Family Limited Partnerships: Valuation Discounts and IRS Scrutiny

A 35% Discount on Assets Transferred to Your Children — Legally

Family Limited Partnerships (FLPs) are among the most scrutinized — and most legitimate — tools in advanced estate planning. The strategy works because a limited partnership interest is worth less than the underlying assets it represents: a holder of a 10% limited partner interest in an FLP cannot demand the sale of underlying assets, cannot control distributions, and cannot easily sell the interest on the open market. Qualified appraisers routinely apply minority interest discounts of 15–40% and lack-of-marketability discounts of 10–35% when valuing FLP interests. Combined discounts of 25–45% below the underlying asset value are common in estate planning contexts. On an estate containing $5 million in marketable securities transferred to an FLP, a 35% combined discount means those assets are valued at $3.25 million for gift and estate tax purposes — saving potentially $700,000 in estate taxes if the estate is taxable. The savings are real. So is the IRS challenge risk.

The Mechanics of an FLP

A Family Limited Partnership is a limited partnership with a general partner (GP) who controls management and one or more limited partners (LPs) who hold economic interests but no control. In estate planning, the senior generation (parents or grandparents) typically form the FLP, contribute assets, and initially retain both the GP interest and the majority of LP interests. Over time, LP interests are gifted to heirs — using the annual gift tax exclusion, the lifetime exemption, or both. The GP retains control over distributions, investment decisions, and the timing of asset sales even after giving away a majority of economic value.

Minority Interest and Lack of Marketability Discounts

Two separate valuation discounts are typically applied to FLP interests:

Minority Interest Discount (MID): Reflects the lack of control a limited partner has over the partnership's operations, distributions, and liquidation. A buyer purchasing a 20% LP interest cannot direct the general partner to sell assets or declare distributions. Published studies and court decisions have validated MIDs ranging from 15% to 40%, with most FLP appraisals using 20–35%.

Lack of Marketability Discount (LOMD): Reflects the absence of a ready market for limited partnership interests. FLP interests are not publicly traded, and the partnership agreement typically imposes transfer restrictions. LOPDs typically range from 15% to 35% in court-tested appraisals.

• Discounts are determined by qualified independent appraisers using recognized valuation methodology
• The IRS routinely challenges discount levels; adequate documentation and a defensible appraisal are essential
• Combined discounts above 45% attract heightened IRS scrutiny and are difficult to sustain in Tax Court

IRS Section 2036: The Primary Attack Vector

Internal Revenue Code Section 2036 pulls assets back into the gross estate if the decedent transferred assets but retained either (a) the right to income from the assets, or (b) the right to control who possesses or enjoys the assets. The IRS frequently invokes Section 2036(a)(1) and 2036(a)(2) against FLPs where the senior generation continued to use FLP assets as personal assets, commingled personal and FLP funds, or failed to follow partnership formalities.

The Tax Court has ruled against FLP discounts in numerous cases where the FLP served no purpose beyond estate tax reduction and partnership formalities were not observed. In Estate of Strangi v. Commissioner (2003), the Fifth Circuit affirmed Tax Court's inclusion of FLP assets under Section 2036 because the decedent retained effective control and the FLP lacked a legitimate non-tax purpose.

The Bona Fide Business Purpose Requirement

For an FLP to survive IRS scrutiny, there must be a genuine, non-tax business purpose for the entity's existence. Acceptable purposes include:

• Centralized management of a family business or investment portfolio
• Protecting assets from the creditors of individual family members
• Maintaining a going concern by avoiding fragmentation of business interests among heirs
• Providing a vehicle for educating younger family members about asset management
• Facilitating systematic, long-term succession planning for a family business

An FLP holding only publicly traded stocks with no investment management activity, no family meetings, and no business operations beyond receiving dividends is vulnerable to challenge. Courts look for substance: the FLP should function as an actual partnership, not merely as a paper entity created solely to generate valuation discounts.

Practical Implementation Requirements

Successfully defending an FLP requires consistent follow-through long after formation. Partnership agreements must restrict transfers and require consent for withdrawals. Capital accounts must be maintained accurately. Distributions must be made proportionally according to partnership interests. General partner fees, if any, must be reasonable and documented. The FLP must maintain a separate bank account; personal and FLP funds must never be commingled.

This article is for informational purposes only and does not constitute legal advice.