Recent Case Highlights the Need for Care When Forming Family Limited Partnerships
by Kirk Snouffer & R. Tyler Hand

In Albert Strangi et al. v. Commissioner, (No. 03-60992, United States Court of Appeals for the Fifth Circuit, July 15, 2005) (“Strangi”), the Fifth Circuit affirmed the decision of the Tax Court that Mr. Strangi's estate includes certain assets Mr. Strangi had transferred to a family limited partnership.  The Court's decision highlights the need to exercise care in the formation and operation of a family limited partnership ("FLP").
 
The Strangi Decision and §2036
Two months before his death in 1994, Mr. Strangi transferred 98% of his assets to the Strangi Family Limited Partnership.  After protracted litigation, the Tax Court ruled that §2036 of the Internal Revenue Code caused the assets he had transferred to the Strangi FLP to be included in Strangi’s taxable estate.  Mr. Strangi's estate appealed the decision to the Fifth Circuit, which upheld the decision of the Tax Court. 

Section 2036 provides that transferred assets can be included in the transferor's taxable estate if the transferor retained until his death (1) the possession or enjoyment of the assets or (2) the right to determine who would possess or enjoy the assets.  However, §2036 will not apply if there was a bona fide sale of the property for full and adequate consideration.

The Tax Court found that there was an implicit agreement between Mr. Strangi and his children that he would retain enjoyment of his property following the transfer to the Strangi FLP, and the Fifth Circuit affirmed that finding.  Mr. Strangi’s estate argued that the "bona fide sale" exception of §2036(a) should apply to the transfer of assets to the FLP.  Although the Fifth Circuit agreed that there was full and adequate consideration for the transfer of assets, it found that there had not been a bona fide sale of those assets because there was no substantial business or other non-tax purpose for the formation of the Strangi FLP. 

The facts of the case led the Court to its decision:

On his deathbed, Mr. Strangi transferred 98% of his assets, including his residence, to the Strangi FLP.  Mr. Strangi retained ownership of 99% of the Strangi FLP; the other 1% was owned by a corporate general partner in which Strangi had an ownership interest.  These transfers were undertaken by Mr. Strangi's son-in-law, who was also his attorney-in-fact.

Mr. Strangi retained insufficient funds to meet his living expenses.  Most of his living expenses, his funeral expenses, and debts he had incurred were paid by the partnership.  Although Mr. Strangi continued to live in the house he transferred to the Strangi FLP, there was no rent paid until two years after his death.  Finally, the Strangi FLP did not make investments or undertake any other activity after its formation.
 
The Court's ruling did not call into question the viability of the FLP as a family planning device.  Instead, the Court applied long-standing principles to a case in which the taxpayer was guilty of poor planning and execution.  The Strangi decision provides useful guidance for FLPs.

• Need for Planning when Forming an FLP
  There are important lessons to be taken from Strangi: 
  The transferor should retain sufficient assets to pay living expenses, personal debts, funeral expenses, with a reasonable reserve for unforeseen expenses.
• Form the FLP while the transferor is in good health.
• There must be a reason other than tax avoidance for family members to pool their assets, and the FLP should actively manage its assets.
• If the transferor makes use of transferred real estate, a fair rental amount should be paid to the FLP.
• Clearly state the non-tax reasons for the FLP in the partnership agreement and transfer documents.
• Make sure the transferor does not retain the right to designate who will possess or enjoy the FLP's assets.

There should always be a clear business purpose for establishing the partnership.  Valid non-tax reasons for establishing for an FLP can include the following:

• Consolidated ownership – FLPs can be used to manage family assets, restrict the ability of nonfamily members to acquire an interest in those assets, and allow annual gifts to be made without fractionalizing family assets; and general partners of FLPs can invest assets of FLPs and conduct FLP business without involving limited partners in management or exposing them to personal liability.
• Disability protection – The FLP can provide protection against disability of a key family member by allowing continued management of family assets.
• Protection from creditors – An FLP provides protection for the assets of the FLP from a partner’s personal creditors by limiting their access to the assets of the FLP.
• Flexibility – The partnership agreement can be amended or the FLP terminated with the consent of the partners without adverse tax consequences. This attribute makes an FLP a more flexible estate planning tool that, for example, an irrevocable trust.

Despite the IRS’s recent success in some cases, the FLP remains a powerful vehicle for transferring family assets from one generation to the next.  Individuals and their tax advisors should ensure that all formalities regarding formation, organization and conduct of business are followed and that there is a valid business or non-tax purpose for forming the FLP. 

If you have any questions about or need additional information on this article, please contact a member of our Taxation & Estate Preservation Group.