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Recent Cases Highlight Need for Proper Formation and Operation of Family Limited Partnerships

January 1, 2004 Articles Corporate

Family limited partnerships are often used as sophisticated estate planning techniques. When properly formed and maintained, family limited partnerships can provide a meaningful reduction in estate and gift tax, as well as creditor protection. Although there have been several cases that uphold the legitimacy of properly structured and operated family limited partnerships, there have been a few recent cases that have caused considerable concern in the estate planning community. The two primary cases that have caused significant discussion are Estate of Thompson and Estate of Strangi.

In Estate of Thompson, the Tax Court held that a partnership lacked economic substance and was to be disregarded for purposes of applying minority and lack of marketability discounts because “in the final analysis, neither [the] decedent nor his family conducted the partnerships in a businesslike manner.” Perhaps relevant to all family partnerships, the Tax Court scrutinized various aspects of partnership operation and determined that the owners failed to treat the partnership as an arm’s length business entity.

The Tax Court in Estate of Thompson reviewed the distribution history of the partnership and focused on the fact that the partnership made distributions to partners on an as-needed basis, rather than on an independent basis. The court found an implied agreement to distribute sufficient cash to meet the decedent’s needs. The court also noted that the partnership was not operated in a formal businesslike context. Family members used distributions and partnership assets without proper authorization or documentation.

The Thompson case also emphasized the importance of adhering to the partnership agreement and maintaining proper corporate records, such as annual minutes of the shareholder and director meetings for a corporate general partner. It is very important to respect the separate accounts of the partnership and corporate general partnership and to implement a distribution schedule that is not tied to the particular needs of individual owners. It is also important to avoid the payment of any personal expenses from partnership or corporate accounts.

The case of Estate of Strangi (which is currently on appeal) is perhaps more troubling, because in this case, the Tax Court broke new ground. In the opinion of many practitioners, Strangi misinterpreted prior case law, possibly to the detriment of very legitimate family businesses. In Strangi, the Tax Court held that the decedent retained sufficient control over the partnership to cause all of the partnership property to be included back in his estate. As a result, the estate was denied discounts for lack of marketability or minority interest. The Tax Court reasoned that by retaining an interest as a limited partner and as a (minority) owner of the general partner, the decedent had the right, exercisable with other members of his family, to cause the partnership to liquidate. Therefore, the decedent had the right to control the timing of the beneficial enjoyment of the transferred assets. The courts’ analysis is in conflict with earlier Tax Court opinions and may be reversed on appeal. It is possible that the Tax Court simply felt that the Strangipartnership was abusive, because it was created close in time to the decedent’s death, involved the transfer of some of the decedent’s personal assets, and appeared not to have a meaningful business purpose. Again, however, the Strangi case emphasizes the importance of maintaining the business integrity of the partnership structure – even where there is an actual operating business.

A full analysis of these cases is beyond the scope of this newsletter. However, we recommend that all of our clients with closely-held business closely review the mechanics of their family business operations to help ensure that they do not run afoul of these cases. If you would like to schedule an appointment to discuss this matter further, please feel free to contact us.