Family Limited Partnerships and Discount Planning

The family limited partnership is a defensible if much-litigated technique for transferring wealth between generations. Senior family members contribute assets to a partnership (or LLC taxed as a partnership), retaining a small general-partner interest with management rights and the right to most distributions, while gifting or selling the limited-partner interests to children, grandchildren, or trusts at a valuation discount reflecting the limited partner's lack of control and lack of marketability. With the federal estate exemption made permanent at $15M per person under OBBBA, the urgency of FLP planning has diminished for most families. For estates above $30M, for states with low exemptions, and for concentrated family-business holdings, FLPs remain a working tool.

How the discount works

A 1% limited-partnership interest in an FLP holding $10,000,000 of marketable securities does not transfer for $100,000 in an arm's length sale. The limited partner cannot force distributions, cannot dissolve the partnership, cannot sell the interest to a non-family buyer, and cannot extract the underlying securities. Willing buyers therefore pay less than pro-rata NAV. The IRS accepts — grudgingly, after extensive litigation — discounts of 15%–35% combined for lack of control and lack of marketability. The discount is independent of any "leverage" or trick; it reflects what an actual buyer would pay.

• Lack of control discount (5–15%): reflects inability of limited partner to direct partnership policy, force distributions, or dissolve.
• Lack of marketability discount (15–35%): reflects absence of public market and restrictive transfer provisions.
• Combined: typically 20–35% for marketable-security FLPs; 30–45% for operating-business or illiquid-real-estate FLPs.

The §2036 retained interest trap

Internal Revenue Code §2036(a) includes in the gross estate any property the decedent transferred during life while retaining "(1) the possession or enjoyment of, or the right to the income from, the property" or "(2) the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom." If the IRS proves §2036 inclusion, the partnership is unwound at death and the full underlying assets — not the discounted interests — are included in the estate. Discounts disappear.

Three case-law principles emerged from Strangi, Bongard, Bigelow, and progeny:

1. Bona fide non-tax purpose. The FLP must have a legitimate business or family reason (concentration risk management, succession, asset protection, joint investment). "Estate tax savings" is not enough.
2. Real partnership operation. Separate books, formal meetings, distributions in proportion to interests, no commingling of personal expenses.
3. Donor's continued personal use. Transferring a personal residence into an FLP and continuing to live there generally triggers §2036.

OBBBA effect on FLPs

OBBBA's permanent $15M per person federal exemption ($30M MFJ) eliminates federal estate tax for most families that previously needed FLPs. For these families, the discount on the LP interest produces little benefit while introducing partnership complexity, K-1 filings, valuation appraisals, and §2036 risk. The remaining users:

• Estates above $30M (and especially $50M+) where every $1M of discount removed is real federal tax savings.
• Residents of states with low estate-tax exemptions (Massachusetts $2M, Oregon $1M, New York $7.16M).
• Operating-business holders for whom the partnership facilitates governance and buy-sell mechanics independent of tax savings.
• Asset-protection planning (LP interests are creditor-resistant under most state law).

Worked example: $40M FLP

Senior couple, joint estate $50M, $40M in liquid securities, $10M home and other personal assets. They contribute the $40M of securities to an FLP. Senior couple retains 1% GP interest (with control); 99% LP interest divided.

Year-one gifting: each spouse gifts a 5% LP interest to each of two children's trusts and each of four grandchildren's trusts (12 trusts total). Pre-discount value of each gift: $40M × 99% × 5% / 12 = ~$165,000. With a 30% combined discount, gift-tax-reported value: ~$115,000 per trust. Total transferred: $40M × 60% = $24M nominal value, reported at ~70% × $24M = $16.8M. Exemption used: $16.8M (well within $30M combined remaining exemption).

Future appreciation on the 60% transferred: outside the senior couple's estate. The remaining 40% (kept as control retention) plus the home produces a residual estate well within the $30M federal exemption. Net federal estate tax: $0; without the FLP the estate would have $20M of excess valued at full FMV, generating roughly $8M of federal estate tax. State estate tax (Massachusetts or New York resident) further reduced by the same percentage.

Common mistakes

• Personal-asset commingling. Using the partnership's checkbook to pay the senior couple's American Express bill is the §2036 smoking gun.
• Death-bed transfers. An FLP funded weeks before death has been repeatedly disregarded for lack of bona fide non-tax purpose. Plan years in advance.
• Overaggressive discount appraisals. A 50% discount on marketable securities draws attention and produces large penalties. Stay in the 20–35% range supported by published studies.
• Forgetting §2701 "estate freeze" rules. Preferred-partnership and disproportionate-distribution structures can trigger §2701 deemed gifts at fair market value, eliminating the discount.
• State-level pass-through-entity tax elections. An FLP electing PTET status materially changes the K-1 character and may interact with state pass-through tax credit limits.
• Treating it as "set and forget." Annual partnership meetings, formal records, and arm's-length conduct must continue for the life of the partnership.

Sources

• Internal Revenue Code §2036, retained interest inclusion: law.cornell.edu/uscode/text/26/2036
• Internal Revenue Code §2701, special valuation rules: law.cornell.edu/uscode/text/26/2701
• Estate of Bongard v. Commissioner, 124 T.C. 95 (2005): ustaxcourt.gov Bongard
• Estate of Strangi v. Commissioner, T.C. Memo. 2003-145; aff'd 417 F.3d 468 (5th Cir. 2005).
• IRS Job Aid, "Family Limited Partnerships and Limited Liability Companies" (2014): irs.gov FLP job aid

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