Family Limited Partnerships and LLCs for Estate Planning

Family Limited Partnerships (FLPs) and Family Limited Liability Companies (LLCs) are legal structures that allow families to consolidate assets, maintain centralized management, and transfer wealth to younger generations at reduced gift and estate tax values. These entities achieve tax efficiency through valuation discounts that reflect the restricted nature of minority ownership interests.

Structure of Family Limited Partnerships

An FLP consists of two classes of partners with distinct roles and rights:

General Partner (GP): Holds 1-2% of the partnership but controls all management decisions, including investment choices, distributions, and day-to-day operations. The general partner bears unlimited personal liability for partnership obligations.

Limited Partners (LPs): Hold 98-99% of the partnership but have no management authority. Limited partners cannot sell their interests without GP approval, cannot force distributions, and cannot participate in business decisions. Their liability is limited to their capital contributions.

Family LLCs operate similarly, with managing members (equivalent to general partners) and non-managing members (equivalent to limited partners). LLCs offer additional liability protection for managing members while providing the same valuation discount opportunities.

Valuation Discounts Explained

When a limited partnership interest is appraised for gift or estate tax purposes, its value is typically reduced by 25-40% from the proportionate share of underlying assets. Two discounts apply:

Lack of Control Discount (10-20%): Limited partners cannot direct investments, compel distributions, or influence management decisions. A buyer would pay less for an interest that provides no control over the asset.

Lack of Marketability Discount (15-25%): Limited partnership interests cannot be freely sold on public markets. Transfer restrictions in the partnership agreement further limit marketability. A buyer would discount the price to compensate for illiquidity.

These discounts are applied multiplicatively. An interest worth $1,000,000 on a proportionate basis might be valued at $650,000-$750,000 after both discounts, depending on the specific restrictions in the partnership agreement and the nature of underlying assets.

IRS Scrutiny and Formation Requirements

The IRS closely examines FLPs and LLCs to ensure they serve legitimate business purposes beyond tax avoidance. Structures have been successfully challenged when:

• The entity was formed shortly before the owner's death
• The owner retained personal use of partnership assets
• Partnership formalities were not observed
• Assets included personal residences or personal effects
• No legitimate non-tax business purpose existed

Proper Formation Requirements:

1. Legitimate Business Purpose: Document valid reasons such as asset protection, centralized management, keeping property in the family, or facilitating family business succession.

2. Adequate Capital Contribution: The general partner should contribute meaningful assets, not just a nominal amount. Courts have scrutinized arrangements where 1% GP interests were funded with minimal capital.

3. Observe Formalities: Hold annual meetings, maintain separate books and records, file partnership tax returns, and make pro-rata distributions when distributions occur.

4. Respect Entity Separation: Do not commingle partnership assets with personal assets. Do not use partnership funds for personal expenses.

5. Allow Seasoning Time: Form the entity well before any anticipated transfers. Last-minute formations invite challenge.

6. Obtain Qualified Appraisals: Use independent, qualified appraisers to value interests. Document the basis for all discounts claimed.

Annual Gifting Strategy

Once properly established, the FLP or LLC facilitates systematic wealth transfer through annual gifts of limited partnership interests:

2024 Annual Exclusion: Each person may gift up to $18,000 per recipient annually without using lifetime exemption. A married couple can gift $36,000 per child per year.

Discounted Value: Due to valuation discounts, a gift of interests representing $50,000 of underlying assets might be valued at $32,500 for gift tax purposes (assuming 35% combined discount).

Crummey Powers: Some families use trusts as recipients, with Crummey withdrawal powers to qualify transfers as present interests eligible for the annual exclusion.

Worked Example: $10 Million Real Estate Portfolio

Initial Setup:

The Smith family owns commercial real estate worth $10,000,000. They form Smith Family LP with the following structure:

• Smith Family Holdings LLC (owned by parents): 2% general partner interest
• Parents: 49% limited partner interest each (98% total)

Appraisal and Discount:

A qualified appraiser determines that limited partnership interests warrant a 35% combined discount (15% lack of control, 20% lack of marketability applied multiplicatively: 1 - (0.85 × 0.80) = 32%, rounded to 35% based on specific partnership restrictions).

The 98% limited partner interest, proportionately worth $9,800,000, is valued at $6,370,000 for transfer tax purposes ($9,800,000 × 0.65).

Annual Gifting Program:

The Smiths have three children. Each year, both parents gift limited partnership interests to each child:

• Annual exclusion per parent per child: $18,000
• Total annual exclusion gifts: $18,000 × 2 parents × 3 children = $108,000

At the discounted value, $108,000 of gift tax value transfers interests worth $166,154 on a proportionate basis ($108,000 ÷ 0.65).

Lifetime Exemption Gifts:

Beyond annual exclusion gifts, the parents decide to transfer additional interests using their lifetime gift tax exemption ($13.61 million each in 2024).

They gift interests with a discounted value of $2,000,000 to trusts for their children. This uses $2,000,000 of lifetime exemption but transfers interests representing $3,076,923 of underlying real estate value ($2,000,000 ÷ 0.65).

Total Transfer:

After the initial large gift and five years of annual exclusion gifts:

• Lifetime exemption used: $2,000,000
• Annual exclusion gifts: $540,000 (5 years × $108,000)
• Total discounted value transferred: $2,540,000
• Proportionate value of underlying assets transferred: $3,907,692

The parents retain control through the general partner entity while having transferred nearly $4 million of real estate (on a proportionate basis) for approximately $2.5 million of gift tax value.

Estate Tax Savings:

At a 40% estate tax rate, removing $3,907,692 from the parents' taxable estate saves approximately $1,563,077 in estate taxes. Additionally, all future appreciation on the transferred interests accrues to the children outside the parents' estates.

Ongoing Management Considerations

• Annual Reporting: File Form 1065 (partnership return) or Form 1120-S/8865 (for LLCs) annually
• K-1 Distribution: Provide Schedule K-1 to all partners showing their share of income, deductions, and credits
• Consistent Treatment: Make distributions proportionate to ownership percentages
• Updated Appraisals: Obtain new appraisals for subsequent gifts, as values change over time
• Succession Planning: Plan for successor general partners when the original GPs can no longer serve

Pre-Implementation Checklist

• Identify assets suitable for FLP/LLC (business interests, investment real estate, securities)
• Confirm assets are not primarily personal-use property
• Document legitimate non-tax business purposes
• Select appropriate entity type (LP vs LLC) based on state law and liability needs
• Draft partnership/operating agreement with appropriate transfer restrictions
• Fund the entity with properly titled assets
• Obtain qualified appraisal of limited partner/member interests
• Establish record-keeping systems for entity formalities
• Consult estate planning attorney regarding integration with overall plan
• Consult tax advisor regarding income tax implications of entity formation
• Allow adequate seasoning time before major transfers
• Review state-specific requirements for FLPs and LLCs