Following on its decision last year on the popular estate planning tool of family limited partnerships, the Fifth Circuit recently issued this decision in the case of deceased Texas millionaire Albert Strangi and, in so doing, provided a guide for what not to do in utilizing a family LP. Here is a NY Times article on the decision.
Family LP’s allow parents to transfer assets to their children at a lower tax rate than is assessed on estates and gifts. Under the typical family LP, the parents retain a few shares of ownership while their children hold most of the shares. Moreover, family LP’s are often set up in an effort to shield assets from the parent’s creditors, so decisions on the vehicle are closely followed by lawyers who specialize in either estate planning or creditors rights.
The Strangi case began when Mr. Strangi died in 1994. The Internal Revenue Service claimed that his children owed taxes on all $11 million in the family LP, while the family claimed that it owed taxes on only $6.6 million. The tax court at first found in favor of Mr. Strangi’s estate, but then the Fifth Circuit in an earlier ruling remanded the case to the tax court directing the tax court either to make findings of fact and conclusions of law explaining why it did not allow the I.R.S. to use a section 2036a of the Internal Revenue Code or retry the case. That particular section of the tax code states that assets that a decedent owns at the time of death are taxable using estate tax rates despite a prior transfer of such assets to a partnership.
Subsequently, the tax court issued a new opinion in 2003 in which it held that against the estate this time because Mr. Strangi continued to use assets contributed to the family LP after it was formed. For example, Mr. Strangi continued to live in his house after it was contributed to the family LP, and the tax court concluded that it could be taxed as an inheritance even though it was part of the family partnership. Indeed, the tax court found that 98 percent of Mr. Strangi’s assets were contributed to the family LP and that the family LP used its assets to pay Mr. Strangi’s debts after his death.
At any rate, in upholding the tax court decision and consistent with its prior ruling, the Fifth Circuit essentially concludes that pigs get fat but hogs get slaughtered when it comes to family LP’s. If the transparent purpose of the family LP is tax avoidance or shielding virtually all of the parents’ assets from creditors while they continue to live off of such assets, then my sense is that courts are going to read the Strangi decision as allowing the courts to disqualify the family LP from providing such a purpose. In regard to the debtor-creditor issues relating to family LP’s, take note of Professor Ribstein’s article Reverse Limited Liability and the Design of Business Associations.