Portions of this article were originally printed in Dallas Bar Association Headnotes, December 2017.
When it comes to luxury property, such as beach houses, lake houses, ski condos, hunting leases, aircraft, watercraft, limousines, and the like, two rules almost always apply: First, they are expensive to own and operate. Second, they tend to sit dormant much of the time. In order to spread out costs, decrease waste, and mitigate damage, it often makes sense for multiple owners to combine resources and share ownership of this type of property.
Whether friends or family, parties wishing to maximize these advantages often hold the property in special purpose entities or “SPE”. But ownership of luxury property involves legal and practical problems that differ from those of the standard, for-profit world. The tips below will help practitioners recognize and address the problems.
LLCs are generally the entity of choice for luxury property SPEs in Texas. General partnerships lack appropriate liability protection, while limited partnerships are more expensive and complicated. Although double taxation may not be an issue, corporations nonetheless raise tax concerns, such as increased potential for violating the nonrecognition provisions of IRC §351. Also, LLCs provide a level of privacy which can be valuable.
Parties to a luxury property SPE must determine how, when, and by whom the property can be used. Options include reservation systems, drawing lots, or simply a first come, first served rule. Similarly, guests, family members, pets, and smoking should be addressed. Parties should also expressly permit or forbid outside rental of the property.
Rules for sharing costs and expenses are also very important. Who will determine what expenses are proper? How and when will contributions be required? Should costs be shared pro rata, per capita, or otherwise? Many usage charges are difficult to track, which leads to infighting. Requiring users to pay for fuel may be appropriate, but allocating a hangar fee may not. Also, budgeting for expenses well in advance and providing limitations on increases can provide comfort.
Penalties are another important concern. Unlike for-profit entities, luxury property SPEs require regular cash contributions for upkeep, taxes, and other expenses, so mechanisms are required to hold owners to their obligations. Thus, interest charges, as well as forfeiture of usage, voting rights, or even the ownership interest itself may be appropriate.
Contributions must be carefully defined. If Uncle Bob takes his favorite recliner to the ski condo for a few years, is it contributed or can he take it back? Answers to such questions will depend on the circumstances and may change over time.
Especially where many owners are involved, appointing and empowering capable managers is important. Expecting family factions to agree on a cable package for the old family homestead is unrealistic.
Managers’ powers should provide flexibility because they may need to make quick decisions. A company agreement can provide broad direction and allow managers to set specific policies and procedures internally, allowing for simpler, quicker amendments.
Ownership and Voting
Permissible owners of luxury property SPEs should be well defined. Transfers within this class should be easily made, while transfers outside the class should be difficult, but not impossible. Similarly, assignees’ rights should be clearly defined, particularly in the context of unintended transfers. For example, should assignees hold usage rights? Also, it may be helpful to limit ownership by disallowing fractionization of interests. For example, transferees receiving less than a whole unit might can be made assignees until the entire unit is held by one person.
Voting rights present other problems. Small luxury property SPEs will likely function better with a per capita voting whereas larger ones work best where votes are cast pro rata. Also, the threshold for supermajority voting should typically be lower with a luxury property SPE than with a for-profit enterprise because the entity represents a liability to its owners and they should have a more available exit strategy.
To summarize, many of the above considerations either play out differently or simply do not apply in the context of for-profit companies. Further guidance can be found in the rules applicable to social clubs and fraternal organizations. Unlike those organizations, however, additional flexibility is required with a luxury property SPE. If the parties are willing to exercise good planning, show a little patience, and adapt their systems, they will reap great benefits.
Christian S. Kelso, Esq. is a Senior Associate at Farrow-Gillespie & Heath, LLP. He draws on both personal and professional experience when counseling clients on issues related to estate planning, wealth preservation and transfer, probate, tax, and transactional corporate law. He earned a J.D. and LL.M. in taxation from SMU Dedman School of Law.