Family ties
A recent court ruling lays down new guidelines for transferring a business to your kids.

NEW YORK (FORTUNE Small Business Magazine) - You might not have heard of Albert Strangi, but your accountant probably has.

Strangi was a savvy Texas businessman who built up a small fortune in manufacturing. Late in life, just two months before his death from cancer in 1994, he put most of his assets into a family limited partnership, an arrangement that offers tax advantages for entrepreneurs and the wealthy.

The IRS looks warily on such "deathbed transfers," which it considers attempts to avoid estate taxes. The IRS sued Strangi's estate, and this past July, after a seven-year court battle, it won a significant ruling. Strangi's family limited partnership, the appeals court held, wasn't valid. His heirs were slapped with a $2.6 million bill.

The good news is that the Strangi ruling set out clear guidelines about how business owners can use family limited partnerships (FLPs, or "flips") and still avoid problems with the IRS. To understand how, it helps to first know the way they work. Think of the partnership as something like a virtual bank vault. A parent transfers assets, such as real estate, securities, or a family business, into a partnership formed with the children.

Once those assets are in the partnership, they are less liquid and harder to sell, and thus given a lower value. A typical business might be discounted 15% to 40%. After the older family member dies, the FLP is taxed as part of his or her estate, but the amount due is lower (same rate, applied to assets that are worth less). After that the younger generation can dismantle the partnership and distribute its assets.

Because the aging U.S. population is looking for smart ways to hand down its wealth, family limited partnerships have grown in popularity over the past decade. The IRS doesn't track FLPs separately from other types of partnerships, but a spokesman there says that, anecdotally, they're on the rise.

Even recent changes in the federal estate tax (the amount of assets you can pass to heirs tax-free was increased from $1.5 million to $2 million for 2006) haven't dimmed enthusiasm for FLPs. But they trigger suspicion at the IRS--even when they're not set up in the last weeks of a business owner's life.

It all came to a head in the Strangi case.

In its decision last July, the U.S. Fifth Circuit Court ruled that Albert Strangi made a number of mistakes in creating and administering his partnership. Specifically, the court held, he put virtually all his assets into the partnership (including his home, which he continued to live in rent-free). The other members of the partnership made only minimal contributions. And Strangi took distributions from it whenever he needed cash, often to cover personal expenses.

"Essentially, the IRS said that the Strangi family was not entitled to any [asset] discounts because the partnership itself was invalid," says John Olivieri, a trust and estates attorney at Dewey Ballantine, a law firm in New York City.

To avoid a similar fate, Olivieri says, entrepreneurs who are considering a family limited partnership should keep a few things in mind:

  • First, you must have a legitimate business reason -- besides avoiding inheritance taxes -- for setting up the partnership. One such reason can be to transfer a business, over time, to the younger members of the family. But to convince a skeptical auditor, you need to back that up on paper.

"The partnership shouldn't just sit there and do nothing," says William Snyder, a partner at the Fort Lauderdale law firm of Snyder & Snyder. "If one of the purposes of the FLP is to educate a younger family member, you must have meetings with the younger generations and document them."

  • Second, says Olivieri, all members of the partnership should make contributions and take distributions according to a set schedule. "Don't allow partners to use partnership funds to pay for personal expenses, and do not time partnership distributions with personal needs for cash," he says. "Hypothetically, that could be a situation in which all of a sudden a parent gets sick, and every time there's a doctor's bill there's a distribution. Or your daughter is getting married and you need to pay for the wedding, so everybody gets a distribution because you have this expense. It doesn't look right."
  • Third, no partner should contribute substantially all of his or her worldly wealth. "The partners all need to keep enough assets to live on, so that they can survive financially even if they never receive a distribution," Olivieri says. "Those issues were big problems for Strangi."
  • Finally, and most important, expect an audit. "You absolutely need to go into a family limited partnership assuming that it will be scrutinized by the IRS," says attorney Mark Williamson of Atlanta's Alston & Bird. "They're going to look at whether the partnership is run in a businesslike way, whether there are records, and, in particular, whether the partnership is really respected and not just treated as a personal checkbook for the taxpayer."

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.