Validly Formed FLP Was Recognized for Estate Tax Purposes

Individual S was a self-made millionaire, with four children and two stepchildren. In 1988, S executed a power of attorney, naming lawyer G (who was married to one of S's daughters) as his attorney-in-fact.

In 1993, after S underwent surgery, G took over S's affairs, pursuant to the 1988 power of attorney. After attending a seminar on the use of family limited partnerships (FLPs), in 1994, G formed SFLP, a Texas limited partnership, and its corporate general partner, Stranco, a Texas corporation. G then transferred S's assets to SFLP, in return for a 99% limited partnership interest. At the same time, S and his children bought all of Stranco's stock. Two months later, S died of cancer.

Following the formation of SFLP, various distributions were made to S's estate and to his children. In 1996, S's estate tax return was filed by G, the executor, reporting $2 million in transfer taxes.

The IRS challenged SFLP's existence, arguing that, under the business-purpose and economic-substance doctrines, it should be disregarded in valuing S's estate. In a reviewed decision, the Tax Court (opinion Cohen, J.) held that, because the FLP was validly formed under state law, it would be recognized for Federal estate tax purposes.

Taxpayers are generally free to structure transactions as they please, even if motivated by tax-avoidance considerations. However, the tax effects of a particular transaction are determined by the substance of the transaction rather than by its form. Transactions with no economic purpose or substance other than the avoidance of taxes will be disregarded.

Family partnerships must be closely scrutinized by the courts because the family relationship so readily lends itself to paper arrangements having little or no relationship to business arrangements. Family partnerships have long been recognized when there is a bona fide business carried on after the partnership is formed. Mere suspicion and speculation about a decedent's estate planning and testamentary objectives are not sufficient to disregard an agreement, in the absence of persuasive evidence it is not susceptible of enforcement or would not be enforced by parties to the agreement.

The estate contends that there were "clear and compelling" nontax motives for creating SFLP, including the provision of a flexible and efficient means by which to manage and protect S's assets. Specifically, the estate argues that its business purposes for forming SFLP were (1) to reduce executor and attorney's fees payable at S's death, (2) to insulate S from an anticipated tort claim, and the estate from a will contest (by creating another layer through which creditors must go to reach assets conveyed to the partnership) and (3) to provide a joint investment vehicle for managing S's assets. There are reasons to be skeptical about the nontax motives for forming SFLP.

On various social occasions, G consulted with a former probate judge about S's anticipated estate. Those consultations, however, were not related in time or purpose to the formation of SFLP. In our view, the testimony about consultation was mere window dressing to conceal tax motives.

We are not persuaded that SFLP was formed to protect assets from will contests by the children or from a potential tort claim by the former housekeeper. The stepchildren's claims were stale when the partnership was formed and they never materialized. There was no direct corroboration that the housekeeper was injured by S while she was caring for him or any indication that she ever threatened litigation.

We also do not believe that a "joint investment vehicle" was the purpose of the partnership. G took over control of S's affairs in September 1993, under the 1988 power of attorney, and continued to manage S's assets through his management responsibilities in Stranco. Directly or indirectly, S ended up with 99.47% of SFLP, having put in essentially 99.47% of the capital.

The formation and subsequent control of SFLP were orchestrated by G without regard to "joint enterprise." He formed the partnership and the corporation and then invited S's children, funded by G's wife, to invest in the corporation. The children shared in managing the assets only after and to the extent that the brokerage account was fragmented in accordance with their respective beneficial interests.

The nature of the assets contributed to SFLP supports the conclusion that management of those assets was not its purpose. There were no operating business assets contributed to SFLP: S transferred cash, securities, life insurance policies, annuities, real estate and partnership interests. The cash and securities approximated 75% of the value of the assets transferred. No active business was conducted by SFLP following its formation.

Having said all that, however, SFLP was validly formed under state law. The formalities were followed and the proverbial "i's" were dotted and the "t's" were crossed. The partnership, as a legal matter, changed the relationships between S and his heirs and S and actual and potential creditors. Regardless of subjective intentions, the partnership had sufficient substance to be recognized for tax purposes. Its existence would not be disregarded by potential purchasers of S's assets, and we do not disregard it in this case.

Estate of Albert Strangi, 115 TC No. 35

REFLECTIONS: Accord, Knight, 115 TC No. 36.