Keeping a family business alive can be plenty hard.

Keeping it in the family can be even harder.

It can be done, assuming both generations really want it to be, but it requires sophisticated planning and a good understanding of the law--at least by the owners' advisers.

There are strategies that will work and strategies that will not, and a recent case in U.S. Tax Court here illustrates what happens when one doesn't work.

The owners of several funeral homes in Minnesota were anxious to pass the business along to their sons. The business had been in the family since 1906 and unless taxes forced its sale, this would be the third generation to operate it.

The owners had two sons and later a grandson, all of whom were licensed funeral directors and worked in the business.

To reduce potential estate taxes, the owners were advised by their lawyer to begin making gifts of stock in the business to their sons and later the grandson.

Under tax law, anyone can make a tax-free gift to anyone else of up to $10,000 every year, a provision often referred to as the "annual exclusion" from gift tax. So the owners began making gifts of $10,000 blocks of stock.

Now, the owners were anxious to move as much as possible out of their estates, so they also began making gifts of $10,000 blocks to their daughters-in-law and later their granddaughter-in-law. But they were also concerned that if one of their offspring died, or if there were a divorce, the stock could end up in the hands of an outsider.

So they arranged for the women to make immediate gifts of their $10,000 blocks to their husbands.

Each year, the lawyer would prepare certificates to transfer the stock to the sons and daughters-in-law, and at the same time would prepare certificates for the shares to be transferred from the wives to the husbands. The lawyer would deliver all the certificates to the father, who as president of the company endorsed them, including shares to be delivered to the husbands after their wives.

This procedure was continued by the mother after the father's death in 1990 and came to include the grandson and his wife.

At the mother's death in 1995, the Internal Revenue Service challenged 27 transfers she had made to the women as indirect transfers to the men and thus ineligible for the $10,000 annual exclusion, the allowable amount having been used up by the direct transfers.

The tab, factoring in some administrative and valuation costs: $129,866.

Earlier this month, the IRS won.

"Viewed as a whole, the evidence shows the daughters-in-law were merely intermediate recipients, and that [the mother] intended to transfer the stock to her lineal descendants who were committed to continuing the operation of the funeral home business."

The court didn't dispute that the gifts correctly followed the form of tax-free gifts, but concluded that in this case the form did not reflect reality.

"In general, we will respect the form of a transaction. We will not apply the substance-over-form principles unless the circumstances so warrant," the court said, but it noted that "courts have applied the substance-over-form principles in gift tax cases to determine the real donee and value of transferred property."

Estate lawyers and other experts here cautioned that the lesson is not merely, Don't be so obvious.

Giving the stock to the daughters-in-law and having them hold on to it for a while might appear to be an easy solution to speeding up the transfer to the next generation without incurring taxes. But that has perils of its own--as the funeral home owners and their attorney anticipated. An untimely death or a divorce could result in a daughter-in-law remarrying, perhaps having children with her new husband, and ultimately dispersing the shares to who knows how many outsiders.

"I almost never see people giving business interests like that to in-laws because of all the things that can go wrong," said Frederick J. Tansill, an estate lawyer with offices in McLean.

Instead, Tansill said, there are ways to "leverage" the $10,000 annual gift that provide almost as much transfer capacity, keep the assets in the hands of lineal descendants, and don't run the risks of an indirect transfer.

One strategy, he said, is to put the business into a family limited partnership. The parents can hold the general partnership interest and over time transfer the limited partnership interests to the heirs.

Tansill said courts have held that because of the restrictions involved in family limited partnership interests--they don't control the company and can't be sold or redeemed for cash--they are entitled to "very substantial discounts off the value of underlying asset" when they are valued as gifts.

These discounts range as high as 55 percent, he said.

Thus, a gift of an interest worth, say, $15,000 when considered as a portion of the underlying business might be valued at $10,000 or less for gift tax purposes and thus would qualify for the annual exclusion.

Many businesses are corporations, of course, and shareholders often have more rights than limited partners, so shares of stock would not get as much of a discount. However, it is often possible with a family business to put the stock into a limited partnership. "You don't necessarily have to convert the [business] entity" to a partnership, Tansill said.

The drawback to the limited-partnership route is that the owners have to get two appraisals, one of the entire business and one of the interest given away the first year. This can be a costly process, and the gift appraisals have to be updated, though that is generally less of an undertaking.

Another approach is to use the parent's entire lifetime gift and estate tax credit to give away $675,000 worth of the business--twice that for two parents--all at once. The downside is that any value remaining in the parent's estate is fully taxed at death, but that may be worth it because the maneuver removes any subsequent appreciation on the gift from the parent's estate and moves it into the heirs' hands.

This strategy appeals to very wealthy people for whom the credit is not significant. It also can benefit those who foresee great appreciation in their assets.

Typical transfers would be "investment property, pre-IPO tech stock, or stock in a company that you think might be acquired at a big premium--anything you think is going to jump up in value a lot. All the future run-up is in hands of the kids," Tansill said.

Tansill also noted that if enough of the business's value has been transferred to the children, what remains in the estate of the last surviving parent might qualify for a tax discount because it would be a minority interest.

Life insurance on the parents, placed in a trust to remove it from their estate, can help pay the remaining taxes.

When using the $10,000 annual exclusion, it's a good idea to file a gift tax return, even though no tax is owed, several attorneys said. Filing the return starts the clock ticking on the IRS's right to challenge the gift, so that after three years (or six in the case of a substantial understatement of tax) the IRS can't revisit the gift when the estate tax return is filed.

If this seems complicated and expensive, it is, and it illustrates why small-business owners hate the estate tax so much.

It favors business owners and others who can afford highly paid professionals, and leads them through all sorts of twists and turns that would be unnecessary were it not for the tax.

And, as the funeral home heirs found, if you don't get it right, you can get whacked anyway.