As the infamous Strangi case worked its way through the courts, many industry pundits declared the death of family limited partnerships (FLPs). In the most recent decision on the case on July 15, the Fifth Circuit Court of Appeals ruled once more in favor of the Internal Revenue Service (IRS) against Strangi's estate, declaring that the assets Strangi transferred to an FLP would still have to be included in the estate at their full value for federal estate tax purposes. While this ruling may have put a nail in the coffin for the Strangi estate's battle with the IRS, it does not in fact signal the death of FLPs as an estate planning technique—particularly if planners are able to avoid the traps that ensnared the Strangi FLP.

FLP Primer

An FLP is a partnership business entity formed among family members under state law. Individuals contribute property to the partnership in exchange for limited or general partnership shares. General partnership shares control management and distributions from the partnership, while limited partnership shares are generally passive and only receive any income at the control of the general partner.

In the context of estate planning, the advantage of FLPs is that the fair market value of a limited partnership share is typically less than the value of the underlying assets. This reflects the fact that limited partners don't have control (only the general partner typically has the power to make distributions, liquidations or otherwise control the partnership) and their shares are less marketable (often with restrictions in the partnership agreement that affect transferability). Such "discounts" to the underlying value of the FLP can potentially allow FLP shares to be valued at only 60% to 90% of their full value, reducing the base on which gift or estate taxes are levied when the shares are transferred during life or bequeathed at death.

For example, Jane Smith contributes $2.97 million of her $10 million net worth to the Smith Family Limited Partnership in exchange for a 99% limited partnership interest in the business entity. Her children Joe and Susie contribute $30,000 to the Smith FLP and receive a 1% general partnership interest in the business entity. Joe and Susie manage the Smith FLP as the general partners and invest the funds in a mix of equities and bonds.

If Jane Smith were to pass away shortly thereafter, her interest in the Smith FLP that represents $2.97 million of investment assets might be valued at only $2,227,500 (a 25% discount). If Jane were subject to a 47% estate tax rate, her estate would save approximately $348,975 in estate taxes due to the discounting of the FLP interest.

By understanding the key details and the ensuing legal battle between Strangi's estate and the IRS, financial advisers can understand how the ruling affects FLPs and their use as a planning technique for clients.

The Strangi Story

Albert Strangi, terminally ill in August of 1994, was expected to live no more than 18 to 24 months. Because of Strangi's condition, his son-in-law Michael Gulig was acting as his attorney-in-fact under a broad power of attorney.

On Aug. 11, Gulig attended a seminar about FLPs, and on Aug. 12 (the very next day!) he formed the Stranco Family Limited Partnership (the "Strangi partnership" or "Strangi FLP"). The Strangi partnership had a corporate 1% general partner—Stranco Inc.—and a 99% limited partner, Strangi himself.

Strangi, through the actions of his agent Gulig, contributed approximately 98% of his wealth (nearly $10 million) in exchange for his 99% limited partnership interest. Assets included more than $7 million in brokerage accounts, several life and annuity policies and multiple pieces of real estate including his primary residence. In addition, Strangi contributed property to receive a 47% interest in the general partner Stranco Inc., while his four children owned the other 53%. (They subsequently reduced their interest to 52% by donating a 1% interest to charity.) Gulig was appointed the managing director of the partnership interests with the power to control the timing and the amount of any distributions from the partnership, while also still serving as Strangi's attorney-in-fact.

While Strangi was still alive, the Strangi partnership paid for some of his personal in-home health care expenses, as well as back surgery for a nurse who was injured while caring for Strangi (also, theoretically, to help avoid a lawsuit from her). After Strangi's death, the partnership made further distributions, including the payment of $40,000 for his funeral, $65,000 in estate administration expenses and $3.2 million to cover his estate taxes. The partnership also had accrued a rent receivable for Strangi's use of the residence after it was transferred to the partnership while he was still alive, which the estate ultimately paid back two years after Strangi's death.

Strangi died just two months after the partnership was formed, and his estate's expert claimed a 25% discount for minority and another 25% discount for marketability for a total discount of 43.75% (the discounts are multiplied, not added) on the value of his limited partnership interests. The IRS immediately challenged the size of the estate's discount, and also claimed that the full amount of the limited partnership interests should be included in Strangi's estate for federal estate taxes, asserting a variety of reasons.

The Battle

The Tax Court heard the case between Strangi's estate and the IRS beginning in 1999, marking a legal battle that has now stretched on for nearly six years. Strangi's estate won the first round against the IRS, which lost several challenges. In fact, the IRS had been trying for several years without success to attack the most questionable FLPs--those formed shortly before death, where the "deathbed transfers" seemed, in the eyes of the IRS, to be purely a way to avoid estate tax.

With Strangi, however, the IRS came up with a new argument it had never tried before in its battles against FLPs. This argument was introduced so late that the Tax Court initially refused to hear it, stating that it was not presented to the court in a timely manner. After the Fifth Circuit Court of Appeals insisted that the Tax Court reopen the case to address the new argument, the IRS suddenly found success in asserting that Strangi's assets should be included in his estate under IRC Section 2036—claiming that Strangi had never actually relinquished the right to income from the partnership and that he had also retained the right to designate who should enjoy the property. (Section 2036 is used to ensure that individuals don't attempt to reduce the value of their estate for estate tax purposes by transferring away property while retaining rights typically attributable to property owners.)

