Why Families With Real Estate and Marketable Securities Keep Coming Back to the FLP
The family limited partnership has been around for decades, and it has survived repeated challenges from the IRS, changes in the tax law, and waves of bad press about abusive arrangements. It survives because it solves a real problem. A family that owns a portfolio of rental properties, a block of marketable securities, or an interest in an operating business often wants to do two things at once: keep the assets under centralized family management, and transfer some of the value to the next generation at a reduced gift and estate tax cost. The FLP is one of the few structures that can accomplish both, and when it is run properly, it remains one of the most effective tools in the estate tax reduction toolkit.
The structure itself is straightforward. A limited partnership is formed under state law, with a general partner who manages the entity and limited partners who hold economic interests but do not participate in management. The parents typically serve as the general partner, or as the managing member of a corporate general partner, and they contribute the family’s assets to the partnership in exchange for general and limited partnership interests. They then gift limited partnership interests to their children or to trusts for their benefit over time, using their annual exclusion gifts and their lifetime exemption.
The tax advantage comes from two sources. The first is the availability of valuation discounts. A limited partnership interest is typically worth less than the underlying assets it represents, because the limited partner has no control over management and no ability to force a sale or a distribution. Those restrictions justify a discount for lack of control and a discount for lack of marketability, which means the gifted interests can be valued at less than their proportionate share of the partnership’s assets. That allows the parents to transfer more value with less use of their exemption, which is the core of the family limited partnership tax benefits story.
The second source is the removal of future appreciation from the estate. Once the limited partnership interests are gifted, the future growth in their value belongs to the children or the trusts, not to the parents. If the partnership’s assets appreciate over time, that appreciation is outside the parents’ taxable estate, which reduces the estate tax exposure. The combination of the discount at the time of the gift and the removal of future appreciation can produce a significant reduction in estate tax, especially for families with large estates and long time horizons.
Setting Up the Partnership Correctly and Avoiding the IRS Playbook
The IRS has challenged family limited partnerships for years, and it has won many of those challenges. The cases that the IRS wins tend to share common features: the partnership was formed late in life, the assets were transferred without a legitimate business purpose, the formalities were ignored, and the parents treated the partnership assets as if they still owned them personally. A family that wants the FLP to hold up should study those cases and do the opposite.
The first requirement is a legitimate and substantial non-tax purpose. The partnership should be formed for a reason that makes sense independent of the tax benefits, such as centralized management of family assets, protection from creditors, or the orderly transfer of wealth to the next generation. A partnership that is formed solely to obtain discounts is vulnerable, because the IRS can argue that the arrangement lacks economic substance. A partnership that is formed to manage a real portfolio, with real governance and real decision-making, is much more likely to survive scrutiny.
The second requirement is proper formation and funding. The partnership agreement should be drafted by an attorney who understands the tax rules, and it should specify the capital contributions, the allocation of profits and losses, the distribution policy, and the management structure. The assets should be transferred to the partnership with proper documentation, and the partnership should have its own bank account, its own books, and its own tax identification number. The parents should not use the partnership account as a personal checking account, and they should not transfer personal expenses to the partnership. Those details may seem minor, but they are exactly the kind of evidence the IRS uses to argue that the partnership is not a real entity.
The third requirement is ongoing operation. The partnership should hold meetings, keep minutes, and make decisions as a real business would. The general partner should have the authority to manage the assets, and the limited partners should receive distributions according to the partnership agreement. The partnership should file its own tax return, and the parents should report their share of the income on their personal returns. The family should keep records of all of those activities, because the records are the evidence that the partnership is genuine. A partnership that operates properly is much more likely to withstand a challenge than one that exists only on paper. FLP estate planning is as much about operation as it is about formation.
Valuation, Discounts, and the Art of Getting the Number Right
The valuation of limited partnership interests is the most technical and the most contested part of the FLP process. The IRS and the taxpayer often disagree about the size of the discounts, and the disagreement can lead to litigation that lasts for years. The family should work with a qualified appraiser who has experience valuing partnership interests, and the appraisal should be supported by a detailed analysis of the partnership’s assets, the restrictions in the partnership agreement, and the market for similar interests.
