Can Family Limited Partnerships Reduce Estate Taxes? + FAQs

Yes – a properly structured Family Limited Partnership (FLP) can reduce estate taxes by allowing you to transfer wealth to your heirs at discounted values, shrinking your taxable estate while you maintain control over the assets. This strategy leverages special valuation rules under federal tax law to lower the reported value of gifts and estate assets, resulting in potentially significant tax savings. Below, we’ll break down exactly how an FLP works to save estate taxes under federal law, highlight differences at the state level, and cover everything you need to know – from pros and cons to common mistakes, real-world examples, and FAQs – so you can decide if an FLP is the right estate planning tool for your family.

What is a Family Limited Partnership (FLP)? 🤔

A Family Limited Partnership is a legal entity formed by family members to jointly own and manage assets. It’s structured like a traditional limited partnership but among relatives, typically with parents (or one parent) as general partner (GP) and children or other family members as limited partners (LPs). The general partner usually holds a small percentage (e.g. 1%) but has full management control over the partnership’s assets and operations. The limited partners (often holding the remaining ~99% ownership collectively) have an ownership stake but no day-to-day control – they cannot make management decisions and generally cannot sell their interests freely.

This structure is powerful because it separates control from ownership: the senior generation can keep control as GP, while gradually transferring ownership value to the younger generation as LPs. Assets commonly placed into an FLP include real estate holdings, investment portfolios, family businesses, and other valuable assets. Once the FLP is formed and funded with these assets, the general partner can gift or sell limited partnership interests to family members. The FLP agreement typically restricts the sale or transfer of interests outside the family and may limit when distributions (payouts of income) can be taken, aligning with the family’s long-term wealth management goals.

Key characteristics of an FLP:

Pass-Through Entity: For tax purposes, an FLP is a pass-through entity (like other partnerships). Income, deductions, and credits pass to partners according to their ownership shares. The partnership itself doesn’t pay income tax; instead, each partner reports their share on their personal tax return. This has no direct impact on estate taxes, but it means there’s no additional corporate tax layer on earnings.
Limited Liability for LPs: Limited partners risk only their investment in the partnership – they’re not personally liable for partnership debts or legal liabilities. (General partners are liable, which is why often the GP interest is held by a family LLC or corporation to shield the individuals.)
Flexibility in Distribution: The general partner can decide if and when to distribute income or profits. This control allows the senior generation to manage cash flow to junior family members responsibly (for example, to prevent spendthrift habits).
Formal Agreement: An FLP is governed by a partnership agreement. This document sets the rules: what the partnership can invest in, how and when distributions happen, any restrictions on transferring interests, and the rights/duties of GPs and LPs. It’s crucial for the FLP’s legitimacy that the family follows the agreement’s terms strictly (more on that later).

In essence, an FLP serves as a family holding company: it consolidates assets under one entity, makes management more centralized (great for real estate or investments that benefit from unified control), and importantly for our purposes, creates an opportunity for tax-efficient wealth transfer. Now, let’s explore how exactly an FLP helps in reducing estate taxes at the federal level. 🔍

How FLPs Reduce Estate Taxes (Federal Law Benefits)

Under U.S. federal tax law, your estate tax liability is based on the fair market value of your assets at death above a certain exemption. In 2025, that federal estate tax exemption is $13.99 million per individual (nearly $28 million for a married couple) – amounts above that are taxed at 40%. (This exemption is historically high; it’s scheduled to drop by about half in 2026, meaning estates above ~$7 million may face estate tax going forward.) A Family Limited Partnership can reduce the taxable value of your estate in a few key ways:

1. Valuation Discounts: The most powerful benefit is the application of valuation discounts on FLP interests. Because limited partnership interests are less marketable and lack control, their value to an outside buyer is considered lower than a proportionate share of the underlying assets. For example, suppose an FLP holds $10 million in assets and you gift a 20% limited partner interest to your child. Without discounts, that 20% share represents $2 million of assets. But due to restrictions (your child can’t readily sell their interest and has no control over management or distributions), a willing buyer might only pay, say, $1.4 million for that interest. Thus, a 30% discount might be applied. The IRS allows these valuation discounts as long as they are properly justified with appraisals and the FLP is not a sham. Two common types of discounts are:

Lack of Control Discount: Since limited partners can’t control partnership decisions (unlike owning assets outright, where you have full control), their minority stake is worth less. Historically, this minority interest discount might range around 10%–40%, depending on how small the interest is and the partnership’s terms.
Lack of Marketability Discount: There’s no public market for your family partnership units, and the FLP agreement often prevents selling or transferring the interest without consent. This illiquidity means an outside buyer would pay less for the interest. Lack of marketability discounts commonly range ~10%–30%.

