Family Limited Partnership (FLP): Valuation Discounts and Multigenerational Wealth Transfer

FLP Structure Basics

FLP is a limited partnership (or limited liability limited partnership) typically formed under state law to hold and manage family assets.

Structure:

– General Partner(s) (GP): typically parents or an LLC owned by parents. GP has management authority and unlimited liability.

– Limited Partners (LP): typically children, grandchildren, or trusts for their benefit. LPs have limited liability but no management role.

– Initial ownership: parents often own most of the partnership (GP + majority LP interests).

– Gifts: parents gift LP interests over time to children, using annual exclusion and lifetime exemption.

Common assets in FLP:

– Marketable securities portfolio

– Real estate (especially income-producing)

– Closely-held business interests

– Cash and short-term investments

What FLP does NOT typically hold:

– Personal residence (would be problematic)

– Personal-use property (cars, art for personal use)

– Active business assets requiring operating decisions

FLP purpose:

Legitimate FLPs serve several purposes:

1. Centralize family wealth management

2. Provide asset protection

3. helps generational wealth transfer with valuation discounts

4. Maintain family voting control over assets

5. Educate next generation in financial management

Without legitimate non-tax purpose: IRS may collapse FLP under §2036 (see below).

Valuation Discounts

FLP power comes from valuation discounts when LP interests are gifted or sold:

Discount types:

1. Minority interest discount (lack of control):

LP interests have no management authority. Buyer of LP interest can’t make business decisions. This lack of control reduces value.

Typical range: 15-30%.

2. Lack of marketability discount:

LP interests in private partnership are not publicly traded. Restrictions on transfer typical. Less marketable than public securities.

Typical range: 20-35%.

3. Combined discount:

Both apply simultaneously. Combined effect: 30-45% discount.

Example:

FLP holds $10M of marketable securities.

Parent owns 1% GP + 99% LP. Gifts 30% LP interest to child.

Underlying value of 30% LP interest: 30% × $10M = $3M.

With 35% combined discount: $3M × (1 – 0.35) = $1.95M.

Reported gift value for tax purposes: $1.95M (uses $1.95M of lifetime exemption).

Effective: $3M of underlying assets transferred for $1.95M of exemption. $1.05M of ‘free’ transfer.

Over multiple gifts and years: family can transfer substantial wealth with discount benefits.

Documentation:

Discounts require qualified appraisal. Cost: $5K-$25K depending on FLP complexity.

Appraisal must use accepted valuation methodologies (income approach, market approach, asset approach).

Lowball appraisals: IRS may challenge. Audit risk increases with aggressive discounts.

Defensible appraisals: properly documented, based on comparable transactions, applied consistently across years.

Recent court trends: IRS has been winning more FLP challenges. Discounts being scrutinized more carefully. Be conservative; document thoroughly.

Annual Exclusion Gifts of FLP Interests

Annual exclusion ($18,000 per donee in 2024, indexed) can fund FLP transfers without using lifetime exemption.

If FLP LP interest is valued at $36,000 (after discount) and parents split gift: covered by annual exclusion.

Multiple beneficiaries multiply the annual transfer capacity:

Parents + 3 children = 6 donee combinations (gift-splitting). Annual transfer: $216,000 of LP interests.

Including 6 grandchildren: 12 donee combinations × $36,000 = $432,000 annual transfer capacity.

Over decades: substantial wealth transferred via annual exclusion without using lifetime exemption.

Present interest requirement:

Annual exclusion requires gift of ‘present interest.’ Direct gifts of LP interests typically qualify as present interest if recipients have immediate right to enjoy the interest (distributions, voting rights to extent applicable, etc.).

Restrictions on LP transfers: typical FLPs have transfer restrictions. Too-restrictive transfers may not qualify as present interest.

Crummey-style mechanics: similar to ILIT, beneficiaries may have temporary right to demand assets, converting future interest to present interest. Complex; consult attorney.

Documentation:

Gift documentation for each LP interest transfer: – Partnership amendment showing new ownership – Appraisal for discount support – Form 709 filing – Records of cumulative gifts per donee Maintain capitalization table: who owns what percentage at what time.

Estate Inclusion Risk Under §2036

IRC §2036(a)(1) includes in gross estate any property where the transferor retained a life estate or enjoyment.

