Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Wealthy Families Use Family Limited Partnerships for Valuation Discounts
Transcript
- Lucas: When a wealthy family owns a closely held business worth, say, $50 million, the estate tax bill at death can be a real problem. So some families use a structure called a family limited partnership, or FLP, to transfer that wealth to the next generation at a steep discount. Luna: A discount? How does that actually work in practice? Lucas: The core idea is that you contribute your assets—shares of the family business, real estate, marketable securities—to a partnership in exchange for both general and limited partnership interests. Then you begin giving the limited partnership units to your children. Because those units are non-controlling and they're tough to sell on the open market, the IRS lets you value them at a discount—typically 25 to 40 percent below the net asset value. Luna: So a $50 million business could be gifted as if it were worth only $30 million or so. That's a huge tax saving. Lucas: Exactly. And the savings compound because the future appreciation on those gifted units is also out of your estate. Over the past decade, families have used FLPs to move hundreds of millions of dollars tax-efficiently. Luna: But the IRS has challenged FLPs aggressively. What makes a structure hold up in an audit? Lucas: The three big ones are: first, the partnership must have a genuine business purpose beyond tax avoidance—like centralized management or asset protection. Second, the assets contributed must be appropriate for a partnership—passive investments are fine, but you can't contribute your personal residence. And third, the partnership must be respected as a separate entity—that means proper formalities: a written agreement, capital accounts, annual filings. Luna: I've heard horror stories where families contributed marketable securities to an FLP and the IRS disallowed the discount entirely because the assets were liquid. What's the rule there? Lucas: Right. The IRS has been especially tough on FLPs holding publicly traded stocks or bonds, because they argue there's no real lack of marketability. The landmark case on that is Holman versus Commissioner from 2015, where the Tax Court basically said that if the partnership holds only publicly traded securities and the only reason for the partnership is to get a discount, it won't fly. Luna: So what kind of assets work best for a defensible FLP? Lucas: Operating businesses, real estate, and private equity interests. Those have inherent lack of marketability and often lack a ready buyer. A real estate partnership with an apartment building—the limited partner interest is illiquid by nature. The IRS is much less likely to challenge a 30 percent discount on that. Luna: And the discounts are based on two factors: a minority interest discount and a lack of marketability discount. Can you break those down? Lucas: Sure. The minority interest discount reflects the fact that a limited partner doesn't control the partnership—they can't make investment decisions, force distributions, or liquidate. That's typically worth 15 to 25 percent. The lack of marketability discount accounts for the fact that you can't sell the interest quickly—maybe another 10 to 20 percent. Combined, you often see total discounts of 30 to 40 percent. Luna: And the IRS has its own valuation guidelines. I remember the IRS Revenue Ruling 93-12, which essentially says that for family-owned entities, the IRS will not assume family unity when valuing minority interests. Lucas: But that ruling is from 1993, and the landscape has shifted. In 2024, the IRS issued a memo suggesting they might challenge discounts that exceed what an independent appraiser would deem reasonable. So it's critical to get a formal appraisal from a qualified firm. Luna: Let's talk about the mechanics of gifting. If a couple has a $50 million business and sets up an FLP, how do they actually start moving units to the next generation? Lucas: They typically use their gift tax exemptions. In 2026, the lifetime gift and estate tax exemption is about $13.6 million per individual, or $27.2 million for a married couple. So they can gift up to that amount tax-free. But if the value of the business is $50 million, even with a 30 percent discount, the discounted value is $35 million, which exceeds the exemption. So they'd have to pay gift tax on the excess or use a technique like an installment sale to a grantor trust. Luna: That gets into more advanced planning. But the FLP itself is just the vehicle. The real magic is the discount. Lucas: Exactly. And it's important to note that the discount is not automatic. You need a well-documented appraisal, you need to respect the partnership formalities, and you need to have valid economic substance. Otherwise, the IRS will collapse the partnership and treat the assets as directly owned. Luna: You mentioned economic substance. Could you give a concrete example of a family that pulled this off successfully? Lucas: Sure. I've seen a case where a family owned a portfolio of industrial real estate—15 warehouses across the Midwest. They formed an FLP, contributed the properties, and began gifting limited partnership interests to their four children. The appraiser valued the minority discount at 20 percent and the lack of marketability at 15 percent, for a total of 35 percent. That lowered the taxable value from $80 million to $52 million. The IRS audited it, but the family had done everything by the book: separate bank accounts, annual meetings, no personal use of the properties, and a legitimate business purpose—centralized management and liability protection. The discount stuck. Luna: That's a powerful example. And speaking of what's worth doing—I have to say, the amount of value you can add for clients with these structures is huge. It kind of makes you think about the cost-benefit of a proper setup. Lucas: Absolutely. A well-structured FLP can save millions in taxes. And if today's episode helped you think about a planning opportunity for your situation or your clients, that's exactly why we do this. Luna: Yeah, and honestly, if today was worth a coffee to you, it's easy to support the show. Just visit buy me a coffee dot com slash fexingo. No pressure, but listener support is what keeps us ad-free and allows us to dive deep into these niche topics. Lucas: Exactly. So back to the FLP: one key risk is that the IRS could apply the 'step transaction doctrine' if the formation and gifts happen too close together. You should wait at least six months—some planners recommend a year—between contributing assets and starting the gifting program. Luna: That seems reasonable. What about the treatment of income from the FLP? If the partnership generates rental income or business profits, how is that taxed? Lucas: The FLP itself is a pass-through entity, so the partners report their share of income on their personal returns. The general partner typically gets a larger allocation, but the limited partners report their proportionate share. This can actually create a benefit: if the children are in lower tax brackets, the income is taxed at lower rates. Luna: But the general partner typically keeps control. That's usually the parents, right? Lucas: Yes, the parents retain the general partner interest, which gives them management control. They draw a reasonable compensation for managing the partnership. That's important—if the GP doesn't actually manage anything, the IRS might argue the partnership lacks substance. Luna: What about using an FLP for assets that already have a low basis? Would that cause any issues? Lucas: That's a common concern. The basis carries over to the partnership. When the partnership sells an asset, the gain is recognized at the partnership level and allocated to partners. But there's no step-up in basis at death if the assets are held in the FLP—unless you use a 'Section 754 election' to adjust the inside basis when a partner dies or when interests are transferred. That's another layer of complexity. Luna: So an FLP isn't something you set up on a whim. It requires careful planning and ongoing compliance. Lucas: Right. But for families with significant wealth—especially illiquid assets like a business or real estate—the estate tax savings can be enormous. Even after paying for legal and appraisal fees, you're often looking at a net benefit in the millions. Luna: Looking ahead to the next administration's potential tax changes—do you think FLPs will become more or less attractive in 2027? Lucas: If the estate tax exemption drops—which is possible if the 2017 tax cuts expire after 2025—then more families will have taxable estates. That could make FLPs even more valuable as a discount tool. But if the IRS increases scrutiny, families will need to be even more careful with valuation and formalities. Luna: So it's a tool that rewards precision. Lucas: Exactly. An FLP done right is a stealthy wealth transfer vehicle. Done wrong, it's a red flag for the IRS. Luna: Well, Lucas, I think we've given our listeners a solid playbook today. Lucas: I hope so. The key takeaway: if you're going to use an FLP, treat it like a real business, get a real appraisal, and involve experienced advisors. The payoff can be substantial.