These discounts can be combined. It’s not unusual for a professional appraisal to conclude, for example, that an FLP limited partnership interest is worth only ~60–80% of its proportional share of the underlying asset value. In practical terms, this means $10 million of assets inside an FLP might be valued at only $6–7 million for tax purposes when those interests are transferred. That lowered value directly translates to estate tax savings – because either you’ve moved assets out of your estate at a reduced gift value or the remaining FLP interests in your estate are valued less.

2. Lifetime Gifting with Lower Gift Tax Cost: An FLP enables you to gift assets to your heirs at a lower tax cost by gifting partnership interests instead of the assets outright. Every U.S. taxpayer has an annual gift tax exclusion (currently $17,000 per recipient each year in 2025) and a lifetime gift and estate tax exemption (the $13.99 million mentioned above). By using discounted values, you can transfer more underlying wealth within those limits.

Example: If you want to give part of a family business worth $2 million to your daughter, gifting a 20% FLP interest in a partnership that holds that business might be valued around $1.4 million after a 30% discount. That gift uses up $1.4M of your exemption instead of $2M. You just saved $600,000 of your lifetime exemption (or avoided a taxable gift on that amount). Repeated over several gifts or across multiple family members, these discounts let you leverage exemptions to shift substantial wealth tax-free.

Moreover, married couples can split gifts or each use annual exclusions. Through an FLP, parents could gift limited partnership units to multiple children/grandchildren each year under the annual exclusion, moving a lot of value out of the estate without even touching the lifetime exemption – and the discounts help keep those gifts under the exclusion cap. In short, FLPs let you stretch your gift-tax-free giving further. 💰

3. Estate “Freeze” – Shifting Future Growth Out: An FLP also works as an estate freeze technique. Once you’ve transferred FLP interests to your heirs (either as gifts or even sales), future appreciation on those interests accrues outside your estate. Any assets you move into the FLP and transfer as LP units will, from that point on, grow in value in your children’s hands, not yours. This freezes the value of that portion of your estate at the time of transfer. For example, if the family business or real estate in the FLP doubles in value over the next 10 years, that growth primarily benefits the limited partners (the kids). Your remaining ownership (say you kept a small GP interest) might not grow much, and if structured properly, the IRS will not include the transferred interests’ value (and growth) in your estate when you die.

In combination, these effects mean that a well-used FLP can substantially reduce the taxable estate of a high-net-worth individual. Here’s a quick breakdown of the mechanics in action:

Initial Funding: You contribute assets (let’s say $15 million of investments and property) to a newly created FLP. In return, you get 1% GP interest and 99% LP interests.
Gift of LP Interests: You gift that 99% limited partner interest to your two children (could be outright or in trust for them) using your lifetime exemption. A qualified appraiser determines that due to a ~35% combined discount, the 99% LP stake is worth only about $9.9 million for gift tax purposes (instead of $14.85 million, which is 99% of $15M). You file a gift tax return reporting a $9.9M gift, using up that much of your exemption (no tax owed since it’s under $13.99M).
Taxable Estate Reduction: Immediately, you’ve removed the $15M of assets from your estate at the cost of only $9.9M of your exemption. You effectively “saved” $5.0M of value from future estate taxation. At a 40% estate tax rate, that’s a $2 million estate tax saving down the road.
Continued Control: As the 1% general partner, you still manage those assets. The family investments can be rebalanced, property sold or acquired, etc., under your control. The children as limited partners can’t force any decisions – they’re along for the ride.
Future Growth: Suppose 10 years later those FLP assets have grown to $30M. The kids’ 99% interest grows in value too (it would be worth ~$29.7M underlying, though perhaps valued around $20M with updated discounts). Regardless, that growth happens outside your estate. Your 1% GP stake might be worth ~$300k of underlying assets (perhaps subject to some premium for control, but still a small portion). When you pass away, only that 1% and any other assets you kept are in your estate, not the $30M that’s now with the kids. By contrast, had you kept all $15M until death and it grew to $30M, your estate would owe 40% on ~$16M (assuming roughly $14M exemption in 2035 adjusted) – a huge tax bill. The FLP strategy averted most of that.