§2036(a)(2): retained power to designate enjoyment.

FLPs are common §2036 targets. IRS argues:

If parent (GP) retains substantial control over partnership assets, life enjoyment is retained.

If parent receives distributions from partnership, that’s life enjoyment.

If parent’s lifestyle depends on partnership assets, retained interest is established.

Court cases:

Estate of Strangi v. Commissioner (5th Cir.): FLP collapsed under §2036; partnership assets included in decedent’s estate.

Estate of Bongard v. Commissioner: similar.

Estate of Liljestrand v. Commissioner: FLP collapsed.

Estate of Gimbel v. Commissioner: §2036 inclusion found.

Pattern: aggressive FLPs with grantor’s continued lifestyle reliance get collapsed.

Defending against §2036:

Establish legitimate non-tax purpose:

– Asset protection from creditors – Centralized management of diverse assets – Continuity of family business – Investment management efficiency – Education of next generation in financial management

Document the non-tax purpose at formation (in partnership agreement, organizational documents).

Operational realities:

– Don’t commingle FLP assets with personal assets – Don’t use FLP assets for personal expenses – Maintain proper books and records – Hold regular partnership meetings – Make formal partnership decisions – Distribute partnership earnings properly – Don’t treat FLP as personal piggy bank

Bona fide sale for adequate consideration safe harbor (§2036(a)):

If grantor retained interest is part of bona fide sale for adequate consideration, §2036 may not apply.

Example: parent contributes $10M of securities to FLP; receives proportional partnership interests. The contribution is bona fide if at FMV.

This is the doctrine that protects properly structured FLPs.

Tax Treatment of FLP Operations

Federal income tax:

FLP is partnership for income tax purposes. Files Form 1065. K-1s issued to partners.

Each partner reports their share of income, gains, losses, deductions on their individual returns.

Pass-through taxation: no entity-level federal income tax.

State income tax:

Depends on state. NY taxes partnerships modestly; CA charges $800 minimum franchise tax; some states have entity-level taxes.

PTE elections: many states allow pass-through entities to pay state tax at entity level (deductible federally as business expense), then partners claim credit on personal returns. Helps with SALT cap.

Capital gains in FLP:

FLP investment income (capital gains, dividends, interest) flows through to partners on K-1.

Long-term capital gain on partnership assets: 0%/15%/20% federal LTCG rates apply at partner level based on partner’s individual bracket.

Special allocations: partnership can make special allocations among partners with substantial economic effect (§704(b)).

Self-employment tax:

General partner’s distributive share of trade or business income subject to SE tax.

Limited partner’s distributive share generally NOT subject to SE tax (limited partner exception).

If FLP holds investment portfolio (not active business): typically no SE tax for any partner.

Gift/Estate tax efficiency:

Discounts compound annually as more LP interests gifted.

Over 20 years of annual gifts: substantial multi-generational transfer.

GP retained: maintains family control; potentially still in estate if treated as retained interest under §2036.

Strategy: gift portion of GP interest too over time, reducing parent’s retained control.

Common FLP Structures

Structure 1: Marketable Securities FLP.

Parents contribute $10M of diversified securities. Form FLP. Parents are GP (1%) + LP (99% initially). Gift LP interests to children/grandchildren over time with discounts.

Easiest structure; standard discounts (25-35%).

Structure 2: Real Estate FLP.

Parents contribute commercial real estate. FLP holds and manages. Gift LP interests over time.

Real estate often supports higher discounts (35-40%) due to indivisibility, management complexity, illiquidity.

Structure 3: Operating Business FLP.

Parents contribute family business interest. FLP holds shares. Gift over time.

Combines business succession with wealth transfer. Discounts apply.

Structure 4: Tiered FLP.

Parent FLP holds operating business; subsidiary FLPs hold real estate. Multiple layers of discounts (compounding).

Aggressive; IRS scrutinizes. Be careful.

Structure 5: FLP + IDGT.

FLP holds assets with discounts. Parents sell FLP interests to IDGT. Combines FLP discount with IDGT tax burn and sale mechanics.

Sophisticated planning for high-net-worth families.

Structure 6: FLP + dynasty trust.

FLP for current wealth management; LP interests gifted to dynasty trust. Multigenerational protection.