The discount for lack of control reflects the fact that a limited partner cannot direct the partnership’s management, cannot force a sale of the partnership’s assets, and cannot compel a distribution. The discount for lack of marketability reflects the fact that there is no public market for limited partnership interests, and a buyer would require a significant discount to compensate for the illiquidity. The two discounts are often combined, and the total discount can range from twenty percent to forty percent or more, depending on the facts. The discount should be supported by market data and by an analysis of comparable transactions, and it should be reasonable in light of the partnership’s specific circumstances.
The family should be careful not to overreach. A discount that is too aggressive invites an IRS challenge, and the cost of litigating the challenge can outweigh the tax savings. A discount that is too conservative leaves money on the table, but it is less likely to attract scrutiny. The right balance depends on the facts of the case and on the family’s tolerance for risk. A qualified appraiser and an experienced tax attorney can help the family find that balance. Family wealth transfer should be built on defensible valuations, because a valuation that does not hold up can unravel the entire plan.
Managing the Partnership Over Time and Avoiding the Pitfalls
The FLP is not a set-and-forget structure. The partnership must be managed over time, and the family must be prepared for the ongoing administrative work. That means maintaining the books, filing the tax returns, holding meetings, and documenting decisions. It also means making distributions according to the partnership agreement, which may require the general partner to balance the needs of the limited partners against the needs of the partnership. A family that is not prepared for that work may find that the partnership becomes a source of friction rather than a tool for harmony.
The family should also be careful about the use of partnership assets. The general partner has a fiduciary duty to the limited partners, and that duty requires the general partner to act in the best interest of the partnership. A general partner who uses partnership assets for personal purposes, or who favors one limited partner over another, may be breaching that duty. The family should have a clear understanding of the general partner’s responsibilities, and the general partner should document the decisions that are made.
The family should also consider what happens when the general partner dies or becomes incapacitated. The partnership agreement should specify who will succeed the general partner, and it should provide for a smooth transition of management. A partnership that does not have a succession plan may face disruption or litigation when the general partner dies, which can undermine the family’s goals. The succession plan should be coordinated with the family’s estate plan, because the two are closely related.
The family should also consider the interaction between the FLP and the rest of the estate plan. The partnership interests may be held in trusts, which can provide additional protection and additional tax benefits. The partnership may hold life insurance, which can provide liquidity to pay estate taxes. The partnership may be sold or dissolved, which can trigger tax consequences that need to be planned for. The FLP should be integrated with the family’s overall strategy, not treated as a standalone structure.
Common Mistakes and the Long View
The most common mistake is forming the partnership too late. The IRS is much more likely to challenge a partnership that is formed when the parents are elderly or in poor health, because the timing suggests that the partnership was formed for tax reasons rather than business reasons. The family should form the partnership well before it is needed, when the parents are healthy and the business purpose is clear.
Another common mistake is ignoring the formalities. A partnership that does not hold meetings, keep minutes, or maintain separate books is vulnerable to a challenge. The family should treat the partnership as a real business, with real governance and real records. That means doing the administrative work, even when it seems tedious, because the records are what will protect the family if the IRS comes calling.
A third mistake is failing to coordinate with the estate plan. The FLP is one piece of a larger plan, and it should be coordinated with the will, the trusts, the life insurance, and the charitable strategies. A partnership that is created in isolation may create conflicts or inefficiencies that reduce its value. The family should work with a team of advisors who understand the full picture, rather than treating each structure as a separate project.
Ultimately, the family limited partnership is a powerful tool for families that are willing to do the work. It can reduce estate taxes, protect assets from creditors, and provide a framework for managing family wealth across generations. But it requires careful planning, disciplined operation, and ongoing attention. Families that approach it with those qualities tend to find that the benefits are substantial. Families that treat it as a shortcut often find that the costs, both in taxes and in family friction, outweigh the benefits. The difference is in the execution, and the execution is what makes the FLP work.