👉 Bottom line: At the federal level, an FLP’s ability to apply valuation discounts and facilitate early gifting is what reduces estate taxes. The IRS (Internal Revenue Service) does permit these savings as long as the FLP is not just a sham for tax avoidance. It’s critical that the partnership has some legitimate non-tax purpose (asset management, asset protection, succession prep, etc.) and that you, as the senior generation, respect all the formalities of the FLP. If you don’t, the IRS can and will challenge the arrangement, attempting to include the assets back in your estate or deny the discounts. (We’ll discuss IRS scrutiny and court cases on this later on.)

Before that, though, we must consider not just federal estate tax, but also how an FLP plays out with state estate or inheritance taxes, which can vary widely across the U.S.

State Estate Tax Differences: FLPs Across the U.S. 🗺️

While the federal estate tax gets most of the attention, state-level estate taxes can also hit wealthy families – often with much lower exemption thresholds than the federal tax. Here’s how FLPs interact with state death taxes, and key differences to be aware of:

States with Estate Tax: As of 2025, 12 states plus the District of Columbia impose their own estate tax. These include New York, Massachusetts, Illinois, Washington, Oregon, Minnesota, Maine, Vermont, Rhode Island, Connecticut, Maryland, Hawaii, and D.C. State estate tax exemptions range from as low as ~$1 million (Massachusetts, Oregon) up to around $5–9 million (Illinois, New York, Hawaii, etc.), far below the federal $13.99M. If you live (or own property) in one of these states, you could owe state estate tax even if you owe nothing federally. The good news: FLP valuation discounts generally apply for state estate tax calculations too. States typically start with the federal gross estate value (or similar “fair market value” concepts) of your assets. So if your FLP interests are valued at a discount for federal purposes, that same lower value will reduce your state taxable estate. Yes – an FLP can reduce state estate taxes in much the same way it does federal, by lowering appraised values.
States with Inheritance Tax: A few states (like Pennsylvania, Nebraska, Iowa, Kentucky, New Jersey, Maryland) levy an inheritance tax, which is charged to the recipients of an inheritance based on their relationship to the deceased. (For example, in PA, transfers to children are taxed ~4.5%, to siblings 12%, etc., while transfers to a spouse or charity are exempt.) An FLP doesn’t directly change the rate or who’s taxed (that depends on the heir’s relationship), but it can indirectly help avoid inheritance tax if you gift assets during life. Notably, Pennsylvania forgives inheritance tax on gifts made more than one year before death. Using an FLP to gradually give limited partnership units to your heirs before you pass can remove those assets from what the inheritance tax applies to. Essentially, it’s similar to estate tax reduction: get assets out early (at discounted values) so they’re not subject to the death transfer tax. Important: some states have “look-back” periods (e.g. one to three years) where certain gifts made shortly before death are pulled back into the taxable estate/inheritance calculation. Always check your state’s specific rules when planning FLP transfers late in life.
Gift Taxes at State Level: Nearly all states do not have a gift tax, which means you can gift your FLP interests to family free of any state-level tax at the time of the gift. (The only state with a true gift tax is Connecticut, which in 2025 has a gift tax unified with its estate tax for lifetime transfers over $12.92M.) So in most places, the only gift tax consideration is federal – your state won’t tax you for gifting pieces of your FLP. This encourages lifetime gifting strategies via the FLP to avoid the harsher state estate taxes at death.
Community Property vs Separate Property States: In community property states (like California, Texas, etc.), married couples jointly own assets acquired during marriage. Forming an FLP in those states typically involves both spouses contributing assets and then gifting to others. The mechanics of discounts and estate removal work similarly, but be mindful to maintain the community property or separate character of assets appropriately when transferring to an FLP (usually not a big issue, but it’s a legal nuance to handle with counsel).
Non-Resident Property and Intangibles: Here’s a savvy state-tax trick an FLP can assist with. Many states do not tax intangible property (stocks, partnership interests, etc.) of non-residents at death. They only tax real estate or tangible property located in the state. If you own, say, a vacation home or a rental property in a high estate-tax state where you don’t live, holding that property through an FLP or LLC can convert it into intangible personal property (a partnership interest). When you die, if you’re a non-resident, the state might not be able to tax that partnership interest, even though the partnership owns property in that state. For example, suppose you’re a Florida resident (no state estate tax) who owns an apartment building in New York (which has estate tax). If you hold the building in a family limited partnership, at your death you technically own an interest in a partnership (intangible), not the New York real estate directly. New York’s estate tax law generally does not tax intangible property of non-residents, so the NY property wouldn’t be subject to NY’s estate tax. 🗽🚫 This can save your heirs potentially hundreds of thousands in state tax. (Note: the exact treatment can vary by state and how the entity is structured; some states may have rules to prevent obvious end-runs, but this technique is commonly used in estate planning.)
State Income Tax Considerations: While not directly about estate tax, keep in mind that if you move assets into an FLP, the ongoing income (rent, dividends, etc.) will typically still be taxable to the partners according to where they reside. An FLP itself doesn’t usually create a state income tax burden beyond what the partners individually have. However, an FLP can sometimes be part of an income tax strategy (like shifting some income to family in lower-tax states or lower brackets, since an FLP can distribute income to the kids). But don’t expect major state income tax savings unless structured with complex trusts – it’s mostly an estate/gift tax play.

