Est. of Strangi Finally Settled

The long and hotly contested saga of Est. of Strangi may finally have ended. On Aug. 8, 2005, the Fifth Circuit upheld the Tax Courts determination (TC Memo 2003-145) that Sec. 2036(a) applied to the transfer of property to a family limited partnership (FLP) and affirmed that the estate should include the entire value of the property transferred to the FLP.

The recognition of FLPs and the discounts attributable to such entities have generated many bitter battles between the IRS and taxpayers. The Fifth Circuits decision supported the IRSs position that there must be substantial nontax reasons for creating a FLP. That court also endorsed the Tax Courts view that a FLP must actually be operated as the taxpayers say it will be operated. Both of these conclusions create potentially expensive problems for clients.

Courts Conclusions

Retained enjoyment: First, the Fifth Circuit found that the Tax Court did not err in determining that the decedent had retained possession or enjoyment of the FLP property. Repeated distributions to pay pre- and post-death expenses provided strong circumstantial evidence of an understanding that the FLPs assets would be so used.

No bona fide sale: The court also found that the Tax Court did not err in determining that the transfer to the FLP was not a bona fide sale, even though the IRS had conceded that there was adequate and full consideration. The court scrutinized the estates stated reasons for forming the FLP and concluded that there were no nontax reasons for its creation. One by one, the court dismissed the estates assertions of various business purposes. The court found minimal risk of tort litigation from the decedents former housekeeper, who had injured herself on the job; a potential will contest never materialized and would not have been successful; there was no substantiation that the FLPs creation deterred a corporate executor from serving; the FLP did not serve as a joint investment vehicle for the decedents children, because their contributions were de minimis; and the FLP was not involved in the active management of the assets after formation. Thus, the court concluded that the transfer was not a bona fide sale, and brought the entire value of the FLP property back into the estate.

Economic benefit: The case sends a strong message: FLP operations are as important as FLP structure. The Fifth Circuits holding that there was an implicit retention of economic benefit was based on the fact that the decedent transferred 98% of his assets to the FLP, lived in the house the FLP owned and paid no rent (despite two years rent accrual on the FLPs books). In addition, after his death, the FLP distributed funds to pay estate administration expenses, funeral expenses, personal debts and specific bequests. Further, even though distributions were made to all partners, the court dismissed them as insignificant. In short, the court concluded that the decedent retained assets barely sufficient to meet his own living expenses for the low end of his life expectancy that is, for about one year.

Recommendations

What Strangi should teach is not that FLPs are bad or should not be used, but that they must be both properly formed and properly operated. Without both factors, the likelihood is that the IRS will win using the same Sec. 2036(a) arguments that proved so successful in Strangi. A second lesson is that the Tax Court is ready, willing and able to scrutinize the actions of the FLP or family limited liability company (FLLC) and its owners and managers, and that the Fifth Circuit is willing to support it.

In three recent cases, Est. of Bigelow, TC Memo 2005-65, Est. of Bongard, 124 TC No. 8 (2005), and Est. of Korby, TC Memo 2005-102, the Tax Court devoted substantial discussion to the operations of the FLPs or FLLCs involved. The purpose, transactions, use of resources, etc., were all thoroughly analyzed before reaching the conclusion that Sec. 2036(a) should apply in each case.

A tax adviser can avoid a disaster like Strangi and the Tax Court cases cited above, by working closely with clients to structure and operate FLPs/FLLCs properly. This often requires a substantial amount of client education, but the payoff is a significant reduction in estate tax and a better ability to withstand IRS scrutiny. In addition, the tax adviser should:

• Deemphasize the tax benefits of creating or using FLPs and FLLCs.

• Ensure that there are legitimate, nontax business reasons for creating the FLP/FLLC, and form the entity correctly, without focusing on the tax benefits.

• Ensure that the donor keeps enough assets to meet his or her normal living expenses and provide a cushion for emergencies.

• Make pro-rata distributions that are significant for the minority members or partners.

• Prohibit loans or other financing arrangements with the donor that could be construed as constructive control over the FLPs/FLLCs assets.

• Consider requiring the FLP/FLLC to make substantial distributions annually.

• Provide appropriate legal do-cumentation and have the FLP/ FLLC charge fair market rental or usage fees for the use of property, if the entity is going to permit the donor to use its property.

• Involve other partners or members in the entitys formation and make sure they contribute more than a token share of the entitys assets.

• Insulate the donor from the control argument, by making the spouse, a child (or, better yet, an independent third party) the entitys general partner or manager.

• Maintain separate FLP/FLLC accounts and retitle all assets in the entitys name. Open a separate bank account in the entitys name.

• Use common sense in creating and dealing with a FLP/FLLC. If the structure looks or smells bad to the practitioner, what will the IRS think?

• Consider an annual meeting with the FLPs/FLLCs general partners or managers, to review compliance with the entitys documents. Any such review or analysis should be a separate engagement, with a separate engagement letter spelling out the practitioners responsibilities.

While Strangi demonstrates the consequences of a bad structure, FLPs and FLLCs continue to be valid and valuable estate and economic planning tools. However, proper compliance with the entitys formation, management and operation is a must.

From Michael E. Mares, J.D., CPA, Witt Mares and Company, Newport News, VA