Estate administration necessarily involves a mix of practical tasks (for example, marshaling, valuing and often retitling the estate assets, closing and opening accounts, filing and paying taxes and distributing bequests) and emotional challenges (for example, dealing with mortality, reawakening family issues and sibling rivalries). From time to time, emotions overwhelm reason, and the practical aspects of estate administration become quite difficult. In my experience, estate-related conflicts among siblings are rarely about the money; instead, they tend to center around personal property (for example, art, jewelry and furniture) or other items that carry significant emotional attachment, including real estate.
Wealthy individuals tend to have extraordinary homes in desirable locations where they’ve made many special memories together as a family. Often, the generation currently in control of the property wishes to have it remain in the family on their death, for the benefit of future generations. Future generations may or may not wish to retain the property or to share in the maintenance and other costs associated with its use. Families with more than one individual in the inheriting generation may find it impossible to achieve unanimity in decision making. As a result, what was meant to be a boon to the family (continued enjoyment of the special property) becomes a bane. It needn’t be so.
Here are some practical considerations to take into account when seeking to meet the needs and expectations of families with unique properties based on real-life experiences I’ve had with clients.
What Not to Do
I’ve found that simply leaving real estate to subsequent generations in direct joint ownership can be very problematic.
In one situation, a great stone mansion sat on multiple acres in a private association for more than 100 years in one of the most sought-after neighborhoods in one of the wealthiest towns in the United States. It was considered a historical treasure and one of the town’s famous “grand estates.” One family owned the mansion throughout most of the 20th century. When the last parent died, the property was bequeathed to their four children in equal, undivided shares.
The inheritors were two brothers and two sisters, one of whom had special needs. The two sons had moved away and had families of their own. The two daughters continued living in the house but weren’t in a position to maintain it. The family decided to put the house on the market but couldn’t reach an agreement on the timing or terms.
One son decided to take the initiative and restore the house in contemplation of putting it on the market. The local real estate market at the time was very active, with prized properties selling for record prices. Still, the family was unable to come to an agreement on a listing, and by the time they did, the market had cooled off. Once listed, the property generated very little interest; one theory was that the market was aware of the family’s history of difficulty reaching unanimous decisions and was skeptical that a closing could ever occur. The family received a series of exceptionally low offers and eventually sold the property for much less than they had anticipated.
In this case, by requiring unanimity, joint ownership created an impediment to effective decision making with negative economic consequences. In addition, because one or more of the siblings could have commenced an action for partition and subsequent sale, this form of ownership inherently carries the potential for frustrating any attempt to keep property within the family.
In my experience, effective solutions to this challenge involve a combination of structures and governance provisions.
Limited Liability Company
It’s quite common today to see title to significant homes held in corporate structures, most particularly limited liability companies (LLCs). This form of ownership provides a number of advantages, including: unitary holding of title; ability to separate control from economic interests and to transfer those economic interests with positive gift and estate tax consequences; and flexibility in terms of governance and control over major decisions.
Example 1: The history of the U.S. estate tax in the first dozen years of this millennium was very confusing, with rates and exclusion amounts fluctuating and even eliminated for one year (2010) before being reinstated for two years (2011 and 2012) with the possibility of reversion back to 2001 levels. Faced with this uncertainty, one family chose in late 2012 to gift the family home to their five children as part of their estate planning. They considered using a qualified personal residence trust (QPRT) (more on that later) but in the end chose to set up an LLC and gift the vast majority of the interests to their children, in equal shares, retaining a small minority interest and full control of all LLC decisions by virtue of serving as the sole managing members. The gift of the LLC interests to the children took the associated apportioned economic value of the underlying property out of the parents’ estates, while the fact that none of the siblings’ individual ownership interests had control over the LLC (because of being a non-managing member minority interest) or were marketable outside the family (per the LLC agreement) meant that the value of each of those transferred interests could be discounted significantly for estate and gift tax purposes. It was the perfect move to make in the face of ongoing legislative uncertainty, and the family felt ready for 2013 and beyond.
One consequence of this family’s gifting strategy was that the very low cost basis in the property was transferred along with the gift of the interests to be realized (and taxed) on any future sale, as opposed to receiving a step-up in basis on the parents’ death. This result was acceptable at the time in light of the then-current difference in rates between the estate and capital gains taxes. It could look particularly prescient should the current administration’s proposals to raise estate and capital gains tax rates and eliminate basis step-up on death become law.
