Imagine you own a $10 million portfolio of commercial real estate and you want to start transferring it to your children. Hand them the deeds outright and the IRS values the gift at $10 million. Drop the same real estate into a properly structured Family Limited Partnership first, then gift them 99% of the limited partner interests, and the IRS may value the gift at closer to $6 million. The assets are identical. The kids end up in the same economic position. Yet $4 million quietly disappears from your taxable estate.
That gap is the magic of valuation discounts — and it is one of the most enduring estate planning tools high-net-worth families use to move wealth across generations. It is also one of the most aggressively litigated. With the federal estate tax exemption sitting at $15 million per person in 2026, families with significant wealth are dusting off the Family Limited Partnership playbook again, especially as the political winds around the lifetime exemption keep shifting.
This guide walks through exactly how the structure works, where the 25–40% discounts come from, what the IRS will look for, and how to avoid the painful Tax Court rulings that have stripped discounts from estates that did it wrong.
What a Family Limited Partnership Actually Is
A Family Limited Partnership (FLP) is a state-law limited partnership in which the partners are members of the same family. It typically holds passive or semi-passive assets — marketable securities, real estate, a closely held operating business, intellectual property, a vineyard, an art collection, royalty streams.
The structure almost always looks the same:
- General partner (GP) — typically holds a 1% interest and retains 100% of the management control. The GP can be the senior family member directly, but more often it is an LLC owned by the senior generation. Putting an LLC between the partnership and the human GP shields personal liability for partnership obligations.
- Limited partners (LPs) — collectively hold the remaining 99%. Limited partners have no voice in management, cannot demand distributions, and cannot force a sale of partnership assets. They share economically but not operationally.
Mom and Dad set it up. They contribute the assets. They keep the GP role. Then, over years, they gift limited partnership interests to the kids — usually inside annual exclusion gifts ($19,000 per recipient in 2026, or $38,000 for a married couple) and against the lifetime exemption when bigger transfers are needed.
The senior generation keeps the keys. The next generation gets the equity. That asymmetry is exactly where the discounts come from.
Where the Discounts Come From
When you transfer 99 partnership units that represent $3 million worth of underlying assets, you are not actually transferring $3 million of liquid value. You are transferring a minority, non-marketable interest in a private partnership — and the IRS regulations themselves acknowledge that those are worth less than the pro-rata value of the assets inside.
Two distinct discounts apply, and order of operations matters.
Discount for Lack of Control (DLOC)
A limited partner cannot:
- force the partnership to make distributions
- veto investment decisions
- pick the general partner
- liquidate the partnership
- compel a sale of underlying assets
Owning a 30% limited interest in an FLP that holds $10 million of real estate is nothing like owning $3 million of real estate outright. You cannot sell a building to pay for a kitchen remodel. You cannot force a refinance. You hold an economic claim with no operational lever.
Courts and appraisers typically apply DLOCs in the 10–25% range, depending on the underlying assets, the partnership agreement's distribution provisions, and any state-law fiduciary protections.
Discount for Lack of Marketability (DLOM)
Even if you wanted to sell your limited partnership interest, who would buy it? There is no public market. The partnership agreement almost certainly restricts transfers to outside parties. Any willing buyer would have to underwrite the family dynamics, the GP's investment philosophy, and the prospect of indefinitely tying up capital with no exit.
DLOMs commonly range from 20% to 35%. Restricted stock studies, pre-IPO studies, and the IRS's own published rulings all confirm that illiquid private interests trade at meaningful discounts to comparable liquid securities.
Multiplicative, Not Additive
Here is the part most families get wrong on the back of an envelope. The two discounts stack multiplicatively, not additively.
A 20% DLOC and a 30% DLOM applied to a $3 million pro-rata value works out like this:
- Apply DLOC first: $3,000,000 × (1 − 0.20) = $2,400,000
- Apply DLOM second: $2,400,000 × (1 − 0.30) = $1,680,000
That is a combined effective discount of 44%, not 50%. Always model the math correctly when planning gifts so you do not accidentally use more of your lifetime exemption than intended.
A Practical Numerical Example
Take a hypothetical: a couple in their late sixties owns $20 million of investment real estate and marketable securities. They want to use a chunk of their remaining lifetime exemption to move wealth to two adult children.
Without an FLP. They gift $5 million of stock and real estate directly. The IRS values the gift at $5,000,000. They burn $5 million of their combined lifetime exemption.
With an FLP. They contribute $20 million of assets to a newly formed partnership. They take a 1% GP interest (via an LLC) and a 99% limited partner interest. Twelve months later — once the partnership has filed its first 1065, opened its own bank account, and operated independently — they gift 25% limited partnership interests to each child.
A qualified appraiser values each 25% LP interest. Pro-rata value: $5,000,000. After a 22% DLOC and a 28% DLOM (multiplicative), the appraised gift value drops to $5,000,000 × 0.78 × 0.72 = $2,808,000 per child.
The kids still hold the same economic share of the underlying assets. But the couple has burned $5.6 million of lifetime exemption instead of $10 million. Roughly $4.4 million stays available for future gifts or future appreciation in the kids' hands, which by definition compounds outside the parents' taxable estate.
That is the entire game in one example.