In summary, federal or state, FLPs operate similarly: they reduce the taxable value of your estate transfers. Just remember to consider the quirks: If you’re in a state with its own estate tax, plan FLP transfers well before death to avoid any look-back inclusion. And always adhere to both federal and state laws in operating the partnership so that the discounts and tax benefits hold up.

Next, let’s weigh the advantages and disadvantages of using an FLP for estate tax planning, because it’s not a one-size-fits-all solution.

Pros and Cons of Family Limited Partnerships 📊

FLPs can be incredibly effective, but they come with trade-offs. Here’s a side-by-side look at the benefits and drawbacks:

Pros of an FLP 😃	Cons of an FLP 😕
Significant estate & gift tax savings. Valuation discounts (often 20–40%) can dramatically lower the taxable value of assets transferred, reducing estate tax liability.	Setup and maintenance are complex. Requires legal formation, partnership agreements, appraisal costs, and ongoing administration (separate bank accounts, annual filings, etc.).
Retained control for senior family members. General partners decide how assets are managed and when distributions occur, allowing parents to keep control even after gifting ownership to kids.	IRS scrutiny risk. The IRS may challenge an FLP that looks solely like a tax-avoidance vehicle. If formalities or a legitimate purpose are lacking, authorities can ignore discounts or pull assets back into the estate.
Asset protection and succession benefits. Family assets inside an FLP are harder for creditors of an individual family member to grab (creditors may get only a charging order, not force a sale). Also helps ensure assets stay in the family across generations.	Loss of direct access to transferred assets. Once you gift limited partnership interests away, you can’t simply take that ownership back. Also, limited partners can’t easily cash out their share – the investment is illiquid.
Facilitates gradual wealth transfer. You can gift portions of the FLP over time (using annual exclusions or phased gifts) without losing control, easing the next generation into ownership and management.	Potential family conflicts. Shared ownership can lead to disagreements. If parents and children differ on management or if siblings co-own FLP interests, disputes might arise, especially once the founding generation is gone.
Centralized asset management. Consolidating assets in one partnership can streamline investment decisions, legal ownership, and bookkeeping for a large family estate. One manager (GP) handles for all.	General partner liability. The GP is personally liable for partnership debts and lawsuits. (This can be mitigated by making an LLC or corporation the GP, but that adds another entity.)

Every family’s situation is unique, so these pros and cons weigh differently in each case. For many high-net-worth families, the tax savings and control features of an FLP make the complexity worthwhile. However, if your estate is modest (well under the tax exemption limits), an FLP could be overkill – the administrative hassles might outweigh any benefit. Next, if you’re considering an FLP, you should know how to set one up correctly to reap the benefits while avoiding pitfalls.