The family also needed to keep in mind that the LLC interests will be included in a member’s estate when they die, necessitating a valuation (the cost of which likely would be borne by the LLC) and potentially exposing the member’s interest to taxation.
Example 2: Another family (coincidentally also with five siblings) used the LLC structure to address a different concern. The property in question was a beautiful lake house situated on a bluff overlooking one of the most scenic and historic freshwater lakes in the American northeast with 270-degree vistas of forested islands and majestic mountain ranges. The setting was home to many family reunions and was emotionally significant to all generations of the family—a jewel that few could imagine being absent from the family’s future.
This family’s objective wasn’t estate planning but managing the decision, once their mother died, of whether and how to keep the home in the family for future generations, given the differences in location, economic situation and interest among the five siblings.
They formed a family LLC, which held title to the property. The mother retained 100% of the ownership interests and named one of the siblings as managing member to take care of all property matters such as arranging for maintenance and paying real estate taxes. The LLC agreement included specific provisions regarding how decisions were to be made with respect to continued maintenance or disposition of the property after the mother’s death. Importantly, parallel provisions were made in the mother’s will to fund the LLC on her death with resources sufficient to carry the property for a few years so that the siblings (who would inherit the LLC interests in equal shares) didn’t have to make that decision at a time when they would be in mourning for the loss of their mother.
The family operated in this manner under the LLC agreement for some time prior to the mother’s death in 2020. At death, she still owned 100% of the LLC interests, and these interests were thus included in her estate for all purposes, including estate taxes. Fortunately for the family, the federal estate tax exclusion amount had increased to a point at which no estate tax was due. Even more fortunately, the tax basis value of the property (and thus the LLC interests) received a step-up to the fair market value at the mother’s death, meaning that the appreciation in value from its original purchase and development to the date of the mother’s death would escape capital gains tax on any future disposition of LLC interests by any or all of the siblings.
Originally, it was contemplated that the property might remain jointly held into the foreseeable future as a part of the family legacy. That option would have required all family members to contribute equally and indefinitely to the property upkeep; the general consensus among the family members was that that option was unworkable, given differences in sibling economic priorities. Another option explored was the sale or lease of the property to one of the family members, but in the end, there was insufficient interest. As a result, the family agreed to market the property externally.
While in the end, this scenario resulted in an outcome different from that envisioned (that is, keeping the property in the family indefinitely), the use of the LLC structure delivered clear benefits to the family. First, by giving one sibling management control of the property, it relieved the mother of that burden and worry, especially as her condition declined. Second, it provided a fully transparent and previously disclosed mechanism for effecting group decision making in a context in which each sibling’s interests were reflected and considered without requiring unanimity of opinion to reach a decision. Third, by ensuring sufficient resources were available to maintain the property after the mother’s death, the structure allowed the siblings to take the time necessary to evaluate their options calmly and rationally notwithstanding the terrible emotional burden of dealing with the death of their mother.
QPRTs
QPRTs are commonly used to remove a residence from the owner’s estate. The owner (grantor) gifts the property into trust, retaining the right to remain living on the property for a specified period of time. The value of the property transferred into trust will depend on the length of the retention period and the then-current applicable federal rate. On expiration of the retained right period, the grantor either vacates the property or, more commonly, begins to pay rent to the trust. If the grantor survives the retention period, the property escapes tax in their estate; if not, the property is pulled back into the estate and subject to tax. Assuming the grantor survives the period, the property can remain in the QPRT for as long as the trust survives, providing a useful vehicle for maintaining the property for family use across generations.
Despite their relative popularity, QPRTs aren’t for everyone. The most obvious limitation is the need to survive the retention period and the natural tension between the desire to have the period longer (to reduce the transfer value of the subject property) versus shorter (to maximize the grantor’s chance of surviving it).
In my experience, there’s another, more delicate issue to be addressed: Many grantors feel uncomfortable with the idea that, after expiration of the retention period, their family can “kick them out” of the family home. This was the case with the family described above that was looking to transfer their home for estate-planning purposes. Notwithstanding the fact that that family was actually exceptionally close and the chance that the children would refuse to allow the parents to stay in the home after the applicable period was basically nil, the mother found the very existence of that possibility to be too much of a hurdle to overcome. This was neither the first nor the only time when I’ve experienced the psychological or emotional cost of a structure outweigh its utility for a particular client.
Traditional Trust
Another family found a successful solution in the form of a traditional trust.
