Family limited partnerships and other family entities can occupy an important role in an estate plan. By combining ownership of certain assets in one structure, to be managed for the general benefit of the participating family members, clients may achieve several goals important to wealth management and succession. However, this form of planning continues to be met with challenges from the Internal Revenue Service. A recent Tax Court decision favoring the IRS position has received much attention in the press and in the estate planning community. While still a valuable technique, the use of family limited partnerships must be considered carefully at the outset, for the implementation and ongoing management of these entities requires serious attention.
Over the past several years, the use of family limited partnerships as a wealth preservation estate planning strategy has received a great deal of attention from the IRS. A recent controversial U.S. Tax Court opinion, which has been widely criticized by practitioners, may significantly affect both new and existing family limited partnerships.
In Estate of Strangi v. Commissioner,[i]a case that was remanded by the U.S. Court of Appeals for the Fifth Circuit, the U.S. Tax Court ruled that a decedent's transfer of assets to a family limited partnership in exchange for limited partnership interests constituted a "transfer with a retained interest," which, upon the decedent's death, subjected to federal estate tax the date-of-death value of the underlying assets transferred to the partnership rather than the interests held by the decedent as a limited partner.
The formation of a limited partnership (or other entity, such as a limited liability company) can be an effective means of consolidating and preserving family wealth, as well as providing some level of protection from what one planner refers to as "creditors, predators, spouses and exes." In addition, this form can afford orderly succession of ownership, where multiple family members may benefit without the need to secure the agreement of all as to management or other decisions. Under this technique, family members form a limited partnership, contributing assets in exchange for limited partnership interests. The partnership's general partner, which has sole management authority over its affairs, is typically a subchapter S corporation or limited liability company that is also owned by family members. Because of the restricted rights of the limited partners to participate in the management and control of the partnership, generally accepted valuation methodology recognizes that the value of the limited partnership interests is worth somewhat less than a pro rata share of its underlying assets. Thus, courts generally have held that, in a properly structured limited partnership, the value of limited partnership interests for federal estate and gift tax purposes must reflect these restrictions and, thus, represents a discounted value as compared to the aggregate value of the combined assets held in the partnership.
The facts addressed by the Tax Court in Strangi are as follows: Mr. Strangi was in his 90s and had been seriously ill for several years. Two months prior to Mr. Strangi's death, his son-in-law, acting under Mr. Strangi's power of attorney, engaged in an estate planning technique recommended by a promoter. On Mr. Strangi's behalf, he formed a family limited partnership to which approximately 98% of Mr. Strangi's assets were contributed, including his home. In return, Mr. Strangi received substantially all of the limited partnership interests. The sole general partner was a corporation, Stranco, Inc., that was also formed by Mr. Strangi's son-in-law. Stranco was owned 47% by the decedent and 52% by other members of the decedent's family. (Following formation, the family gave a 1% interest in Stranco to an unrelated charity.) Stranco hired the decedent's son-in-law, in his individual capacity, to manage the partnership's assets. The partnership could be dissolved and terminated upon, among other things, a unanimous vote of the limited partners and the unanimous consent of the general partners.
The court presented two theories for its decision to disregard the entity in valuing the assets owned by Mr. Strangi at his death. First, the court found that there was an implied agreement among the family members for the decedent to retain possession or enjoyment of the assets. In this regard, the court noted certain factors that were previously found under I.R.C. § 2036(a)(1) [ii] to indicate an implied agreement sufficient for inclusion in the decedent's gross estate: (i) the transfer of the vast majority of a decedent's assets to the partnership; (ii) continued occupation of transferred property by the transferor; (iii) commingling of personal and entity assets; (iv) disproportionate distributions among the partners; (v) use of entity funds for personal expenses; and (vi) testamentary characteristics of the arrangement.
In finding against the taxpayer, the court found compelling the fact that the decedent had contributed virtually all of his wealth to the partnership. Partnership assets were needed to provide a home for the decedent, to pay for his medical care and to meet his other liabilities. The estate argued that the decedent had nonetheless retained sufficient assets to provide for his basic living expenses, but the court found it unreasonable to expect the decedent to rely upon the liquidation of non-partnership assets to meet such expenses.
Another feature the court found indicative of an implied agreement to continue to treat the assets held in the partnership as belonging to Mr. Strangi was the decedent's continued physical possession of his residence after its transfer to the partnership and his failure to pay rent in a timely manner.
The court also cited several instances in which partnership distributions coincided with the personal expenses of the decedent's daughter or, following the decedent's death, the payment of the decedent's estate administration expenses, debts and taxes. The court emphasized the decedent's inability to pay his living expenses and the inability of his estate to pay its administration expenses, without relying upon partnership distributions.
Finally, the court believed that the formation of the partnership agreement was consistent with testamentary intent based on (i) the formation of the partnership primarily with the decedent's assets and without input from other family members, (ii) the continued management of the decedent's affairs by his son-in-law, who served as his agent and as a manager of the partnership, and (iii) the failure of the decedent's children to obtain a meaningful economic stake in the partnership property during the decedent's life or object to the distributions made by the partnership to the decedent or his estate.
The court's second rationale was that because the decedent's attorney-in-fact was retained by Stranco to manage the partnership's assets, the decedent had retained actual control of the partnership assets under section 2036(a)(2). In so finding, the court disregarded the U.S. Supreme Court's decision in U.S. v. Byrum,[iii]which held that fiduciary duties imposed upon a general partner under state law were sufficient to negate section 2036(a)(2). The court reasoned that fiduciary duties owed to family members in a family limited partnership did not deserve the same weight as the obligations present in Byrum, an instance in which third parties and operating businesses were also involved.
The estate argued that section 2036(a)(2) did not apply because of an exception contained therein pertaining to bona fide sales made for fair and adequate consideration. The court also rejected this argument, however, holding that (a) the formation of the partnership was not conducted on an arms'-length basis because the decedent stood on "both sides" of the transfer and that (b) the partnership resulted merely in a "recycling of value" rather than a transfer for consideration.
The Tax Court's decision in Strangi does not signal the end of the viability of family limited partnership's as wealth preservation and estate planning vehicles. It remains to be seen, for example, whether or not the decision in Strangi will be applied simply to "deathbed" partnerships or otherwise limited in its application. Furthermore, this much-criticized decision was a Memorandum Opinion that was not reviewed by the full Tax Court and, to date, has not been subjected to appellate review. Nonetheless, the decision does raise concerns for existing and contemplated family limited partnerships. All such partnerships should be evaluated and structured in light of Strangi.
[i] T.C. Memo 2003-145 (May 20, 2003).
[ii] All section references herein are to the Internal Revenue Code of 1986, as amended.
[iii] 408 U.S. 125 (1972).
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