The unexpected victory of the IRS after a long string of defeats suddenly threatened many FLPs that had previously seemed to be safe. With the Strangi estate losing its appeal to the Fifth Circuit (although it may attempt to further appeal the Fifth Circuit's decision), it appears the Strangi case may finally be laid to rest, with the knockout blow (and a precedent for future IRS attacks against FLPs) going to the IRS.

The Implications

In the end, there were a few key issues that defined the IRS's victory in the Strangi case:

• The FLP did not have a sufficiently substantial business or other non-tax purpose for the partnership to be eligible for an exception from the application of IRC Section 2036. Because the 2036 exception didn't apply, the Strangi FLP was subjected to the tests of 2036(a)(1) and 2036(a)(2).

• Under 2036(a)(1), Strangi was deemed to have an implied agreement to retain enjoyment of the transferred property's income because he received substantial payments during life and on his behalf to his estate after death; was allowed to use the residence for deferred rent that was only paid years later; and retained so little in liquid assets that he "must have" had some implied agreement to receive income from the FLP or he could not have supported himself in the future.

• Under 2036(a)(2), Strangi was deemed to have retained control to decide who should receive income from the property because he still had indirect control. His attorney-in-fact was the manager of the partnership; there was a questionable constraint of fiduciary duty since Strangi was a 99.43% owner of the limited partnership; and Strangi still had rights as a 47% owner of the Stranco Inc. general partner.

It is notable that many commentators believe that the Tax Court's interpretation of 2036(a)(2) was unusually broad as a legal precedent and that such an expansive application of the rule might not hold in the future. Unfortunately, since the Fifth Circuit ruled in favor of the IRS on 2036(a)(1), it declined to comment further on the validity of the 2036(a)(2) issues and the Tax Court interpretation. Nonetheless, the 2036(a)(2) issue still represents a genuine concern for FLPs going forward, if the underlying 2036 "bona fide sale" exception cannot be met.

Consequently, there are several planning tips and implications from the Strangi saga that planners should be aware of in estate tax planning (notably, IRC Section 2036 is an estate tax provision and consequently has no bearing on the gift tax implications of FLP valuation and transfers during life):

The most straightforward way to avoid the application of 2036 is to meet the "bona fide sale" exception—in other words, the exchange of property for the family limited partnership shares should be a fair value exchange of assets for limited partnership shares, and there should be a substantial business or other non-tax purpose for creating the FLP. In some cases, this might include running an operating business or other assets that require active management, jointly managing investment assets if other limited partners also contribute a substantial amount of property for management, alleviating substantial creditor/asset protection issues in some cases, or significantly reducing management or other costs and expenses. For FLPs where the 2036 exception might not apply, it is important not to be included under the 2036(a)(1) or 2036(a)(2) rules.

There are several steps advisers can suggest to reduce the risk of assets being included under 2036(a)(1):

• Clients should not include all of their assets in the FLP (note that this was a key factor in Strangi). Instead, they should retain sufficient assets to cover personal and living expenses—including a residence—as well as expenses that may be due at death. (Under current case law, it is not clear if this would also include sufficient assets to pay estate taxes.)

• FLPs should be cautious about making substantial or irregular distributions back to the primary contributor at risk, especially when the distributions are not pro rata to all owners or are within a short period of time after the FLP is established.

• If possible, other family members should make contributions to the FLP—lending credence to the argument for joint investment management and a joint venture business approach, not "just" an estate tax planning strategy.

• The general partner should be someone other than the original contributor at risk, his or her agent (as an attorney-in-fact or trustee of a revocable living trust), or a family member who might clearly be subject to "implicit" control of the contributor.

• Respect all of the formalities of the business, dot the i's and cross the t's and make it clear through actions and account maintenance that the FLP is a genuinely separate and distinct business entity from personal assets.

To minimize the risk of assets being subject to 2036(a)(2), advisers can suggest the following actions:

• Again, the general partner should be someone other than the original contributor or someone that might be serving as his or her agent.

• Give control of the general partnership to an independent trustee/ party where a bona fide fiduciary relationship could exist.

• Don't give the original contributor at risk too much control over voting rights, unlimited ability to remove and appoint new general partners/managing members or extensive power to amend the partnership agreement. Otherwise the original contributor may run afoul of the 2036(a)(2) test by having the ability to control distributions or liquidation of the partnership.

The bottom line is that FLP planning for estate tax discounts is certainly not dead, even though the Strangi case may be. In fact, the growing number of litigated cases on the topic continue to provide additional guidelines (albeit on a slow and haphazard basis) on how to avoid explosions while crossing this dangerous mine field.

Strangi, unfortunately, falls into the category of cases in which "bad facts make bad law." The questionable fact pattern of Strangi's near-deathbed arrangement with implied control set a precedent for including FLP assets in the estate of the decedent, where a "good" set of facts might never have been challenged in the first place.

In the end, Strangi's set of "bad facts" bodes ill for any other cases with a similar set of questionable circumstances. But for clients who are genuinely willing to surrender rights and control over the property or have legitimate business or other non-tax purposes, FLP planning continues to be an excellent estate planning technique when the proper steps are followed.

Michael E. Kitces, MSFS, CFP, CLU, ChFC, is a speaker, writer and editor, and director of financial planning for Pinnacle Advisory Group, a private wealth management firm located in Columbia, Md. He welcomes your questions and comments at michael@kitces.com. This article should not be relied upon as tax or legal advice.