March 8, 2006

FAMILY LIMITED PARTNERSHIPS CURRENT GUIDELINES

Taxpayers are increasingly looking to family limited partnerships ("FLPs") as a means of reducing estate taxes. Such partnerships are effective because assets transferred to an FLP are less liquid and thus more difficult to sell. Accordingly, the Internal Revenue Service ("IRS") values the transferred assets at a discount for purposes of calculating taxes (26 C.F.R. ¤ 20.2031-1(b)). Obviously, this is an attractive option for taxpayers who wish to transfer significant wealth. Less obvious, however, is the risk involved in employing such an option Ð the very real risk that the IRS will challenge the FLP and assess a sizeable deficiency.

The IRS is closely scrutinizing such FLPs to ensure that they are, in fact, valid partnerships and are not intended solely for tax-avoidance purposes. If deemed invalid, the taxpayers will be assessed a deficiency based on the full (i.e., not discounted) value of the assets in question. However, determining which FLPs are valid and which are invalid has been difficult: while broad statutory parameters do exist, these have been subject to confusion and Ð of course Ð litigation. Fortunately, a recent decision in the Fifth Circuit, Strangi v. Commissioner, 417 F.3d 468 (2005) ("Strangi"), has finally given some clarity to the issues. In Strangi, the taxpayer, Albert Strangi, transferred the bulk of his assets to an FLP shortly before his death. His children also made contributions to the FLP, although these were relatively small. Subsequently, disbursements from the partnership were made to meet Mr. Strangi's expenses as well as those, post-death, of his estate. While alive, Mr. Strangi continued to live in one of the residences that he had contributed to the FLP. After his death, the IRS reviewed the estate's return and assessed a substantial deficiency. The estate challenged the decision in court.

The Fifth Circuit based its analysis on a key statute, 26 U.S.C.S. ¤ 2036(a). Under this statute, estate taxes cannot be avoided through an FLP if the transferor retains either (1) possession or enjoyment of the transferred assets; or (2) the right to designate the persons who shall possess or enjoy the assets or income therefrom. A transferor retains possession or enjoyment of property if he retains a "substantial present economic benefit" from the property. The IRS will also look to whether there is an express or implied agreement at the time of the transfer that the transferors retain possession or enjoyment of the assets. The statute provides for only one exception: assets transferred as part of a bona fide sale for full and adequate consideration. In Strangi, the estate argued both that Mr. Strangi had not retained possession or enjoyment of the transferred assets and that, even if he had, he had transferred them to the FLP as part of a bona fide sale for adequate and full consideration. The IRS and the Fifth Circuit disagreed.

The Court had no difficulty in concluding that Strangi's use of the transferred house and the periodic payments made from the FLP's assets to meet Strangi's expenses constituted substantial, present benefits. Such benefits were sufficient to demonstrate that Strangi retained possession and enjoyment of the transferred assets. Nor did the Court have difficulty agreeing with the IRS's conclusion that an implied agreement existed among the partners that Strangi would maintain such possession and enjoyment. The critical facts supporting this conclusion included the disbursements and use of the house, as well as the fact that Strangi had transferred roughly 98% of his wealth to the FLP Ð leaving him with very little in the way of liquid assets to meet any future expenses without relying on partnership assets.

The Court also disagreed with the estate's argument that a bona fide sale for adequate and full consideration occurred when Strangi transferred the assets to the FLP. In particular, the Court noted that a bona fide sale cannot exist absent the presence of a substantial, non-tax purpose. (In general, the requirement that consideration be full and adequate is met when a transferor exchanges assets for a proportionate interest in the partnership.) The estate raised five separate "non-tax" rationales, including those of "investment" and "active management", each of which the Court rejected: there was no evidence that any investments were ever made or any active business conducted following the formation of the partnership; nor was there any evidence that the assets themselves had been "actively" managed.

In short, the Fifth Circuit had little difficulty in agreeing with the IRS that: (1) the FLP established by Strangi shortly before his death allowed him to retain possession and enjoyment of his assets; (2) there was an implied agreement by all the limited partners that Strangi would retain such possession and enjoyment; and (3) the FLP did not serve any bona fide, non-tax business purpose. Going forward, taxpayers wishing to make use of FLPs should take care to avoid a similar result.

GUIDELINES

The Fifth Circuit's decision in Strangi cautions taxpayers to structure FLPs with care to fully comply with statutory requirements and IRS rules. At the same time, the decision provides some much needed guidelines on how to do so. In particular, taxpayers wishing to use FLPs should consider the following:

· Taxpayers should have a legitimate (non-tax avoidance) business reason for establishing the FLP: transferring a business over time and various concrete investment and business opportunities should meet this requirement.

· Distributions from the FLP's assets should not be tied to the personal needs or expenses of the transferors. Rather, distributions (and contributions) should occur at pre-determined, scheduled intervals.

· Transferors should retain enough wealth to meet their own personal needs and expenses Ð reliance on distributions from the partnership may be viewed as indicative of an implied agreement to retain possession of partnership assets.

· Continued use of residential property by the transferor should be accompanied by clear, fair-market rental obligations.

· Taxpayers should keep thorough records that clearly indicate the partnership's purpose and demonstrate that the partnership is managed in a business-like manner.

ADDITIONAL INFORMATION

For additional information on family limited partnerships or assistance in estate planning, please contact either Larry Inouye or Colleen Sechrest either by telephone (310.712.0100) or email: linouye@shiotani-inouye.com or csechrest@shiotani-inouye.com.