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Don’t trash your family partnership; repair it if necessary

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Pity the late Albert Strangi. He tried to save his family from estate taxes by transferring the bulk of his assets into a family limited partnership (FLP). But the IRS stepped in and nixed the tax benefits.

That IRS position created a highly publicized stir about the viability of FLPs as a tax strategy. Just recently, the Tax Court stepped in and agreed with the IRS that Strangi's FLP was effectively a sham.

The lesson: Don't abandon your FLP or halt your plans to launch an FLP. Just make sure you don't make the same mistakes as Strangi.

If you keep too much control over the FLP—whether it's directly or indirectly—the IRS may shoot down the whole deal. But you can preserve the tax benefits if you observe the necessary formalities and run the partnership like a legitimate business or investment entity.

How an FLP works. Typically, you'd transfer assets to a limited partnership and name yourself as the general partner. You'd name your family members as limited partners. By setting up the FLP, you effectively remove assets from your taxable estate by giving away limited partnership interests to family members. But you still can call most of the shots as the general partner.

Best of all, the limited partnership shares can be discounted in value for gift-tax purposes. Reason: No public market exists for those shares. That means you can shift a good chunk of your net worth—including a closely held business interest—to the younger generation at a tax bargain.

The long Strangi trip. In Strangi's case, he transferred most of his assets late in life to an FLP and named his adult children as the limited partners. The value of the shares was substantially discounted. Although Strangi owned a minority interest, the FLP's only distributions were made for his living expenses.

The court kiboshed the arrangement, saying that Strangi was still using the FLP's assets personally. It allowed no discounted valuation and all of Strangi's assets were subject to estate tax. In other words, the FLPs existence was completely ignored by the IRS, and the court agreed. (Estate of Strangi, 5th Cir., 03-60992, 7/15/05)

Advice: Fortunately, it's not that hard to avoid this dire tax result. To hold onto the tax breaks, administer the FLP properly using the four steps described above. The more the FLP looks and acts like an actual partnership, the better your chances of passing muster with the IRS.

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