A family limited partnership (FLP), when constructed properly, is an excellent tool to protect and consolidate assets for management through one instrument. For asset protection, assets held by a FLP are not subject to an individual’s creditors; instead, a charging order is usually required to attach a limited partnership interest.[1] The charging order would require the FLP to pay creditors the partner’s share of the income until the debt is satisfied, it would not give creditors de facto partnership status.[2]  

Consolidating assets in FLPs provide efficient management and the added benefit of reducing estate, gift and generation-skipping transfer taxes. Instead of transferring assets directly to beneficiaries, the transferor would transfer limited partnership interests in the FLP; if it was formed, structured and operated properly, the value of the gifted partnership interests will be discounted for lack of control and marketability.[3] The assets transferred to the FLP and the limited partnership interest transferred to the beneficiary are gifts. Gifts are valued at the time of the transfer; any future appreciation would not be taxable for transfer tax purposes.[4] 

Internal Revenue Code § 2036 is the primary tax provision that triggers estate tax inclusion for FLPs.[5] This provision requires estate tax inclusion when the decedent has at any time made a transfer under which he has retained a restricted interest or right for his life, any period not ascertainable without reference to his death, or for any period that does not in fact end before his death.[6] The restricted rights under § 2036 (a)(1) include the right to possess, enjoy or receive the income from, the property; or under (a)(2), the right to designate the persons who shall possess or enjoy the property, or the income therefrom, whether alone or in conjunction with any person.[7] 

Strangi, though not the first, is a foundational case for FLPs.[8] After the taxpayer’s death, the estate filed an estate tax return based on the discounted value of his interest in the partnership instead of the actual value of the transferred assets. The Internal Revenue Service (IRS) issued a notice of a deficiency for multiple reasons but this article will focus on two: the court’s finding of an implied agreement, and the lack of legitimate and significant nontax reasons for establishing the FLP which led to Stranco Family Limited Partnership (SFLP)’s treatment as a disregarded entity.[9] 

In Strangi, the taxpayer’s health was declining and his son, as the taxpayer’s power of attorney agent, created a three-tiered entity with SFLP at the top. The taxpayer transferred $10,000,000 of his personal assets to SFLP in exchange for a 99% limited partnership interest with no formal control. Stranco held a 1% general partnership interest and sole authority to conduct SFLP's business affairs. Further, SFLP paid the taxpayer’s living expenses, personal debts and funeral expenses, provided cash distributions and permitted him to remain in the home owned by SFLP.

The court found an implied agreement in part because SFLP was financially responsible for much of the taxpayer’s personal living expenses.[10] Additionally, the court found SFLP was not formed for a legitimate and significant nontax reason, instead the apparent purpose was to financially take care of the taxpayer. There were no management nor investment functions; therefore, it was easy for the court to conclude as such. Consequently, valuation discounts were not respected and pursuant to § 2036, all the assets were properly included in the taxpayer’s gross estate.[11]

The Grieve case, on the other hand, provided best practices to manage a FLP.[12] The taxpayer established a FLP with Pierson Grieve Management Corp (PMG) as the general partner. His daughter, Margaret, purchased PMG from the taxpayer for $6,200 and served as its president. Margaret managed the family’s wealth through PMG without compensation for her services.  Thereafter, the taxpayer and his wife updated their estate plans and created the Rabbit and Angus LLCs. They transferred approximately $9 million in assets to Rabbit LLC and approximately $32 million to Angus LLC. The taxpayer submitted valuations of $6 million and $21 million respectively.[13]

PMG owned Class A voting units for both Rabbit and Angus LLCs.[14] Margaret was the sole owner of PMG and chief manager of both Rabbit and Angus LLCs. The taxpayer held Class B stock which held no voting power. The IRS argued the .2% interest should eliminate the lack of control and marketability issues because if a buyer purchased 99.8%, he would reasonably seek to purchase the remaining .2%; therefore, the discounts were not warranted. In response, Margaret produced an appraisal, conducted by an independent appraiser, submitted with the previously filed gift tax return to justify the claimed valuations. Further, Margaret asserted the taxpayer had no voting power, and therefore no right to determine who would enjoy the property.[15]

The taxpayer won on both counts. This success was attributable in part to the independent valuation at the time of the transfer. That valuation was based on the independent value of class B stock and the court found it more reliable. Further taxpayer documented relinquishment of taxpayer’s control by issuing only Class B stock. In the end, the taxpayer received the benefit of consolidated management and maximized wealth transference without triggering estate tax inclusion. Despite the benefits to the taxpayer, the transfers and valuation discounts were respected in large part because Margaret treated the LLCs as independent businesses, not extensions of the taxpayer.

Unlike Grieve, the taxpayer, Howard Moore and his attorneys made the same mistakes as Strangi. Howard Moore was an 88-year-old farmer who planned to sell his 845-acre farm; however, before the sale was completed, he was admitted to the hospital with congestive heart failure, and later suffered a heart attack and stroke before he was released to in home hospice care.[16] Taxpayer hired an estate planner and to develop a plan that would enable the following: annual $150,000 distributions after gifts and taxes, liquidity for emergencies, opportunity to make annual gifts, protection from creditors, reduced income taxes and to eliminate or reduce estate taxes among other things. To accomplish these multifaceted goals, the attorney drafted multiple instruments, comprised of five trusts and the Moore Family Limited Partnership (MFLP).[17] I will focus on the management trust and MFLP. 