GP voting control:

Parents retain GP role for lifetime. After death, GP role can pass to surviving spouse or to children.

Some structures: separate LLC owns GP interest. Family members own LLC; LLC controls partnership.

Family succession: who becomes GP, when, how decided.

Operating an FLP

Proper operation is essential for surviving IRS challenge:

1. Separate bank account. FLP must have its own checking account. Personal funds must NOT be commingled.

2. Formal recordkeeping. Books for FLP separate from personal. Annual financial statements.

3. Regular meetings. Partnership meetings (annual minimum) with documented minutes.

4. Distributions:

Distribute earnings to partners proportional to ownership.

If only parents receive distributions while children are limited partners: looks like retained interest. §2036 risk.

Ideal: regular distributions to all partners.

5. Tax filings:

Annual Form 1065. K-1s to all partners. State filings as required.

6. Compensation:

GP can be compensated for management services (reasonable amount). Receive W-2 or reasonable compensation.

7. Capital contributions:

All capital contributions must be at FMV. Documented.

Don’t transfer assets to FLP at below-market values (would be additional gift; possible §2036 issue).

8. Withdrawal/redemption procedures:

Partnership agreement specifies how partners can withdraw or redeem interests.

Restrictions support marketability discount.

9. Amendments:

Partnership agreement amendments require partner approval per agreement terms.

10. Annual valuation:

Track FLP value annually. Useful for gift planning and audit defense.

Cost of FLP operation:

Initial setup: $10K-$30K legal. Annual operations: $5K-$25K (tax preparation, valuation, legal review).

For substantial FLPs ($10M+): cost is small relative to gift/estate tax savings.

Common FLP Pitfalls

Issues we see:

1. Inadequate non-tax purpose. FLPs purely for tax benefits get collapsed under §2036.

2. Operating like personal account. Parents use FLP assets for personal expenses; commingling.

3. Inflated discounts. Claiming 50%+ discounts that aren’t supportable. IRS reduces; estate tax results.

4. Improper valuations. No appraisal; lowball appraisal; aggressive methodology.

5. Death-bed FLP. Forming FLP shortly before death (1-2 years) — IRS treats as transparently tax-driven.

6. Single-asset FLP without business purpose. Holding only marketable securities with no active management or business activity may be challenged.

7. Capital account discrepancies. Partners’ capital accounts inconsistent with contributions; suggests informal entity treatment.

8. Failure to follow partnership formalities. No meetings, no minutes, no books — invites §2036 challenge.

9. Spousal control retention. Surviving spouse becomes GP without limitations; continues retained interest.

10. Lifestyle dependence on FLP. Parent’s living standard funded entirely by FLP distributions; clear retained life enjoyment.

Mitigation:

– Establish FLP well before death (years, not weeks) – Genuine non-tax purpose documented – Operational discipline – Conservative discounts with strong appraisal – Regular distributions to all partners – Separate finances – Independent counsel for FLP matters

Recent case law: courts have favored conservative FLPs with proper purpose and operation. Aggressive FLPs face increased scrutiny.

Coordinating FLP with Other Vehicles

FLP combines with other estate planning:

FLP + GRAT:

FLP interests with discounts contributed to GRAT. Discount further improves GRAT benefit.

FLP + Dynasty Trust:

LP interests gifted to dynasty trust. Discounts maximize GST exemption use.

FLP + IDGT:

FLP interests sold to IDGT. Combined discount + IDGT mechanics.

FLP + SLAT:

FLP interests gifted to SLAT for spouse + descendants.

FLP + ILIT:

FLP funds life insurance premiums via Crummey gifts to ILIT.

Each combination compounds the planning benefits.

Comprehensive plan for $50M family:

1. Form FLP to hold diversified investment portfolio + real estate.

2. Parents are GP. Initially own 100% (1% GP + 99% LP).

3. Gift LP interests over time to dynasty trust for grandchildren benefit.

4. Apply minority + marketability discounts (25-35%).

5. Use annual exclusion + lifetime exemption efficiently.

6. Combine with SLAT for additional wealth transfer.

7. Maintain proper operations to avoid §2036.

Result: substantial multigenerational wealth transfer with reduced gift/estate tax cost.

Family wealth coordination: FLP can serve as ‘family bank’ — providing financial education, investment learning, governance experience for next generation.