Family Limited Partnership (FLP) Agreement: Estate Planning and IRS Scrutiny

The Structure: GP, LP, and the Family

A family limited partnership is a state-law limited partnership formed under ULPA or the state limited partnership act. The general partner (GP) holds typically 1-5% of the partnership interests and has management control. The limited partners (LPs) hold the remaining 95-99% and have no management role, no ability to force distributions, and no ability to dissolve the partnership unilaterally. All partners are family members; the FLP exists to hold and manage family assets.

The classic FLP formation: parents form an FLP, contribute marketable securities or a closely held business to the FLP in exchange for both a small GP interest and large LP interests, and then gift the LP interests to the children over time using annual exclusions and lifetime gift exemption. The discount valuation of the LP interests means the parents can transfer more economic value to the children per dollar of taxable gift than they could by gifting the underlying assets directly.

A modern FLP almost always uses an LLC as the general partner to avoid the GP’s unlimited personal liability for partnership debts. The LLC-GP is owned by the parents (or by a separate trust) and the parents serve as managers of the LLC. The structure achieves both limited liability and management control without exposing the parents personally to partnership liabilities.

Valuation Discounts: DLOC and DLOM

The economic case for an FLP rests on the valuation discounts that apply when the LP interests are transferred. Two discounts are recognised:

Discount for lack of control (DLOC). An LP interest in an FLP has no management rights, no ability to elect or remove the GP, no ability to force distributions, and no ability to compel a sale of the underlying assets. A willing buyer would pay less for that interest than for a pro rata share of the underlying assets. The discount typically ranges from 10% to 25% and is supported by data on closed-end fund discounts (publicly traded entities holding portfolios at discounts to net asset value).

Discount for lack of marketability (DLOM). Even after accounting for lack of control, an LP interest in a private partnership is not marketable: there is no public exchange, transfer is typically restricted by the partnership agreement, and the buyer faces uncertainty around future income and exit. The discount typically ranges from 15% to 35% and is supported by studies of restricted-stock transactions and pre-IPO transaction prices.

Combined discounts of 25-45% are typical for FLPs holding marketable securities or operating businesses. The discounts must be supported by a qualified appraisal at the time of the gift; reliance on rule-of-thumb discounts without appraisal documentation invites IRS challenge. Appraisal fees for an FLP valuation typically run $5,000-$20,000 depending on complexity.

The §2036 Retained-Control Trap

IRC §2036(a)(1) and (a)(2) bring transferred property back into the transferor’s gross estate if the transferor retained possession or enjoyment of the property, the right to income from the property, or the right to designate who would possess or enjoy the property. The IRS has repeatedly invoked §2036 to disregard FLPs and pull the gifted LP interests back into the parents’ estates at full undiscounted value, defeating the entire planning purpose.

The principal §2036 cases:

• Strangi v. Commissioner (5th Cir. 2005). The transferor parent funded the FLP shortly before death with most of his personal assets, continued to use personal-use assets owned by the FLP, and made personal expenditures from FLP funds. §2036 applied; FLP discounts disregarded.
• Bongard v. Commissioner (T.C. 2005). The transferor formed the FLP for legitimate non-tax business purposes (consolidation of family stock holdings, succession planning) and observed formalities. §2036 did not apply; FLP discounts respected.
• Estate of Powell v. Commissioner (T.C. 2017). Reaffirmed Strangi pattern; transferor’s retained ability to participate in dissolution decisions sufficient to trigger §2036(a)(2). FLP discounts disregarded.
• Estate of Moore v. Commissioner (T.C. 2020). §2036 applied where transferor used FLP funds to pay personal taxes and other personal obligations shortly before death.

The line from these cases: an FLP with genuine non-tax purposes, formed sufficiently in advance of death, funded with non-personal-use assets, and operated at arm’s length with observed formalities, generally survives §2036. An FLP that looks like a deathbed estate-tax dodge, retains the transferor’s personal use of assets, or commingles personal and partnership funds, fails.

Best Practices for an FLP That Survives Audit

Based on the case law, the FLP planning checklist:

• Document non-tax purposes. The recitals to the FLP agreement should clearly articulate the non-tax purposes for formation (consolidation of family wealth, succession planning, asset protection, simplified administration of family assets, education of children in financial management).
• Form well in advance of death. FLP formation should occur with substantial life expectancy remaining. Deathbed FLPs are nearly impossible to defend.
• Do not contribute personal-use assets. The family residence, personal vehicles, vacation property used by the parents, and similar assets should generally stay outside the FLP. If they must go in, the parents must pay arm’s-length rent.
• Maintain separate accounts and records. The FLP must have its own bank account, its own books, and clean separation from personal accounts. Distributions to partners must follow the partnership agreement and be documented.
• Observe formalities. Annual partnership meetings, written consents for major decisions, prepared annual financial statements, and timely tax filings.
• Make gifts that fully part with control. Gifts of LP interests must be unconditional. Strings (the transferor retains a right to amend, revoke, or change beneficiaries) trigger §2036 even where formalities are otherwise observed.
• Use a qualified appraiser for each valuation. Discounts asserted without appraisal documentation will be challenged. The appraiser should be a Member of the American Society of Appraisers, a Certified Valuation Analyst (NACVA), or comparable credential, with FLP-specific experience.

Sample FLP Provisions

The Charging Order: Asset Protection Reality

FLP literature often oversells asset protection benefits. The protection mechanism is the charging order remedy, which is provided by most state limited partnership statutes: a personal judgment creditor of a limited partner cannot reach the partnership’s assets or force a liquidation; the creditor’s only remedy is a charging order against the partner’s economic interest, entitling the creditor to receive any distributions the partner would have received.

In practice, the FLP’s GP simply does not make distributions while the charging order is outstanding. The creditor is left with a lien on hypothetical distributions, plus (in some states) the IRS treatment that the creditor receives a K-1 for partnership income even when no distributions are made. This combination is unpleasant for the creditor and motivates settlement at a discount. It is not absolute protection: courts in some states (notably California after Olmstead v. FTB Acquisitions 2010 in Florida) have permitted foreclosure on the LP interest in certain circumstances, particularly for single-member LLC GPs.

Asset protection should never be the primary rationale for an FLP. The estate-tax planning, family-governance, and consolidation purposes do the heavy lifting; charging-order protection is a useful side benefit.

Authoritative Sources

• IRC §2036 (transfers with retained life interest). Cornell LII.
• Uniform Limited Partnership Act (2001). Uniform Law Commission.
• Strangi v. Commissioner, 417 F.3d 468 (5th Cir. 2005).
• Estate of Bongard v. Commissioner, 124 T.C. 95 (2005).
• Estate of Powell v. Commissioner, 148 T.C. 392 (2017).
• Estate of Moore v. Commissioner, T.C. Memo 2020-40.
• IRS Publication 559, Survivors, Executors, and Administrators. IRS.

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