A family limited partnership (FLP) can be a powerful tool for consolidating and managing family wealth while reducing gift and estate taxes, in part through valuation discounts. However, the IRS closely scrutinizes these arrangements, especially when they involve deathbed transfers or when donors fail to retain sufficient personal assets outside of the partnership. A recent U.S. Tax Court case — Estate of Anne Milner Fields v. Commissioner (T.C. Memo. 2024-90) — highlights some potential red flags when using this estate planning tool.
Nuts and bolts
Setting up an FLP is straightforward: A senior family member contributes assets, such as marketable securities, real estate and private business interests, to a limited partnership. In turn, he or she receives general and limited partner interests, which may be “gifted” to family members and charitable organizations. Limited partners can’t control day-to-day activities and, therefore, their units tend to be worth less than general partner units.
Other partners (typically children and grandchildren) also may make capital contributions to the partnership in return for general or limited partner interests. Or they may receive general or limited units as gifts from senior family members. Partner rights, which typically limit who can buy and sell partner units, are governed by an FLP agreement.
An FLP must be established for a legitimate business purpose, such as efficient asset management and protection from creditors. Partnerships set up exclusively to minimize gift and estate taxes won’t pass IRS muster.
Qualified appraisals
Independent asset appraisal is key to executing an effective FLP. Without appraisals, donors can’t accurately determine the number of partner units to allocate when making gifts. And the IRS will likely challenge any gift of FLP units based on a do-it-yourself appraisal.
Valuation experts begin by determining the partnership’s net asset value, which is the combined fair market value of its assets on a controlling, marketable basis minus any liabilities. The value of marketable securities can be obtained from sources such as brokerage statements or The Wall Street Journal. A real estate appraiser will value real property, while a business appraiser determines the value of private business interests.
Valuation discounts
An FLP’s key tax benefit lies in valuation discounts. Regardless of the FLP’s underlying assets, business valuation pros are also customarily used to quantify two discounts:
1. The discount for lack of control (DLOC). General partners manage all aspects of partnership operations, including cash distributions, asset sales and acquisitions, and partnership dissolution. Because limited partners (by state law) lack control over partnership affairs, the interests are at an economic disadvantage, which typically warrants a DLOC from the FLP’s net asset value.
2. The discount for lack of marketability (DLOM). Limited partner units also lack a ready market on which they may be sold. This reduces or discounts their value and makes them less attractive to a potential investor. Lack of marketability may further reduce value if the partnership agreement restricts transfers to people outside the family.
These discounts may often be substantial and separate from discounts taken at the net asset level. The magnitude of discounts varies depending on numerous factors, such as:
- The nature and composition of the partnership’s underlying assets,
- Partnership agreement rights and restrictions,
- State laws,
- Current market conditions,
- Historic and projected income distributions,
- Relevant legal precedent, and
- The rate of return that an investor would expect given overall risk associated with the subject interest.
DLOMs are taken after DLOCs. This is important because the two discounts are multiplicative, not additive. In other words, a 20% discount for lack of control and a 30% discount for lack of marketability equal a combined discount of 44%, not 50%.
Case in point
In Estate of Fields, the estate attached a qualified appraisal report to its timely filed return. The valuation expert appraised the decedent’s limited partner interest in an FLP at approximately $10.8 million, including a 15% DLOC and a 25% DLOM. The IRS issued a notice of deficiency, finding that, under Internal Revenue Code Section 2036(a), the undiscounted value of the assets contributed to the FLP should have been included in the decedent’s estate. Sec. 2036(a) provides that the value of property transferred before death is included in the estate if the decedent retains either 1) the possession or enjoyment of, or the right to 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 its income. The IRS also assessed a 20% accuracy-related penalty for underpayment of tax.
The Tax Court sided with the IRS for two main reasons. First, the decedent’s assets were contributed to the FLP less than a month before the decedent passed away. Second, the decedent hadn’t retained sufficient liquid assets outside of the FLP to pay cash bequests and estate taxes.
Based on these facts, the court found that, until she died, the decedent “effectively held the right to virtually all of the income from her transferred assets.” She also had the right, in conjunction with her agent, to dissolve the partnership, liquidate its assets and distribute cash to herself. The court also ruled that the FLP lacked a substantial nontax purpose.
Lesson learned
While FLPs are a proven estate planning technique, it’s important to understand the potential pitfalls under Sec. 2036(a). If the IRS persuades the Tax Court that you (or your client) retained an economic interest in the FLP’s assets, tax-saving valuation discounts may be lost. Contact us to discuss ways to identify and navigate these risks. We can help ensure accurate FLP valuations, including reasonable discounts, for your estate planning needs.
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