The grandfather in this family bought at auction a uniquely beautiful stone and wood hunting lodge with 10,000 acres, a lake and a pond in Maryland. It became the favorite spot for family gatherings and such wonderful memories that the family decided it must be preserved for future generations. After the grandfather died, the property was bequeathed to his two children and their spouses in joint ownership form, which had the potential to be problematic, as discussed above. Fortunately for this family, the heirs agreed to transfer the property into trust, with a representative of each of the two branches of the family chosen to serve as trustees. The trustee positions were self-selected as to successors, and all decisions required unanimous agreement of both trustees.
The family developed agreed-on rules and guidelines regarding the use of the property, with schedules developed a year in advance. Timbering initially provided continuous funds for the upkeep of the property. A later-discovered seam of coal, along with selected land dispositions, provided additional funds. This ability to be self-funding was perhaps the single most important reason the trust structure has been so successful for this family.
This particular trust was created prior to the advent of the federal generation-skipping transfer tax, which rendered it an exceptional vehicle for long-term ownership of the property. But like most trusts of the time, its duration was limited by the rule against perpetuities to lives in being plus 21 years, and as a result of the size and demographics of the two branches of the family, it’s unlikely to remain in existence for multiple additional generations.
One of the advantages of trust ownership is the fact that there’s no need for a valuation, estate tax exposure or other reporting obligation on the death of a beneficiary. Given the extraordinary authority and responsibility inherent in the trustee role, the choice of trustee(s) is often the most challenging, and definitely the most important, decision to be made when holding treasured property in trust form.
Costs
Probably the single most common challenge for families wishing to keep a treasured property in family hands across generations is how to pay for it. The Maryland family was able to monetize mineral rights associated with the property, effectively creating an ongoing endowment, but most other families aren’t so fortunate.
Some families split the ongoing costs pro rata among the branches. This has the advantage of generally being seen as the fairest method, but in practice, it can be unworkable, especially if there are differences among the branches in terms of location, interest and financial resources. Apportionment according to financial ability is generally doomed to fail, as it can breed resentment and create or reinforce unequal power relationships among siblings, which can create further family issues. Some families charge a sort of rent for use, with those branches who use the property most paying a larger share of the overall cost. This too can cause problems when one or more branches have greater resources to pay the rent and may try to dominate the schedule, especially at the most popular times and seasons. Depending on family dynamics, a hybrid solution may be successful: Have all branches share equally in covering a portion of the base cost while also charging rent for individual usage. To the extent that revenue in a particular year exceeds the actual costs (plus some set-aside for unexpected maintenance and capital expenses), the surplus could be shared pro rata among the branches. This approach reinforces the idea that all branches are equal in their ownership while also recognizing that some branches will use the property more than others.
Governance
While cost-sharing may be the most common reason that long-term family sharing fails, attention to issues of governance is most likely to help them succeed. Broadly speaking, governance issues in this context break down into three categories: ownership (including the transfer thereof); management; and access.
In whatever form the family members own the property—directly (for example, jointly), via shareholder or membership interests in a corporation or LLC, or as beneficiaries of a trust—it’s critical that there be a clear understanding of owners’ rights and some agreement or structure to govern key decisions and the transfer of ownership interests.
With respect to joint ownership in fee, there should be a written agreement among the property owners waiving any rights to partition and providing for the resolution of any issues that aren’t settled unanimously; for example, agreement that the decision to sell or rent the property could be made with the consent of a supermajority of owners and a binding waiver and prohibition of any action to the contrary by any dissenters. Note that the practical difficulty of reaching such an agreement after the original transfer of fee interests further contributes to the problematic nature of the joint property interest solution.
Shareholder and buy-sell agreements are common among holders of stock in corporations and can be drafted to include provisions regarding voting, extraordinary actions and restrictions on transfer. To the extent that they aren’t in place prior to the distribution of interests from the estate, they’ll face challenges similar to those described above with respect to joint ownership. LLC interests are created by agreement, which also can be drafted to provide the necessary provisions.
These provisions commonly address sale or rental of the property or member interests to another family member (which might require only majority approval) and sale or rental of the property or member interests to a non-family third party (which might require supermajority consent or even unanimity). They might include rights of first refusal, allowing dissenting members to purchase the property (or member interests offered for sale) in the event of a proposed third-party sale or a “put” right allowing members who no longer wish to remain owners of the property to tender their interests to the others for buyback at an agreed valuation. The most common valuation method I’ve seen in this instance is the three-appraisal approach, in which each party chooses their own appraiser, the two appraisers choose a third and the agreed price is some average of the three appraisals (the more difficult issue is how to determine any minority and/or lack of marketability discounts; the parties could agree to use the view of one accountant or seek the opinions of three).
