A Tax Deal Too Good to Be True?

Rules for family partnerships may get stricter

For years, the Internal Revenue Service has brought lawsuits to invalidate the generous tax breaks claimed by family limited partnerships -- popular vehicles often used to pass wealth to younger generations. And for years, the IRS has had little success. But in May, the tax man's luck changed.

That's when a U.S. tax court rocked the quiet world of estate planners by declaring tax breaks off-limits to a Texas partnership. The court did so on the grounds that its donor, Albert Strangi, had retained too much control over key decisions, such as the distribution of money among partners. "For a lot of people who set these up, maintaining control is very important," says Joanne Johnson, managing director at JPMorgan Private Bank in New York. "But now, they may have to compromise on that control."

Typically with these arrangements, the donor, say, a father, gives at least $1 million of assets, such as stocks, real estate, or stakes in a family business, to a partnership. Generally, he allocates 99% of the shares to his kids, while keeping 1% for himself. Despite his small ownership stake, until now the father has been able to retain decision-making authority by naming himself or an entity he controls general partner. The children, in contrast, are usually designated limited partners with no voice.

The benefit of all this is that instead of paying gift taxes on the full value of the shares he gives his kids, the father pays tax on a far smaller amount. Why? Because the kids' shares are often discounted by 20% to 40%, in part to reflect that they can't be sold as easily as, say, stock in General Motors (GM ) or IBM (IBM ) says Dane Dudley, partner at Day, Berry & Howard in Hartford, Conn.

INVALIDATING THE DISCOUNT. The Strangi case created an uproar in part because the court invalidated the discount. As a result, the court found the Strangis liable for taxes on the full $11 million value of their partnership's assets, instead of on the nearly $6.6 million they had claimed. The court reasoned that because Albert Strangi, who died in 1994, retained control in conjunction with family members over the partnership's decisions, he hadn't really given anything away. So everything was brought back into his estate.

The ruling may be reversed or toned down. The Strangis' lawyer, Norm Lofgren, a partner at Looper, Reed & McGraw in Dallas, says the family is weighing an appeal. Now, estate planners are advising donors to reduce -- or even relinquish -- control over partnerships they've funded. "This isn't the death knell of family limited partnerships," says Don Weigandt, managing director at JPMorgan Private Bank in Los Angeles. "But it's going to make planning them more difficult."

If you have a family partnership or are considering establishing one, you can lessen the risk of an IRS challenge. Make sure you're running the partnership according to strict rules designed to prevent conflicts of interest. That means maintaining a separate bank account for the partnership, paying each partner in proportion to his ownership, and declaring distributions when the underlying assets perform well -- not, for example, when the donor needs to pay a bill.

It's also important to examine how much control the donor has over a partnership. If a parent is the sole general partner, it may be prudent to turn over control to an independent third party, such as a bank, accountant, or lawyer, says Johnson. Although giving up control isn't always desirable, it's better than paying more tax than you have to.

By Anne Tergesen

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