The management trust was an irrevocable trust with a 1% general partnership interest in MFLP, its only asset. Two of the taxpayer’s children were co-trustees of the management trust. The Howard V. Moore Living Trust had a 95% limited partnership interest in MFLP and taxpayer’s four children each had a 1% interest in MFLP. Thereafter, taxpayer contributed his 4/5th interest in Moore Farms to his living trust.[18] The living trust sold the interest to MFLP, which immediately sold the interest to the irrevocable trust. The irrevocable trust then sold the interest to Mellon Farms.[19]

In Moore, even though Mellon Farms paid fair market value for Moore Farms, the IRS argued the transfer was not a bona fide sale because of the taxpayer retained control. Bona fide sales generally eliminate § 2036 estate tax inclusion when the sale is made for adequate and full consideration in money or money’s worth.[20] In typical sales, the bona fide purchaser’s paid consideration replenished estate’s value lost on the transfer. Further, the new purchaser would have ownership and control of the asset and the transferor would have no retained right to attach. The court reasoned the entire transaction was designed to avoid taxation and had a “testamentary essence” and concluded the taxpayer had no legitimate and significant nontax reason for creating the FLP.[21]  

First, the court noted, the taxpayer retained too much control. The taxpayer controlled every aspect of the sale of Moore Farms even after it was transferred to MFLP and the children had no meaningful participation in the process.[22] Further, the taxpayer’s living arrangements and management of Moore Farms were the same before and after the sale. The estate presented evidence that it was customary for farmers to live out their days on a farm after a sale, but the court found there was no such evidence of continued management post-sale.[23]

Next, MFLP had no business purpose, no active management, no legitimate creditor concerns. MFLP had a number of restrictions that negated effective management including a prohibition of sale or transfer without the consent of all general and limited partner, which included the taxpayer, and limited partners had no right to participate in the business nor its operations. Similar to Strangi, it appears that MFLP’s purpose was to the take care of the taxpayer. MFLP was responsible for paying the taxpayer’s expenses, including his income tax liability.  

The estate argued the taxpayer’s principal reason for forming MFLP and transferring the farm was “to bring his family together so that they could learn how to manage the business without him.”[24]  The flaws in this reasoning include the immediate sale of Moore Farms by the taxpayer; MFLP restrictions on management opportunities by the children, and liquid assets were managed by a financial advisor who made the necessary investment decisions. Consequently, the court found that MFLP lacked legitimate and significant nontax reasons for existence because it had no management functions.[25]

The Moore Farms case demonstrated an extreme example where the taxpayer transferred the property to a revocable trust and immediately made subsequent sales that looked like a sequence of illusory transactions.[26] The Tax Court found that the decedent’s transfer of Moore Farms to MFLP in the final months of life was not done for a legitimate and significant nontax reason.[27]  There was no express agreement, similar to Strangi, but an implied agreement was easily surmised from the facts; therefore, it was appropriate to include the value of Moore Farms in the gross estate under § 2036.[28]

The Powell case is another multifaceted case; however, I focus on the retained interest and illusory nature of the transactions. Powell’s son, her power of attorney agent, transferred $10 million in cash and securities from the taxpayer’s living trust to create the NHP Enterprises LP (NHP) in exchange for a 99% limited partnership interest one week before her death.[29]  Taxpayer’s children were co-owners who contributed unsecured promissory notes. The son who served as the power of attorney named himself as the general partner of NHP. NHP’s agreement permitted dissolution with the written consent of all parties, including the taxpayer.

The IRS issued a notice of deficiency denying the valuation discount on the 99% interest in NHP based, in part, on taxpayer’s retained the power to alter, amend, revoke or terminate NHP, whether the right was alone or in conjunction with any other person.[30] The estate conceded to the IRS’ technical arguments that the taxpayer’s retained power to vote for termination of NHP, exercisable in conjunction with her sons, was enough to trigger the retained interest provisions subject to § 2036(a)(2), however, they argued taxpayer did not retain her right in NHP upon her death.[31] The court explained that even if the transfer to the charitable lead annuity trust (CLAT) was valid, the taxpayer died within three years of the relinquished right, as such, the property would have been properly includable under § 2035.[32]

Another key factor in this case was the illusory nature of the transactions. The transfers occurred approximately one week before the taxpayer’s death and were clearly designed to obtain valuation discounts. Similar to Strangi, NHP had no meaningful management nor business operations other than holding taxpayer’s investments; therefore, NHP was disregarded.[33]

These cases provide several practice points. First, a FLP should not be responsible for financial liabilities nor living arrangements of the transferor. Second, a FLP should not provide regular payments to the transferor. Third, the taxpayer’s level of control should change, post-sale. Each of these circumstances exhibits retained interests and implied agreements which lead to estate tax inclusion; any retained interest is a key to unlocking a FLP to cause estate tax inclusion, therefore, avoiding a retained interest is a solution to negate the reach of § 2036. Fourth, avoid the step transaction. When transactions are planned together with obvious tax avoidance goals and executed simultaneously or in close sequence, the transactions will not likely be viewed in isolation as demonstrated in the Moore and Powell cases. 

Finally, demonstrating the legitimate and significant nontax reason for creating a FLP is critical.  Deathbed transactions, as demonstrated in Strangi, Moore and Powell, are obvious indicators of tax avoidance motives. Alternatively, Grieve provided excellent tools for demonstrating legitimate and significant nontax reasons for creating a FLP. These effective methods to include: creating proper records, conduct meetings, obtaining appraisals, structuring transactions between family members to account for expectations and true fair market value, incorporate asset protection, and engage in property management. Following these practice points provide the best opportunity to benefit from wealth management, asset protection and discounted wealth transference benefits of FLPs without triggering an estate tax.

Phyllis Taite, JD, LLM, is a professor of law at Oklahoma City University, School of Law. She teaches a combination of federal income tax, wills, trusts & estates, and property-based courses. She has over 18 years of teaching experience. Professor Taite also serves on committees including the Legal Education Committee for the American College of Trust and Estate Counsel (ACTEC), Florida Bar Probate Rules Committee, and the Tax Section of the Florida Bar.