George Westerman (a pseudonym) is the second generation owner of a thriving waste management firm. His company owns a large fleet of trucks, which provides collection service to residential and commercial customers in a four-county area in the upper Midwest. A separate Westerman-owned entity owns a landfill with at least 10 years of capacity remaining.

Westerman, who is 77 years old, almost single-handedly managed the company until seven years ago when health problems forced him to surrender control to two of his children. Among other things, his children improved accounting and billing practices and upped the percentage of winning bids on competitive contracts.

A few years ago, George Jr. introduced his father to an estate planning expert who recommended creating a family limited partnership. The device is designed to limit death taxes by taking assets that would otherwise be included in an estate and transferring them to a partnership. Another benefit of this plan is the protection of assets. Creditors may need a court order to seize money held by family limited partnerships.

Typically, parents shift ownership of a family business, an investment portfolio, or real estate interests to a partnership formed with their children. The partnership shares are divided among the parents and the children in whatever proportion the parents decide.

Westerman liked the concept, but he did not wish to fully relinquish control. He wanted considerable say in investment choices and veto power over certain management decisions. The estate planner, together with the company's attorney, created a partnership where Westerman was designated as general partner. His children became limited partners.

The arrangement looked sound and efficient until this year when a U.S. Tax Court judge invalidated a family limited partnership created by a now-deceased businessman. As a result, the heirs are obliged to pay estate taxes totaling about $2 million.

The case involved a Texas businessman, Albert Strangi, who, as the judge saw it, had too much influence over the partnership. For one thing, Strangi could decide how much income each partner received. For another, he did not sufficiently relinquish control over the assets, including his place of residence. He continued to live there but paid no rent. The judge termed the partnership a mere “recycling” of assets and not a bona fide business enterprise. Strangi's estate has appealed the ruling to the U.S. Court of Appeals for the Fifth Circuit.

Alarmed by the decision, estate planners and lawyers are notifying clients and furiously re-examining the partnerships they have created and making necessary changes. In particular, partnerships are being restructured to reduce or eliminate client control over assets, for example, by naming an independent third party or child as general partner. The trade-off: sacrificing control over assets for more favorable treatment by the Internal Revenue Service (IRS). Also, these partnerships are being stripped of personal assets.

Family limited partnerships are not a tax-haven, according to Bill Conlon, an IRS official. If individuals are “merely using partnerships to reduce taxes, they are not going to be effective,” he told The Wall Street Journal.

Westerman met with his tax lawyer and reluctantly ended up scrapping the partnership and substituting a family limited liability corporation where he has considerably less control.