The Internal Revenue Service (IRS) is looking to nullify the tax benefits of family limited partnerships (LPs) and family limited liability companies (LLCs). Despite early successes by taxpayers, several cases recently have been decided in favor of the IRS. Those cases that apply to Section 2036(a)(1) of the Internal Revenue Code concluded that where a decedent effectively retained the right to use partnership assets, any assets in the entity contributed by the decedent were includible in the decedent’s estate, with no valuation discounts available, even where the decedent had gifted interests in the entity.

In Estate of Strangi vs. Commissioner, the tax court disregarded a family LP for estate tax purposes, including the partnership’s underlying assets in the taxpayer’s estate. First, the court held that Strangi had an implied understanding with family members that he could personally use partnership assets. Strangi had placed 98 percent of his assets into the partnership, making it necessary for him to rely on the entity to pay his expenses. As a result, the court ruled the partnership’s assets were includible in his estate.

The alternative holding in Strangi stipulated that the taxpayer’s 47 percent interest in the corporate general partner afforded him the right to control, along with others, decisions affecting partnership distributions and liquidation. The court ruled that these retained rights gave the decedent control over the timing of the partners’ enjoyment of partnership assets, causing the partnership’s underlying assets to be included in his estate.

The court disregarded the argument that the general partner was constrained by fiduciary concerns and could not exercise control in favor of any one partner. Many feel that this decision is inconsistent with a previous Supreme Court ruling that voting stockholders owe a fiduciary duty to other stockholders. As such, the fiduciary duty diminishes the decedent’s control and prevents transferred stock from being includible in taxable estate. By contrast, Strangi held that the decedent’s fiduciary duty to his family did not sufficiently limit his right to vote. The Strangi court creates a distinction between family and non-family situations, stating that fiduciary duties in intra-family entities, particularly those that hold only marketable securities, should be disregarded.

The importance of observing an entity’s formalities - operating as a business, segregating income and paying expenses, keeping books and records, filing income tax returns, etc. - cannot be overemphasized. There should be no commingling of assets, no payment of personal expenses and no disproportionate distribution. It is critical that, when creating a family entity, individuals retain sufficient assets to avoid relying on the entity for living expenses. Finally, to avoid the application of Strangi, any client creating an entity must not retain direct or indirect control.

If the transferor has retained a controlling interest, several decisions should be made as a result of Strangi. First, should immediate remedial measures be taken? Since many believe the alternative in Strangi is inconsistent with the Supreme Court, it may make sense to wait for the completion of the appellate process. Next, should the family entity be continued or terminated? Advisors should determine whether the tax-planning objectives can be achieved if the family entity is terminated. This generally will be the case if significant transfers of entity interests were made. Consider whether an immediate termination would make it more difficult to sustain valuation positions already taken. If it makes sense to terminate, the income tax consequences of distributions from the entity to its owners must be evaluated.

If the entity is to be continued, the transferor must divest all voting interests to avoid the application of the Strangi alternative holding, provided this ruling is sustained. If the client is willing to explore the transfer of a voting interest, he or she also must consider the recipient of such interest and the structure of the transfer.

The transfer of a voting interest can be accomplished either by gift or sale. A gift within three years of a taxpayer’s death would be ignored for tax purposes under Section 2035. If the voting interest is transferred by sale for full and adequate consideration, the three-year inclusion rule can be avoided. Accountants valuing voting interests sold should consider the application of a control premium. If the IRS successfully re-values the interest sold, the client could be deemed to have gifted a portion of the transferred voting interest, thereby triggering the three-year rule. 

Reprinted from New Jersey CPA with the permission of the New Jersey Society of Certified Public Accountants.