Family Limited Partnerships

A Family Limited Partnership (FLP) is one of the most powerful estate planning tools for transferring wealth to the next generation while maintaining control and obtaining significant valuation discounts. When properly structured, FLPs can substantially reduce gift and estate taxes while keeping family assets under centralized management.

What is a Family Limited Partnership?

An FLP is a limited partnership owned entirely by family members, typically used to hold investments, real estate, or operating businesses. The partnership structure creates two classes of ownership:

General Partner (GP)

• Typically holds 1-2% of the partnership interest
• Retains full management control over partnership operations
• Makes all investment, distribution, and operational decisions
• Has unlimited liability for partnership debts
• Often an LLC owned by the senior generation (to limit personal liability)

Limited Partners (LP)

• Hold the remaining 98-99% of partnership interests
• No management rights or control over operations
• Liability limited to capital contributions
• Receive distributions only when GP declares them
• Cannot force distributions or liquidation

How FLPs Work for Estate Planning

The basic strategy involves the following steps:

Step 1: Formation and Funding

1. Parents create the FLP (or family LLC with similar structure)
2. Parents contribute assets (investments, real estate, business interests)
3. Parents receive 1-2% general partner interest and 98-99% limited partner interests

Step 2: Gifting Limited Partner Interests

1. Parents gift limited partner interests to children/grandchildren
2. Gifts qualify for annual gift tax exclusion ($19,000 per recipient in 2025)
3. Larger gifts use lifetime gift tax exemption ($15.00 million in 2026)
4. Valuation discounts apply to reduce the taxable value of transferred LP interests

Step 3: Ongoing Management

1. General partner (parents or their LLC) retains full control
2. Limited partners have no say in distributions or management
3. Income and losses pass through to partners based on ownership percentage
4. GP can make distributions at their discretion

Valuation Discounts for LP Interests

The transferred limited partner interests qualify for significant valuation discounts because they lack control and marketability.

Minority (Lack of Control) Discount

Limited partners have no ability to:

• Force distributions of income or capital
• Control investment decisions
• Participate in management
• Liquidate the partnership

Typical discount range: 15-30%

Lack of Marketability Discount

Limited partner interests cannot be easily sold because:

• No public market exists for LP interests
• Partnership agreement typically restricts transfers
• Finding a buyer takes time and expense
• Buyers require additional discounts for illiquidity

Typical discount range: 20-35%

Combined Discount Effect

When both discounts are applied (stacked), total discounts of 30-50% are common:

Example: Parent gifts 20% LP interest

• Proportionate share of FLP assets: $2,000,000
• After 25% minority discount: $1,500,000
• After 25% marketability discount: $1,125,000
• Effective discount: 43.75%
• Gift tax value: $1,125,000 (instead of $2,000,000)

Legitimate Business Purpose Requirement

The IRS closely scrutinizes FLPs and may disallow discounts or include assets in the estate if the partnership lacks a legitimate non-tax business purpose.

Acceptable Business Purposes

• Centralized management of family investments or real estate
• Asset protection from creditors
• Educating younger generations about wealth management
• Preventing fragmentation of family assets
• Facilitating an active family business operation
• Providing professional management of diverse assets

Red Flags for IRS Challenge

• Deathbed transfers: Creating FLP shortly before death
• Retained control: Transferor continuing to use assets as their own
• Commingling funds: Using partnership funds for personal expenses
• No distributions: Never making distributions to limited partners
• Passive assets only: Holding only marketable securities with no active management
• Pro-rata distributions: Distributions always equal to ownership percentage (suggests sham)

Requirements for a Valid FLP

To withstand IRS scrutiny, the FLP must be properly structured and operated:

Formation Requirements

1. Legitimate business purpose documented in partnership agreement
2. Arm's-length terms that unrelated parties would accept
3. Proper funding of partnership before any gifting
4. Adequate capitalization of the general partner entity

Operational Requirements

1. Maintain separate accounts for partnership and personal funds
2. Hold regular partnership meetings and document decisions
3. File required tax returns (Form 1065)
4. Make distributions to partners (even if modest)
5. Follow formalities in partnership agreement
6. Retain records of all transactions

Section 2036 Issues

Under IRC Section 2036, the IRS can include transferred assets in the decedent's estate if they retained:

• Right to income from transferred property
• Right to control who receives income or property
• Implied agreement to continue using property

To avoid Section 2036 inclusion:

• Do not retain excess assets needed for living expenses
• Do not continue using partnership assets personally
• Make legitimate distributions to all partners

Gifting LP Interests Using Annual Exclusion

The annual gift tax exclusion ($19,000 per recipient in 2025) can shelter many LP interest gifts:

Example: Annual Exclusion Gifting Strategy

Facts: Parents own FLP worth $5 million; 3 children; 35% combined discount

Over 10 years, parents could transfer $1.75 million in pre-discount value ($1.14 million after discount) per child using only annual exclusions.

Present Interest Requirement

To qualify for the annual exclusion, the gift must be a present interest (immediate right to use, possess, or enjoy). LP interests may fail this test because:

• Limited partners cannot demand distributions
• GP controls all distribution decisions

Solutions:

• Include Crummey withdrawal powers in trust receiving LP interests
• Make gifts directly to individuals (not trusts)
• Ensure partnership agreement provides some minimum distribution rights

Family LLCs as an Alternative

Family Limited Liability Companies (LLCs) are increasingly used as alternatives to FLPs, offering:

Advantages of LLCs

• Simpler formation and administration
• More flexibility in structuring management and distributions
• No general partner liability (all members have limited liability)
• Fewer formalities required
• Single filing in most states

Similar Benefits

• Same valuation discounts available
• Similar asset protection features
• Flexibility in allocating income and losses
• Centralized management possible

Structure Options

• Manager-managed LLC: Manager (parents) control; members (children) are passive
• Member-managed LLC: All members participate in management

IRS Scrutiny and Case Law

The IRS actively challenges FLPs that appear designed solely for tax avoidance. Key cases to know:

Cases Where IRS Prevailed

• Estate of Strangi: FLP created on deathbed; no business purpose
• Estate of Bongard: Assets used personally after transfer
• Estate of Powell: Decedent continued to control and use assets

Cases Where Taxpayer Prevailed

• Estate of Church: Legitimate management and asset protection purposes
• Knight v. Commissioner: Reasonable discounts with proper structure

Key Takeaways from Litigation

1. Document business purposes at formation
2. Transfer well before death or disability
3. Maintain strict operational formalities
4. Do not use partnership assets personally
5. Make actual distributions to partners
6. Keep adequate assets outside the FLP for living expenses

2025-2026 Planning Considerations

Current Exemption Levels

The federal estate and gift tax exemption is $15.00 million per person in 2026, providing substantial transfer opportunities. Combined with valuation discounts, FLPs can shelter significantly more than the exemption amount in underlying asset value.

Potential Legislative Changes

Congress has periodically considered eliminating or limiting valuation discounts for family-controlled entities. While proposed Section 2704 regulations were withdrawn, future legislation could:

• Disallow discounts for "passive" FLPs holding marketable securities
• Require minimum thresholds for legitimate business activity
• Limit combined discounts to certain percentages