IRS scores significant victories in recent attacks on family limited partnerships.

For years, the IRS has fought to minimize the tax savings opportunities of the family limited partnership ("FLP")--an established estate planning technique. What has irked the IRS is the gift and estate tax valuation advantage the FLP creates. By transferring interests in an FLP to family members, a donor can apply substantial discounts in valuing the gift for gift tax purposes.

Recently, the courts decided to assist the IRS in its efforts. In two very recent decisions, the Tax Court:

* disallowed the use of the $11,000 gift tax annual exclusion in a family limited liability company (an "LLC" taxed as a partnership), and

* included the entire undiscounted value of the assets transferred to an FLP in the donor's taxable estate.

The current law protects a family's wealth by allowing each donor an annual gift tax exclusion of $11,000 per donee. Therefore, a married couple is permitted gifts of $22,000 per year to every child, son-or daughter-in-law, grandchild or other recipient. Applying the valuation discount rules, the annual gift tax exclusion is a powerful tool to shift business and investment interests to lower generations without any gift tax impact to the older generation. The $11,000 exclusion is available, however, only if the gift is of a "present interest" as opposed to a "future interest."

In Hackl v. Commissioner, the Tax Court interpreted the "present interest" to mean "immediate value to the donee." The court found that the donees had no right to liquidate their transferred LLC interests or withdraw their capital without first obtaining the consent of the donor manager. In the court's view, the donee was locked into the investment, which happened to be for long-term growth and produced no current cash flow (meaning it lacked "immediate value to the donee").

Consider the following suggestions on how to avoid the loss of the gift tax exclusions (though they might impact the discounted value of the gift):

* Grant a "put" right, where for a limited time the donee could require the entity to purchase the transferred interest for fair market value.

* Grant a "withdrawal" right, where for a limited time the donee could withdraw the value of the transferred capital account.

* Grant the donee a right to freely transfer the transferred interest.

In Strangi v. Commissioner, two months prior to Mr. Strangi's death, his son-in-law, through a power of attorney, formed an FLP and assigned nearly $10 million of Mr. Strangi's assets (representing about 98% of his wealth), including his personal residence, to the FLP. Mr. Strangi was issued a 99% limited partner interest, and a 1% general partner interest was issued to a corporation owned by both Mr. Strangi and his children. After Mr. Strangi's death, the children used partnership funds as needed without regard to the form of the entities they organized.

The court included the full value of each asset contributed by Strangi to the FLP in the value of his gross estate, thereby eliminating the benefit of any discounts. The court felt that, as a practical matter, Mr. Strangi retained the same relationship to his assets that he had before the formation of the FLP.

The Strangi decision is the latest in a string of cases where the court disallowed valuation discounts in connection with deathbed transfers.

The following are some basic rules to follow to help avoid the Strangi result:

* Refrain from commingling the FLP's funds with personal funds.

* Keep detailed and accurate books.

* Comply with all of the formalities of the partnership agreement.

* Make sure distributions are made in proportion to the partners' proportionate interests.

* Don't transfer so much of the donor's assets that he or she becomes dependent upon the distributions from the FLP to maintain his or her style of living.

* Don't transfer personal assets.

More troubling is the Tax Court's alternative rationale for including the full value of the FLP assets in Mr. Strangi's gross estate. The alternative holding was, in essence, based on Mr. Strangi's ability to control (although only with consent of the limited partners) the liquidation of the partnership and the distribution of the partnership assets. The full impact of this alternative holding is much debated--some think it may sound the death knell of FLPs; others think the decision is simply wrong and won't be upheld in future court decisions.

To address the court's alternative holding, keep the following in mind:

* If the FLP operates an active business, the business constraints arguably limit the donor's right to direct distributions.

* The existence of unrelated investors would be helpful (however unlikely that may be in the typical family business situation).

* Substantial contributions by other owners would be helpful.

* Another alternative would be for the donor to transfer, at least three years prior to death, any interest held in the general partner.

* Although less certain, if the donor makes substantial gifts of interests in the FLP to family members before he or she dies, arguably the fiduciary duty of the donor as the general partner should be a sufficient impediment to prevent inclusion in the donor's estate.

Both decisions--Hackl and Strangi--represent a clear warning to families with FLPs. The decisions underscore the importance of working with your estate-planning attorney to ensure that your family-owned business entity is structured to avoid the pitfalls of these and other court decisions.

D. Matthew Richardson is a Partner in the Tax, Employee Benefits, Trusts & Estates Practice Group at Sheppard, Mullin, Richter & Hampton LLP. He can be reached at 213.617.4222 or [e-mail].