Family Limited Partnerships: Valuation Discounts, Control, and IRS Scrutiny

A family limited partnership (FLP) is an entity that holds family assets, with senior family members typically controlling a small general partner interest and transferring limited partner interests to children or trusts. Because limited interests carry no control and cannot be readily sold, appraisers commonly apply combined valuation discounts in the range of 20% to 40% for lack of control and lack of marketability, reducing the gift and estate tax value of what is transferred. The technique works, but only when the partnership is real: respected, operated, and funded for genuine nontax reasons.

This article explains the mechanics, the discounts, the Section 2036 trap that has undone careless FLPs, and when the structure is simply the wrong tool.

How does a family limited partnership work?

Parents (or a family entity) contribute assets, often marketable securities, real estate, or a family business interest, to a limited partnership or, increasingly, a family LLC taxed the same way. The general partner, often an LLC controlled by the parents, manages the entity and typically holds 1% or less of the economics. Limited partners hold the remaining interests but have no management rights and face transfer restrictions set out in the partnership agreement.

The estate planning happens when limited interests move to the next generation, by gift, by sale, or by sale to a grantor trust. Each transfer is valued not as a slice of the underlying assets but as what a hypothetical buyer would pay for a noncontrolling, illiquid interest in this particular entity. Consolidating assets also brings nontax benefits: centralized management, easier annual gifting of uniform units, some creditor protection through charging-order rules, and a governance forum for the family.

How large are the valuation discounts?

Two discounts are customary. A discount for lack of control reflects that a limited partner cannot force distributions, sales, or liquidation; commonly cited ranges run roughly 15% to 25% or more depending on the assets and the agreement. A discount for lack of marketability reflects that there is no ready market for the interest; commonly cited ranges run roughly 15% to 35%. Appraisal commentary and case law generally place combined discounts around 20% to 40%, with the two applied multiplicatively rather than added (valuation and estate planning literature; figures vary by facts).

Hypothetical example: parents contribute $10,000,000 of diversified securities and rental real estate to an FLP and later gift 40% of the limited interests to trusts for their children. A qualified appraisal supports a 15% lack-of-control discount and a 25% marketability discount, a combined discount of about 36.3% (the discounts compound: 0.85 times 0.75 equals 0.6375). The gifted interests, $4,000,000 of underlying value, are reported at roughly $2,550,000, using about $1,450,000 less of the parents' $15 million lifetime exemptions than an undiscounted gift would. The discount must be supported by a credible appraisal of both the entity and the underlying assets; aggressive numbers invite examination and often end with smaller discounts plus professional fees.

What is the Section 2036 trap?

Section 2036 pulls assets back into a decedent's estate if the decedent transferred them while retaining possession, enjoyment, or the right to income, or the right to control who enjoys them, unless the transfer was a bona fide sale for full consideration. For FLPs, this is the recurring kill shot. When parents put nearly everything they own into the partnership and keep living off the assets as before, courts have included the full undiscounted asset value in the estate, erasing the planning entirely.

The case law pattern is consistent. Estates have lost where partnerships were funded on a deathbed, where the decedent retained implicit agreements to use partnership assets for personal expenses, where distributions tracked personal needs rather than partnership economics, and where no legitimate nontax purpose existed. The Tax Court reached this result again in Estate of Fields v. Commissioner, T.C. Memo. 2024-90, where assets transferred to a partnership weeks before death under a power of attorney were included in the estate and discounts were denied. The winning pattern is the mirror image: real nontax purposes, formation well before any health crisis, parents keeping ample assets outside the entity, formalities observed, distributions pro rata, and no personal use of partnership property.

What does the IRS look for in an audit?

Examiners look for bad facts before they argue valuation theory. The common ones are commingling personal and partnership funds, paying personal expenses from the entity, ignoring the partnership agreement, retroactive or sloppy paperwork, disproportionate distributions to the senior generation, and gifts made immediately at formation with no interval of real operation. Each is avoidable with discipline, which is why an FLP is best understood as an operating commitment, not a one-time document signing.

Valuation itself is the second front. The IRS frequently challenges discount size, and taxpayers with thorough appraisals from credentialed valuation professionals fare far better than those relying on rules of thumb.

When is an FLP the wrong tool?

Several situations argue against the structure. With the federal exemption at $15 million per person ($30 million per couple) and permanent under OBBBA, many families no longer face federal estate tax at all; for them, discounting can be counterproductive, because discounted gifts carry the donor's basis and forgo the step-up in basis at death, trading a tax the family will not owe for a capital gains tax heirs actually will. We cover that calculus in The $15 Million Estate Tax Exemption.

FLPs are also wrong for families unwilling to live with the formalities, for personal-use assets such as a primary residence, and for holders of marketable securities who want maximum simplicity. Setup and maintenance costs are real: legal drafting, appraisals at each transfer, annual partnership tax returns, and state fees. Finally, an FLP is one tool among several; GRATs, sales to grantor trusts, and dynasty trusts often pair with or substitute for it, as described in The Trusts Wealthy Families Actually Use, and multi-generation plans must also handle GST exemption allocation, covered in The Generation-Skipping Transfer Tax.

Key numbers

Frequently asked questions

What is the difference between an FLP and a family LLC?Economically little. Both can hold family assets and support discounted transfers; the LLC offers simpler governance and liability protection for all members, and most of the tax analysis is identical.

Are FLP valuation discounts legal?Yes, when supported by a qualified appraisal and a partnership that is operated as a genuine entity. Courts routinely sustain reasonable discounts and just as routinely deny them where the entity was disregarded in practice.

Can I put my house or personal accounts in an FLP?You should not. Personal-use assets and continued personal reliance on partnership funds are the classic Section 2036 facts that cause full estate inclusion.

Does an FLP protect assets from creditors?It can help. Creditors of a limited partner are generally restricted to a charging order against distributions, though protection varies by state and is weaker for the general partner.

Do discounted gifts sacrifice the basis step-up?Yes. Gifted interests keep the donor's basis, while assets held until death generally receive a stepped-up basis. Families below the exemption often do better holding assets than discounting them.

How long should an FLP exist before making gifts?There is no statutory waiting period, but allowing meaningful time of real operation between funding and transfers, and avoiding deathbed formation, materially strengthens the structure.