They're not infinitely flexible, but FLPs are still powerful planning tools. Marcia Nelson is a senior v.p. for business development in the New York office of FMV Opinions, a valuation and financial advisory-services firm.

The family limited partnership (FLP) has long been an effective tool used to reduce estate and gift taxes for transferred assets. Since 1997, however, the Internal Revenue Service has waged war on planning techniques that utilize FLPs -- and the IRS appears to be winning.

The IRS's success in this arena has given it momentum to continue challenging FLPs while causing some estate-planning practitioners to abandon the FLP altogether.

Aside from throwing out the baby with the bathwater, what can an estate planer do to protect this useful tax-planning tool?

Strict guidelines

The FLP is formed and assets are contributed in exchange for an interest in the partnership. The FLP must be formed for a bona fide business purpose, such as protecting assets or managing a small business, a rental property or a portfolio of investments. It can't be formed simply to reduce tax liability.

The transferor typically receives an interest as the general partner, and also an interest as a limited partner. Subsequently, non-controlling limited partner interests are often gifted or transferred to children, grandchildren, charities, or trusts. The general partner retains control and manages the FLP and its assets, while the limited partners maintain limited control regarding the day-to-day operations of the partnership, including a say as to when cash distributions are made.

Because of the limited control maintained by a limited partner, such interests require a discount. The Tax Court also allows discounts for lack of marketability because there is no liquid market for non-controlling limited partner interests.

And counting

Depending upon the circumstances and the type of asset held by the FLP, aggregate discounts can be quite substantial, ranging from 15% to 65%with the average discount around 35% to 40%. Such valuation discounts can result in tremendous tax savings -- and hence the interest estate-planning professionals take in them.

The on-going case of Albert Strangi et al. v. Commissioner; No. 03-60992 (15 July 2005) is as an example of what not to do when forming an FLP as it highlights many of the red flags the IRS will be looking for.

Strangi has now been to court four times -- Strangi I, II, III and IV. It's exactly the kind of case that keeps estate planners awake at night. In addition to shedding light on obstacles to avoid when forming an FLP, practitioners can learn some important lessons by taking a closer look at the court's rulings.

Weak points

One of the issues the IRS focused on in Strangi is the transfer of the primary residence into a partnership while the transferor continued to occupy the residence rent free. Section 2036 of the IRS Code provides that transferred assets can still be included in the taxable estate if, prior to death, the decedent retained

"possession or enjoyment" of the assets or
the "right to designate persons who shall possess or enjoy the assets or the income therefrom."

Failure to adhere strictly to the rules laid out in Section 2036 is a common mistake, and a big red flag for the IRS.

The IRS also focused on the fact that the transferor retained control over the income from the partnership. The court agreed, noting that the partnership continued to pay the transferor's expenses. Although the FLP made pro rata distributions among all the partners, the primary impetus for the distributions was to benefit the transferor, not for a valid business purpose. The court eventually ruled that the partnership appeared to violate both components of Section 2036, compelling the estate to pay additional estate taxes in the amount of several million dollars.

Conclusion

Strangi may discourage some practitioners from using FLPs, but a close reading of the case suggests that there may be some circumstances when they are legitimate and worthwhile. One important takeaway from the case is that an FLP should be structured for sound business purposes and not set up strictly as a tool to avoid paying taxes. And, when setting up an FLP, planners should make sure they adhere to the strict guidelines set forth in Section 2036.

Ultimately, Strangi is a reminder of what can happen when a partnership fails to adhere to the tax code and related regulations, and points the way to avoid certain pitfalls. The FLP can still be an effective planning tool, and if the guidelines are adhered to, it can reduce the possibility of your clients having to endure multiple-part court cases. -FWR

This is not intended or written to be used by any taxpayer or advisor to a taxpayer for the purpose of avoiding penalties that may be imposed upon the taxpayer or advisor by the IRS. This writing is not legal advice, nor should it be construed as such.