Trusts are generally a cumbersome method for continuing ownership and often will direct another form of ownership upon the death of the original owners/trustors and transfer to the next generation. The "uncapping" circumstances for trusts are quite complex.

Entity Ownership - Limited Liability Company / Partnership

For numerous reasons, the Limited Liability Company (LLC) has become the real estate owning entity of choice in Michigan. It is an outgrowth of the Partnership, which was perhaps the preferred method before the LLC. The partnership's "achilles heel" was the unlimited liability every partner had on all partner activities. The LLC effectively created a Partnership with the same limited liability that a corporation traditionally had. And, over time, the Michigan LLC Statute has evolved as the most flexible and creative business entity tool available for planning.

The LLC has become the Real Estate Owning Entity of Choice in Michigan – but it has "uncapping" Issues.

With an entity format, the owners can have an agreement for management and succession of ownership for multiple generations. A manager(s) can be designated and "branches" among the family can be defined, for purposes of voting. A "buy and sell" agreement can be put in place, providing for valuation methods and payment methods, as well as limitations on sales and transfers. Accounts can be established for payment of expenses. And, because the entity is the owner of the real property, as "members" come and go, the ownership stays within the company. Because of this structure, the LLC is, in my view, a better practical and legal planning alternative to the Joint Property Agreement.

There are negatives. There is a cost to set up the LLC, and a (generally nominal) cost of annual maintenance. Like the Trust, federal and state tax reporting is required. The LLC is a "public" entity, in that it is on file in Lansing, with a register address and agent. Perhaps the most significant negative is the "uncapping" issue mentioned above.

How Klooster Applies

The Michigan Tax Tribunal has ruled that transfers of real property interests to a LLC will automatically cause uncapping. While a reading of the statute does not, in my view, intuitively suggest that result, the rulings of the Tribunal have the force of law in Michigan until a court having proper jurisdiction says otherwise. To the best of my knowledge, at the time of this writing, no court has done so. Nor is the Klooster result, in my opinion, the intuitive result of a reading of the statute. But the Michigan Supreme Court is the highest legal authority in the state and they have spoken.

If "uncapping is an issue, consider Joint Ownership with a written agreement; If it is not, go the route of the LLC

In summary, if "uncapping" is not a significant issue, you should strongly consider the formation of a LLC. Conversely, if "uncapping" is a significant issue, you should consider joint-ownership with a Property Agreement. However, before spending too much time on the "uncapping" issue, it is probably worth looking at whether the "uncapping" issue is as significant at one might think. Currently, most vacation property values are at a long-time low here in Michigan. Thus, the "jump" from current taxable value and fair market value (loosely, SEV in Michigan) may not be as significant as it first appears. Even though the "value" looks like a substantial number, it is worth doing the math to see what the actual increase in taxes might be. It may be that "uncapping" in the current environment is a "window" that should be taken advantage of. Remember that once the "uncapping" occurs, the "cap" starts over again for the succeeding owners.

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