This FLP Alert is directed at clients and their advisors who have already established Family Limited Partnerships (“FLP’s”) and those clients who are considering a partnership as part of their estate plan.

With all the attacks the IRS has made on FLP’s over the past few years, culminating at the Strangi III decision in July 2005, many have inquired as to the continued viability of FLP’s, particularly with respect to estate tax valuation discounts. The Strangi cases (I, II and III) were extreme cases involving a fact pattern that weighed heavily against the taxpayer and should be used to clarify how to structure an FLP in order to minimize tax consequences.

Background – In the Strangi case, Mr. Strangi’s son-in-law, acting as his agent under a durable power of attorney, created an FLP two months before his death in 1994. Approximately 98% of Mr. Strangi’s net worth was transferred to the FLP and he became the 99% limited partner; however, he also retained a small percentage of the 1% general partnership interest.

On Mr. Strangi’s estate tax return, the executor reported the value of Mr. Strangi’s partnership interest at a discount from the value of the underlying partnership assets using the “estate tax valuation discount.” In claiming this discount the executor asserted that the FLP agreement created restrictions that would cause a third party to value the limited partnership interest lower than the value of the underlying assets held by the partnership. On audit, the IRS disagreed and informed the executor that it was seeking an additional $2.5 million in estate taxes. Litigation has continued since then, with the most recent decision in favor of the IRS, referred to a Strangi III. It is unknown at this time whether the Estate will appeal this decision to the U.S. Supreme Court.

§ 2036(a) of the Internal Revenue Code provides that transferred assets can still be included in the taxable estate if prior to death the decedent retained (1) possession or enjoyment of the assets or (2) the right to designate persons who shall possess or enjoy the assets. In Strangi II, which was upheld by Strangi III, the courts determined that § 2036(a) applied to the assets held by the Strangi FLP, thereby increasing the estate’s tax liability considerably.

Lessons from Strangi III – Here is what we have learned as far as what to avoid in the formation of FLP’s, and things to look for in the operation and management of FLP’s.

• Don’t put all your assets in the partnership. The partnership should be viewed as a business or investment vehicle, not a tax planning vehicle or account. Reserve an amount of assets outside of the partnership sufficient to allow you to live in your desired standard of living for the remainder of your anticipated life expectancy. In addition, in the Strangi case, the IRS was highly critical that the FLP paid estate administration expenses following Mr. Strangi’s death. Therefore, it is probably a good idea to include anticipated expenses in the reserve described above, perhaps even considering a reserve for estimated estate and inheritance taxes, or providing for those taxes through a life insurance policy.

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