The Section 2036 Trap That Has Sunk Hundreds of Estates
The IRS does not love these discounts, and Congress has shown no appetite for blessing them legislatively. The IRS's primary weapon is Internal Revenue Code Section 2036, which pulls assets back into a decedent's gross estate if the decedent retained an interest in or control over the transferred property — unless the transfer qualified as a bona fide sale for full and adequate consideration.
That "bona fide sale" exception has been litigated to death. The two cases every estate planner has memorized:
- Estate of Strangi v. Commissioner. The Fifth Circuit, in 2005, affirmed the Tax Court's finding that the bona fide sale exception was not satisfied. The decedent had transferred essentially all his personal assets into an FLP, kept living in a house owned by the partnership, and had the partnership pay personal expenses. The discounts were wiped out and the assets pulled back into the estate at full value.
- Estate of Bongard v. Commissioner, 124 T.C. 95 (2005). The Tax Court articulated the modern test: the transfer must serve a legitimate and significant non-tax reason. Cosmetic recitals in the partnership agreement do not count. The court looks at what actually happened.
The lesson is brutal. If the IRS successfully invokes Section 2036, you do not just lose the discounts — the IRS values the assets at their full date-of-death fair market value as if the FLP never existed. Years of careful gifting can collapse in a single Tax Court opinion.
What "Bona Fide Sale for Full and Adequate Consideration" Actually Requires
Surviving Section 2036 means treating the FLP as a real entity, not a tax-driven shell. Courts have looked for:
- A legitimate non-tax purpose. Consolidating family management of an operating business. Centralizing investment policy across siblings. Protecting assets from creditors or divorcing spouses. Maintaining family ownership of a legacy property.
- Proportional capital accounts. Each partner's capital account must reflect the value of what they contributed, in proportion to their ownership interest.
- No commingling. The partnership has its own bank account, files its own tax return (Form 1065), and does not pay the senior generation's personal expenses.
- Real operations. Distributions follow the agreement. Investment decisions are documented. Annual meetings happen. Books and records exist and are kept current.
- No deathbed transfers. Funding an FLP weeks or months before death, when the decedent is already in failing health, is the single biggest red flag in the case law.
- Don't put everything in. Retain enough assets outside the partnership to cover personal living expenses. Otherwise, the IRS will argue the FLP is being used as the decedent's personal checkbook.
A clean FLP that has been operating for years, with documented business purpose, real distributions to all partners, and assets that the senior generation does not need to fund daily life is a tough target for the IRS. A rushed FLP funded shortly before death, holding only liquid securities, with no governance and no real activity, is a gift to the agency's estate tax examiners.
Setup Costs and Ongoing Maintenance
FLPs are not cheap. Plan on:
- Legal fees of $8,000 to $15,000 for the initial partnership agreement, certificate of limited partnership, GP entity formation, and tax structuring advice. Complex structures or unusual asset types push this higher.
- Qualified appraisals of the underlying assets and the limited partner interests every time you make a gift large enough to require a Form 709. Expect $5,000 to $25,000+ per appraisal, depending on asset complexity.
- Annual Form 1065 partnership tax return preparation plus K-1s to every partner. Budget $2,000 to $5,000 annually.
- State filing fees, annual report renewals, and registered agent fees in the state of formation.
- Bookkeeping. Real, documented bookkeeping that tracks contributions, distributions, capital accounts, and partnership-level investment activity year by year.
That last item is where most do-it-yourself FLPs quietly fall apart. Capital accounts drift. Distributions get categorized incorrectly. By the time an estate tax audit shows up — sometimes a decade after the partnership was formed — the records that would have proved the entity was operating as a real partnership are gone.
Accurate bookkeeping is not a luxury for an FLP. It is the documentary spine that makes the bona fide sale defense believable to the IRS.
When an FLP Makes Sense — and When It Doesn't
FLPs work best for families with:
- A taxable estate that meaningfully exceeds the lifetime exemption ($15 million per person in 2026, $30 million for a married couple).
- Assets that genuinely benefit from centralized management — an operating business, a real estate portfolio, a family compound, concentrated stock.
- A multi-generational horizon so the partnership can operate for years before any transfer that triggers IRS attention.
- A willingness to give up some flexibility. The senior generation cannot use partnership assets as a personal piggy bank.
FLPs are usually wrong for families with:
- Estates near or below the lifetime exemption — there is nothing to discount toward.
- Only liquid marketable securities that need to be available for living expenses.
- A short time horizon, particularly when the senior generation is already in poor health.
- Family dynamics so contentious that the partnership will end up in court anyway.
For the right family, the discounts compound dramatically over time as appreciation occurs in the limited partners' hands rather than in the senior generation's taxable estate. For the wrong family, they create cost, complexity, and audit exposure with little tangible benefit.
Keep Your Wealth Transfer Records Clean From Day One
Whether you are setting up an FLP, layering it inside a grantor trust, or simply tracking gifts against your lifetime exemption, the durability of your estate plan depends on the quality of your books. Partnership capital accounts, K-1 flows, gifted units, appraised values, distributions to limited partners — these are the records the IRS will demand years from now, and reconstructing them after the fact rarely goes well.
Beancount.io gives families and their advisors plain-text accounting that is transparent, version-controlled, and AI-ready — every transaction, every account, every reconciliation auditable in a single text file your CPA, estate attorney, and successor trustees can all read. No vendor lock-in, no proprietary database, no surprises when the records have to outlive their author. Get started for free and build the financial record that protects everything you are trying to transfer.