By Jane E. Bernardini

As families became wealthier in recent years, family limited partnerships (FLPs) became an increasingly common asset-transfer and estate-planning tool. Although FLPs have always been more popular with taxpayers than with the Internal Revenue Service, the IRS’ efforts to end the use of FLPs as tax-avoidance tools had been relatively unsuccessful until recently. As the result of a surprising May 2003 Tax Court decision, taxpayers and practitioners need to exercise more care in establishing these structures.

FLP Defined

In an FLP, a parent transfers assets (e.g., a family business, real estate or investments) to a partnership. The majority of partnership shares are gifted to the children, and although the parents involved retain a minority interest, they often establish themselves as the general partner (GP).

For example, John and Betty Owens own a successful dry cleaning business. As they get closer to retirement, they set up an FLP and fund it with their ownership of the business in exchange for interests in the partnership. Two percent of the FLP interests are reserved for a GP. The other 98 percent are limited partnership interests that the Owens give to their three children. The limited partners have no voting rights, and cannot force the GP to distribute earnings or liquidate the entity. This lack of control, as well as a lack of marketability for the limited interest, allows for significant discounts in the value of the interests in the entity.

An FLP’s benefits go beyond tax advantages, however. Unlike asset transfers directly from parent to child, the FLP:

Impact of Strangi II

In Strangi II, which was actually the IRS’ appeal of an earlier Tax Court decision in favor of the taxpayer, the FLP was formed in 1994 to handle the assets of Albert Strangi, a terminally ill man who died two months after the partnership papers were signed. After attending a seminar on FLPs, Strangi’s son-in-law set up the structure under a power of attorney.

Ninety-eight percent of Strangi’s assets, including his home, other real estate, liquid investments and partnership interests, were transferred to the FLP in exchange for a 99 percent limited partnership interest. A 1 percent general partnership interest was held by a newly created entity known as Stranco, Inc. Strangi purchased a 47 percent interest in Stranco, while his daughter, on behalf of herself and her three siblings, acquired the other 53 percent. The children also received the limited partnership interests, giving 1 percent of them to charity.

In successfully arguing that all of the FLP’s assets had to be included in Strangi’s taxable estate, the IRS turned to section 2036 of the tax code, which says that the full (i.e., not discounted) value of partnership assets must be included in the taxable estate of the decedent if 1) the decedent had retained income for life from the partnership or 2) the decedent retained for life the power to designate who would possess or enjoy the assets or income from them.

The Tax Court found that Strangi effectively controlled the partnership assets before and after the transfer to the FLP and indeed relied upon them for his living expenses as well as his medical bills and funeral costs. In a rather complex decision that has been criticized sharply by some, the judge ultimately found that the partnership merely recycled Strangi’s assets, rather than functioning as a real business, and declared the FLP invalid. The Strangi family is now appealing the case in the Fifth Circuit Court.

Dos and Don’ts of FLPs Post–Strangi II

Until Strangi II, the IRS tended to argue against discounts on gifts of limited partnership interests in an FLP. The decision in Strangi II creates a more serious threat to the FLP structure itself, but it is not a death knell. Following are some of the most current post–Strangi FLP rules of thumb:

Do: