Ruling may be a roadblock for the Rolls Royce of estate planning tools.

There are various ways to flaunt your wealth; some are more subtle than others. You can pull up to the curb in a Rolls Royce, or you can casually mention "my little island in the Aegean," or you can wear a diamond ring so large it makes everyone assume that Kobe Bryant has been cheating on you.

But for the past ten years, the real sign of wealth-the understated way to make sure everyone knew you were one of life's winners' was to let slip that you had set up a family limited partnership, your very own "FLP." Everyone at the country club knew what that meant. An FLP was the Rolls Royce of estate-planning tools, the vehicle that let you cruise down Easy Street in real style. If you had serious money, then an FLP was a must-buy-as essential a part of the wealthy lifestyle as tailored suits, swank accommodations and multiple alimony checks.

The FLP was popular with the rich precisely because it didn't flaunt its wealth. Indeed, the whole appeal of the FLP was that, through a kind of alchemy of tax law, it seemed to make wealth disappear. When the FLP worked as advertised, the assets placed into an FLP would drop in valuation by 35% to 40% or more. No, the assets didn't actually drop in value, just in valuation-as in "lower gift and estate tax valuation." Dodging the gift and estate tax is, quite understandably, the official parlor game of the well-to-do. That is why wealthy individuals spent much of the past ten years loading their FLPs with assets, in the hopes of cruising down the highway of life and, at the end of the road, handing over the keys to the next generation-and denying the government its usual free ride.

Not surprisingly, the Internal Revenue Service (IRS) spent most of the past ten years trying to put the brakes on this popular vehicle, but with a singular lack of success-until recently. Then, in a rather abrupt U-turn, the U.S. Tax Court handed the IRS a string of victories, culminating in a recent decision called Estate of Strangi ("Strangi II"). In Strangi II, the Tax Court held that the value of property transferred to an FLP was includable on death in the transferor's gross estate under Code §2036(a). In simple English, the assets transferred to the FLP were taxed to the decedent at the full fair market value, with no discount.

What makes Strangi II unusual and scary is that the Tax Court allowed the transfers to be disregarded based on not one but two separate grounds: §2036(a)(1) and on 2036(a)(2). The analysis is complicated, but the stakes are huge, so let us explain the Strangi II case briefly and then in greater detail.

The brief explanation is this: The IRS, after failing for almost ten years to put a dent in FLPs, finally started winning cases by asserting Code §2036(a). This is a complicated provision, but its intent is simple: If a person makes a nominal transfer of assets, but actually retains use or enjoyment of the assets for the rest of his or her life, the transfer is viewed as occurring at death and the assets are includable in the decedent's estate.

Code §2036(a) is written in the usual incomprehensible tax jargon, but Strangi II can be distilled to two specific and chilling conclusions: 1) Under §2036(a)(1), the conventional wisdom is that an FLP can work, and the taxpayers are to blame if they don't operate it in the proper fashion; 2) The far more disturbing message is that, under the Strangi II interpretation of §2036(a)(2), it may be that no FLP works as estate planners had hoped. In brief, the first message is: "Buy this vehicle, but drive safely." The second message is: "Don't buy this vehicle at all."

The more detailed analysis of Strangi II starts with an examination of its rather unusual facts.

Albert Strangi, the decedent, had executed a power of attorney (POA), giving his son-in-law broad powers to purchase, manage, sell, lease or mortgage any real or personal property Strangi owned or might acquire. Five years later, Strangi had surgery to remove a cancerous mass from his neck, and was diagnosed with various brain disorders.

Pursuant to the POA, his son-in-law formed an FLP with a corporate general partner. Under the POA, approximately $10 million in assets was transferred to the FLP, including interests in real estate, securities and insurance policies. All contributed property was properly reflected in Strangi's partnership capital account.

Strangi owned 47% of the corporate general partner, with the remaining 53% owned by his four children. Later, a 1% interest in the corporate general partner was given to a tax-exempt 501(c)(3) foundation. Unlike some earlier cases, the Strangi FLP obligated the managing general partner to use good-faith efforts to manage the partnership in a prudent, business-like manner, and to act in the best interests of the partnership.

Strangi died shortly after the formation of the FLP, and the operation of the FLP by his children was more than a little suspect. The Tax Court noted that the FLP: 1) Paid for back surgery for the decedent's housekeeper, 2) Paid more than $100,000 to cover funeral expenses, estate expenses, debts and bequests, 3) Distributed $3,187,800 directed toward the decedent's estate and inheritance taxes.

Under §2036(a)(1), a transfer of assets is disregarded if the decedent retains during his lifetime "the possession or enjoyment of, or the right to the income from, the property." The Tax Court held that there was an implied agreement for Strangi to continue to enjoy the economic benefit of the assets. First, Strangi contributed approximately 98% of his wealth, including his residence, to the FLP, and essentially had no retained assets on which to live. Second, the Tax Court emphasized that Strangi was allowed to occupy his personal residence after it was transferred to the FLP, and while there were book entries to show the payment of rent, no rental payment was actually paid. Ultimately, the court concluded, "The crucial characteristic is that virtually nothing beyond formal title changed in decedent's relationship to his assets." Decedent's children did not raise objections when large sums were advanced for expenditures of decedent or his estate, thus implying an "understanding."

Having found that the transfer could be disregarded under §2036(a)(1), the Tax Court went on to address §2036(a)(2). This provision applies to a transfer if the decedent retained during life "the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom."

The estate argued that Strangi had no legal control over the FLP, since he was a minority shareholder in the corporate general partner, and that Strangi, or the corporate general partner, would be subject to state law fiduciary duties as a general partner in the partnership.

However, the Tax Court distinguished U.S. v. Byrum, 408 U.S. 125 (1972), because the fiduciary duties in that case "ran to a significant number of unrelated parties and had their genesis in operating businesses that would lend money to the standard of that being the best interest of the entity." The Tax Court concluded that Byrum does not require a "blind application of its holdings to scenarios where the purported fiduciary duties have no comparable substance."

The Tax Court concluded that Strangi retained the right, in conjunction with others, to designate the persons who would receive the income from the assets transferred into the FLP, and that, therefore, §2036(a)(2) caused the transfers to be disregarded.

The New Road to Success

The IRS' recent attacks on FLPs teach the basic lesson that you not only need to build the vehicle properly, but also to operate it correctly. However, Strangi II raises serious risks beyond that, namely that the vehicle itself may be unsafe at any speed.

In Strangi II, the Tax Court ultimately took the position that an FLP composed solely of family members, coupled with other indications of family cooperation, may permit the IRS to ignore entirely the form, and even the operation, of an FLP. By restricting the Byrum decision and its application to FLPs, the IRS has created great uncertainty and huge economic risk.

So what is a wealthy American family to do? A possible way to avoid §2036(a)(2) is to operate an actual business within the FLP, since the inherent constraints of operating a "real" business, including bank relationships, would create meaningful constraints on the ability to make distributions and thus, at some point, would trigger application of the Byrum case. However, in many FLP planning situations the intent was to avoid risk within the FLP, and therefore, at the very least, this is not a good solution for many people.

In short, the road to paradise just got a whole lot bumpier. The FLP has been a popular vehicle, and with literally billions of dollars parked in FLPs, the stakes are enormous. Whether Strangi II is just an unusually large pothole, or a form of permanent roadblock, remains to be seen.

Joseph B. Darby III is a corporate and tax shareholder at the Boston office of the international law firm of Greenberg Traurig. Natasha Zacharias is a student at Harvard Law School.