A recent federal appeals court decision could spell trouble for anyone who desires to set up a family limited partnership (FLP) in order to reduce estate and gift taxes.

On September 1, The U.S. Court of Appeals for the Fifth Circuit in New Orleans ruled that the estate of Albert Strangi, a Texas millionaire who set up a FLP prior to his death had to pay an increased tax deficiency because he, in fact, maintained possession of the assets he had transferred into the partnership.

The Fifth Circuit court’s ruling is the latest victory for the IRS involving these commonly used planning tools. However, while the court explained the criteria it used to determine as to whether an FLP can withstand a challenge from the IRS, there are problems still remaining for advisers.

"The impact on the securities industry is there is no hard and fast rule," says Brant J. Hellwig, an assistant professor at the University of South Carolina School of Law in Columbia, S.C. "These things are going to be examined on a case-by-case basis."

Norman Lofgren, who is a partner with Looper, Reed & McGraw in Dallas and represented the Strangi estate, says: "If you look carefully at the Fifth Circuit opinion, in order for the transfer of assets to the partnership to be respected, it must have a substantial non-tax purpose or business purpose." But how either applies is unclear, says Lofgren. "Do you have to have one or both?" he asks. "The troublesome word is the word substantial.' "

And that was the problem for the estate of Strangi. Strangi was a former radiator manufacturer who passed away in 1994. According to the court opinion, Strangi transferred close to $10 million in personal assets into a family limited partnership he created a couple of months before he died. Although the estate filed an estate tax return following Strangi's demise, the IRS said there was a tax deficiency of over $2 million. The agency based the deficiency on the larger size of the estate if the transferred assets had been included.

Both the Tax Court and the court of appeals found that Strangi, under IRC Section 2036(a), had continued to be in possession of or benefited from the transferred property and there was no business purpose to the transfer. The court concluded that, under the Code, the assets should have been included in the taxable estate.

Where exactly did the Strangi Family Limited Partnership go wrong? The court found that the FLP made payments for some of Strangi's expenses, including nearly $40,000 to cover his funeral, along with payments for certain personal debts as well as estate administration expenses. The FLP also distributed over $3 million to the estate to pay federal and Texas state inheritance taxes a year after Strangi died. Prior to his death, Strangi continued to live in one of the two houses he had transferred to the partnership.

The ruling makes one thing clear, says Joe D. Seckelman, an attorney specializing in tax law. If you form a FLP, he says, "you have to have a business purpose to do it, and you have to actively manage it, and you cannot enjoy the benefits" of the assets you put into it.

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