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.