Trusts are different in that the family’s interest in the property is derivative: The trustee(s) holds legal title to the property as fiduciary for the family, while the family members have a beneficial interest in the property. As beneficiaries, they don’t control what happens with or to the property; that power is in the hands of the trustee(s) who must act solely in the beneficiaries’ best interests and according to the terms of the trust instrument. The trust instrument could be drafted to include specific directions, but generally the more preferred approach is to leave the trustee(s) full discretionary authority while perhaps including some guidance via precatory language in the trust agreement. Trust beneficiaries also can’t transfer their beneficial interests, whether among themselves or to others outside the family, except with the consent of the trustee and pursuant to the provisions of the trust agreement.
Access
There are probably as many right ways to coordinate access to treasured property as there are fully functional families. The opposite is also true. The most common approach I’ve seen is to prepare and communicate an annual schedule of access.
Much like a time-share arrangement, each family requests certain days, weeks or months in an amount not in excess of their proportionate ownership share. This is best done well in advance (for example, annually, as the Maryland family does). Popular times (for example, holidays and in-season periods) when more than one family member or branch expresses interest can be allocated by seniority (which can breed resentment), rotation (alternating yearly) or lot (also problematic). Some families charge higher rent for those periods as well. Transparency is critical: All family members must believe that the process is being handled fairly and as agreed on. Some families use a shared electronic calendar and formalize the request procedure.
There also must be clarity on the issue whether and to what extent other family members may be present on or use any portion of the property when it’s not their time. In most cases, the scheduled family members wish to be alone. In that case, there needs to be a structural disincentive for unpermitted presence by non-scheduled members. Perhaps the most effective disincentive is loss of their scheduled access time or loss of a turn in the rotation.
Planning Considerations
The Biden administration has proposed or suggested significant changes to the gift and estate tax regime, including reductions in exemption amounts, increases in tax rates and the elimination of the step-up in basis on death. A few thoughts about planning in that context:
As noted above, eliminating the basis step-up on death removes one of the traditional costs associated with making lifetime gifts of appreciated assets; however, if the proposed 43.4% top marginal tax rate on capital gains in excess of $1 million for high income taxpayers becomes law, those gains could potentially be subject to greater tax exposure than they would if the property had remained in the estate and taxed at the current marginal estate tax rate of 40%.
The administration’s proposal to eliminate the basis step-up at death is also coupled with the concept of immediately taxing all unrealized capital gains in an estate at a top marginal rate of 43.4% (subject to a $1 million lifetime exclusion and excluding farms and family-owned businesses). Assuming no change to the current estate tax rates and exclusion amounts, consider making lifetime gifts and transfers of appreciated property in 2021 taking advantage of those current exemptions and rates, so that any tax due in respect of that gain could be deferred until a later sale (at which point it would be taxed at the rate in effect at that time, which conceivably could be lower than 43.4%). As a result, it now could be a very good time to consider transferring a highly appreciated treasured property.
The Biden administration had also previously proposed reducing the estate tax exemption from $11.7 million per individual to $3.5 million and raising the top marginal estate tax rate from 40% to 45%. Unlike the elimination of the basis step-up, increase in capital gains tax rate and forced realization of gain on death, these estate tax proposals weren’t included in the most recent administration budget, and it’s unclear exactly how they could be reconciled with the budget proposals. Nevertheless, the prospect of possible changes to the estate tax rates and exemption amounts further supports the case for considering transfers in 2021 of substantially appreciated property.
Family Compounds
Families are by nature unique, but they can have issues and challenges in common, especially when those families are very wealthy. In my experience, many families of means tend to buy or build family compounds where multiple generations can gather in privacy and security, much like the Kennedy family in Hyannis Port, Mass. and the Bush family in Kennebunkport, Maine. Not surprisingly, this trend has increased recently given concerns regarding the appearance of COVID-19 and SARS. For example, the recent summer months experienced unprecedented interest in compound-size properties in suburbs outside New York City and similar large metropolitan areas. These purchases may be prompted by near-term concerns, but I believe those properties will likely remain within families, presenting them with all of the legacy issues, concerns and aspirations described above. With proper planning, they can be enjoyed over generations. And right now may be the best time to consider all available alternatives.
— This article was adapted from one that originally appeared in the December 2020 issue of The International Family Offices Journal.