Family Limited Partnerships . . .

Plan Transactions Carefully

Family limited partnerships (FLPs) are a popular way to transfer businesses and other assets from one generation to the next at a reduced tax cost. However, one court decision raises a critical question for many family limited

The Case

    In the Estate of Albert Strangi case, the U.S. Court of Appeals for the Fifth Circuit determined that the value of the assets contributed to the FLP should be included in the decedent's gross estate. The reason: There was an "implicit understanding" between Strangi and his children that he would retain enjoyment of the partnership assets.
    Among the factors the court considered:
    ¤ The majority of Strangi's assets were transferred to the FLP, including his residence.
    ¤ Strangi continued living in his home without paying rent while he was alive.
    ¤ Personal and entity assets were co-mingled and entity funds were used for personal expenses.

A Long Legal Road: The Strangi Timeline

8/11/94
As Albert Strangi's health is failing, his son-in-law, an attorney, attends a seminar about FLPs.

8/12/94
Stangi's son-in-law prepares a FLP agreement and transfers 98% of Strangi's assets (approximately $10 million) into it in exchange for a 99% limited partnership interest.

10/14/94
Albert Strangi dies of cancer at age 81.

1/16/96
An estate tax return is filed with the IRS, which included a fair market value of $6,560,730 million for the FLP. Valuation discounts were taken for lack of marketability and control.

December 1998
The IRS issues a notice of deficiency to the estate for $2,545,826 in estate taxes. The estate petitions the U.S. Tax Court. for a redetermination of the amount.

11/30/00
The Tax Court rules for the estate. The IRS appeals the decision.

6/17/02
The Fifth Circuit Court of Appeals "affirmed in part and reversed in part" and remanded the case to the Tax Court to decide if Section 2036(a) applies.

5/20/03
The Tax Court rules against the estate, stating: "The crucial characteristic is that virtually nothing beyond formal title changed in decedent's relationship to his assets." The estate appeals the decision.

7/15/05
The Fifth Circuit affirms the Tax Court decision, meaning the FLP is disregarded for federal tax purposes.

Bottom line: Although the courts ruled the Strangi FLP was not handled properly, you can help avoid similar challenges by following the steps in the checklist below.

partnerships: How can you avoid IRS arguments that FLPs should be ignored for federal estate tax purposes?

The IRS arguments are based on Section 2036(a) of the Internal Revenue Code. This provision says the value of assets that are purportedly contributed to an FLP must be put back into the contributor's estate for federal estate tax purposes when that person effectively retains:

¤ The possession or enjoyment of the contributed assets.
¤ The right to the income from the assets.

¤ The right to designate who will possess or enjoy the contributed assets or the income from the assets.

Bottom Line: If the IRS is successful in claiming that Section 2036(a) applies, as it did in the Strangi case, it's as if the FLP was never established in the first place. The contributor is considered to still own the assets for estate tax purposes. Therefore, all of the anticipated estate tax benefits are lost. (This issue also applies to family limited liability companies.)

That's the bad news. The good news is you can avoid running afoul of the Section 2036(a) rule by planning your transaction carefully and recognizing that a family limited partnership is a legitimate legal entity - separate and apart from you and your family.

Below is a checklist of steps to help accomplish that goal, but first, here's a brief explanation of how a family limited partnership works to reduce the value of an estate: After setting up a FLP, the contributor transfers a closely-held business and/or other assets in exchange for an ownership interest in the partnership. A professional valuation of the assets should be obtained before the transfer.

Then, the contributor makes gifts of the limited partnership interests to children or other heirs. The contributor retains the general partnership interest, which is usually 1 percent of the total value.

In 2009, you can give away up to $13,000 a year, or $26,000 for married couples, to as many recipients as you want without any gift tax consequences (up from $12,000 and $26,000 in 2008).

When the contributor makes gifts of limited partnership interests to family members, valuation discounts are generally claimed. In effect, the contributor is saying that the assets given away via limited partnership interests are worth less than full market value because the recipients have limited power and liquidity - generally described as a lack of marketability and control.

For example, let's say you and your spouse own a $5 million family business that you want to pass on to your four children. You transfer the company to an FLP. You retain a 1 percent general partnership interest and give the remaining limited partnership interests to your children over a period of years

A professional appraiser values the partnership interests at $3.75 million -- a 25 percent discount - because an independent buyer wouldn't pay the full price for a minority share in a family company.

You subtract value from your estate by giving each of your children annual gifts of limited partnership interests. This year, you and your spouse can jointly give interests worth up to $26,000 to each child gift-tax-free so you can cut your estate by $104,000 ($26,000 times four children).

Over a period of years, you can reduce the value of your estate to the amount of the federal estate tax exemption or below. If you do this, you will eliminate any federal estate tax liability. The federal estate tax exemption is $3.5 million in 2009 (up from $2 million in 2008).

The following checklist suggests some specific steps you can take to help prevent problems with the Section 2036(a) rule:

√ Step 1. Make sure the FLP (or FLLC) is properly established under applicable state law.

√ Step 2. Set up the FLP while you are still in relatively good health with a reasonable life expectancy.

√ Step 3. In the entity's governing documents (FLP partnership agreement or FLLC operating agreement), identify several legitimate non-tax reasons for setting up the entity. For example, to protect assets from creditors, to plan for business succession or to keep long-held assets under family control.

√ Step 4. Retitle all contributed assets in the entity's name. But don't transfer so much to the FLP that you are left without enough financial resources to live on. In other words, don't count on dipping into the entity's assets to cover your personal financial needs. Don't transfer personal assets (such as residences, cars and furniture). Contribute only assets that will be held by the entity for business or investment reasons.

√ Step 5. Set up a separate bank account for the FLP. Obtain a taxpayer ID number for the entity. Obtain necessary licenses and permits and pay all applicable state and local fees. File all applicable federal, state, and local tax and information returns. You will probably need professional help with this.

√ Step 6. Recognize that in today's tax world, you cannot have undiluted management control over the FLP. Instead, be ready to share management powers with your spouse, a lower-generation family member, or an independent third party (such as your accountant or attorney). Be prepared to give this person (or these persons) sufficient voting power to override you on key issues, such as when to liquidate the entity, when to authorize cash distributions, and when to permit lower generation family members to sell their ownership interests or have them redeemed.

√ Step 7. Distribute cash from the FLP strictly in proportion to ownership interests. Avoid other cash transfers such as purported loans from the entity to you. (Do not rely on non-prorata distributions to cover your personal financial needs.)

√ Step 8. Make meaningful annual cash distributions to all FLP partners. This heads off the perception that partners other than you don't actually have any current stake in the entity.

√ Step 9. If possible, arrange to have the other family members who will become FLP partners contribute at least some assets at the time the entity is established. When possible, include one or more partners who are not family members. Of course, the advice in this last step may be unrealistic. If so, you should still be on solid ground with the IRS if you dutifully take Steps 1 through 8.