Family Limited Partnership (FLP)

A family limited partnership, commonly abbreviated FLP, is a limited partnership formed under state law whose partners are members of one family and which holds family assets: a securities portfolio, rental real estate, farmland, or an operating business. The senior generation typically takes a small general partner interest carrying management authority and a much larger limited partner interest carrying value but no control, then transfers limited partner interests to children and grandchildren over time. Nothing in the federal tax code creates the entity. The Internal Revenue Service uses the phrase descriptively and tracks such entities on estate and gift tax returns under its own project code.

The structure is one idea: separate control from value. A limited partnership already does this by design. The general partner manages and bears unlimited liability for partnership obligations; the limited partners have capped exposure and restricted participation in management. In an FLP the senior generation holds the general partner interest, which can be very small as a share of capital while carrying all of the decision-making, and the limited partner interests hold nearly all of the capital while carrying none.

What actually moves down a generation, then, is a limited partner interest: a share of the profits and capital of an entity the recipient cannot manage, cannot force to liquidate, and generally cannot transfer freely because the partnership agreement restricts it. That interest is worth less than the same fraction of the underlying assets, and lowering the value of what is transferred is the point of the exercise. How much less is a valuation question, answered by a qualified appraiser for the particular interest on the particular date, and it is covered on the valuation discount page.

Section 2036(a) is the attack, and it is specific to this structure. The provision reads: "The value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in case of a bona fide sale for an adequate and full consideration in money or money's worth), by trust or otherwise, under which he has retained for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death: (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."

Read against an FLP the danger is visible. A parent who contributes assets, keeps living off the income, keeps deciding who gets distributions, and pays personal expenses out of the partnership account has retained both the enjoyment of the property and the right to designate who enjoys it. If section 2036(a) applies, the assets come back into the gross estate at their own value, and the discount that the whole structure was built to produce disappears. What keeps the section off is either not retaining those things, or falling inside the parenthetical: a bona fide sale for adequate and full consideration.

The operating discipline is therefore the substance, not the paperwork. The facts that matter are the ones that show the partnership was real: it was formed for a reason that would exist without the tax result, such as consolidating management of a property or setting rules for a family business; contributions were properly recorded and capital accounts maintained; distributions went to partners in proportion to their interests rather than on demand to one of them; the senior generation kept enough assets outside the partnership to live on; and the partnership's money paid partnership expenses only. A partnership that is administered as a personal account with a partnership name is the case the Internal Revenue Service is looking for.

Section 2704(b) removes a shortcut that would otherwise be too easy. If a family could depress the value of a transferred interest simply by writing a restriction into its own partnership agreement and lifting it later, the valuation question would answer itself. The statute closes that: where "there is a transfer of an interest in a corporation or partnership to (or for the benefit of) a member of the transferor's family" and "the transferor and members of the transferor's family hold, immediately before the transfer, control of the entity, any applicable restriction shall be disregarded in determining the value of the transferred interest." An applicable restriction is one that "effectively limits the ability of the corporation or partnership to liquidate" and that either lapses after the transfer or can be removed by the transferor or the family, alone or together.

Two exceptions matter. A commercially reasonable restriction arising from genuine third-party financing is not an applicable restriction. Neither is "any restriction imposed, or required to be imposed, by any Federal or State law." That second exception is why the default rules of a state's limited partnership statute do work that a bespoke clause cannot: a limitation the law imposes is not one the family wrote for itself.

How the Internal Revenue Service currently treats these entities. The Internal Revenue Manual instructs examiners to flag family limited liability entities appearing on estate and gift tax returns with a dedicated project code, whether the issue is apparent on the return or emerges during the examination. It also records two changes worth knowing: family limited partnerships are no longer designated as an Appeals Coordinated Issue, and the Appeals Settlement Guidelines that once governed how such cases were resolved have been de-published and, in the Manual's words, "may not be cited as authority in any case."

1. A limited partnership is formed under state law, with a partnership agreement setting out management authority, transfer restrictions, distributions and dissolution.

2. Assets are contributed in exchange for partnership interests. The senior generation typically takes a small general partner interest and a large limited partner interest.

3. The partnership operates as a partnership: separate accounts, capital accounts maintained, its own return filed, distributions proportional, and personal spending kept out of it.

4. Limited partner interests are transferred down, by gift, by sale, or by a combination, over a period of years.

5. Each transfer is valued by a qualified appraiser, and the value reflects what the recipient actually receives: a minority interest in an entity they cannot manage or force to liquidate, subject to transfer restrictions. What those features are worth is the valuation question.

6. Section 2704(b) is applied to the valuation, so any restriction the family itself could lift is disregarded, while restrictions imposed by federal or state law are not.

7. At the senior generation's death, section 2036(a) is tested against how the partnership was actually run, not against how the agreement reads.

A hypothetical, showing only the ownership arithmetic. Ana and Ben contribute a rental portfolio to a new limited partnership and take a 1 percent general partner interest and a 99 percent limited partner interest, which together account for 100 percent of the entity. Every year each of them gives limited partner interests to each of their two children, which is four separate gifts a year. Each of those gifts can be sheltered by the annual gift tax exclusion, currently $19,000 per recipient per donor, so a gift at or under that amount uses none of the lifetime exclusion and generally requires no gift tax return. What each gift is worth in dollars is an appraisal question, because a limited partner interest is not the same thing as the same percentage of the buildings. Over a decade the limited partner interests gradually leave Ana and Ben's estates while the 1 percent general partner interest, and with it the management of the buildings, does not move at all. That last sentence is the structure. Everything else is execution.

What the structure does

• Management stays with the senior generation through a general partner interest that can be a very small share of the capital.
• Value moves down in interests rather than in assets, so a portfolio or a property can be transferred gradually without dividing the thing itself.
• The partnership agreement sets rules for transfers, valuation on exit and dispute resolution, which unstructured co-ownership does not.
• Consolidating family assets in one entity can genuinely simplify management and give the arrangement a purpose that would exist without any tax result.
• Transferring an interest that a recipient cannot manage or liquidate is worth less than transferring the underlying assets, which is why these are used.

What it costs and where it fails

• Section 2036(a) can pull the assets back into the estate if the senior generation kept the income, kept deciding who benefits, or ran the partnership as a personal account.
• The discipline is permanent. Formalities, separate accounts and proportional distributions have to hold for the rest of the transferor's life.
• Every transfer needs a qualified appraisal, which is a recurring professional cost and is itself the thing most likely to be examined.
• Section 2704(b) disregards liquidation restrictions the family can lift, so a restriction written into the family's own agreement may buy nothing.
• The recipients hold an illiquid interest they cannot sell, in an entity they do not control, which is a real cost to them and not only a valuation input.
• Set-up and annual compliance are meaningful for a family whose estate would not owe tax anyway, and for many families that is the whole answer.