How to Set Up a Family Limited Partnership (Step-by-Step)

Setting up an FLP requires careful planning and professional guidance. Here’s a step-by-step roadmap to creating an FLP that can stand up to IRS scrutiny and achieve your estate planning goals:

Establish Clear Purpose and Goals: Begin by outlining why you want an FLP. 🔑 Tip: Identify non-tax reasons in addition to tax savings – for instance, “to centralize management of family investments,” “protect assets from potential lawsuits against family members,” or “transition the family business to children gradually.” Having a bona fide purpose is crucial if the IRS ever asks why you formed the partnership.
Choose the Partners and Percentage Interests: Decide who will be the general partner(s) and limited partner(s). Typically, parents (or a parent) serve as GP and will initially own 100% of the partnership (both GP and LP units). Children or trusts for their benefit will be brought in as LPs when you gift or sell interests to them. You might use a management LLC or a corporation you own as the GP to shield personal liability – this entity might hold a 1% GP interest. The remaining 99% will be limited partnership units to split among the family.
Draft the Partnership Agreement and Form the Entity: Engage an experienced estate planning attorney to draft an FLP agreement. This document will set restrictions on transfer, outline management powers, distribution rules, etc. It should be tailored to support discounts (e.g. clearly restrict partners’ ability to withdraw or sell shares) and aligned with your goals (perhaps mandating that ownership stays in the family). File the necessary certificate of limited partnership with your state to legally create the FLP. At this stage, also set up bank accounts or brokerage accounts in the FLP’s name – it needs to function as a real entity.
Fund the FLP with Assets: Transfer the chosen assets into the FLP. This might mean re-titling real estate deeds into the partnership’s name, moving investment account holdings to the FLP account, assigning business interests, etc. Important: Ensure you actually transfer the assets – unfinished transfers (like saying assets are in the FLP but not changing title) can be a fatal flaw. Generally, transferring your own assets into a partnership you control is not a taxable event (no gain or loss, it’s a capital contribution). You’ll usually want to get appraisals or statements of value for any assets (especially real estate or business interests) as of the date of contribution to document the FLP’s starting value.
Transfer Limited Partnership Interests to Heirs: Now the wealth transfer happens. You can gift LP units outright to your children or to trusts for them. Alternatively, some families sell a portion of LP units to their kids or a trust in exchange for a promissory note (this is an advanced strategy to freeze value and shift growth, often paired with intentionally defective grantor trusts, but it must be done carefully with valuations). Most commonly, parents use their lifetime gift exemption or annual exclusions to give LP interests. Any time you transfer FLP interests, get a professional appraisal of those interests reflecting appropriate discounts. This appraisal will be critical evidence for the value you report to the IRS.
File Required Tax Returns and Documents: If you gifted FLP interests above the annual exclusion amount, you’ll need to file a federal gift tax return (Form 709) for that year. On the form, you’ll disclose the details of the gift and attach the appraisal report supporting the discounted value. Proper reporting helps start the clock on the IRS’s statute of limitations to challenge the gift value (generally 3 years). Also, ensure the FLP obtains an Employer Identification Number (EIN) and files annual partnership tax returns (Form 1065) as required.
Operate the FLP with Formality: After setup, treat the FLP like a real business. Hold at least annual meetings (and keep minutes). 🗂️ Keep FLP finances separate from personal finances – no mixing funds. Follow the partnership agreement’s rules on distributions and decision-making. The general partner should actually exercise control (and fiduciary responsibility) as outlined, and limited partners should behave consistent with their passive role. All major transactions (buying/selling FLP assets, making distributions, etc.) should be documented. Essentially, respect the FLP’s independence. This ongoing discipline strongly evidences that the FLP is legitimate, not just an alter ego of the parent.

Setting up an FLP isn’t a DIY project for most; you’ll likely involve attorneys, and possibly valuation experts and tax advisors at multiple steps. The upfront cost and effort are investments toward potentially huge tax savings and other benefits. However, mistakes in setup or management can undermine the whole purpose. Let’s go over some common mistakes to avoid so your FLP plan doesn’t backfire.

Common Mistakes to Avoid with FLPs ⚠️

Even well-intended FLP plans can go awry. Avoid these frequent mistakes and misconceptions that have tripped up others:

❌ “All Tax, No Substance” – Lacking a Legitimate Purpose: If your FLP exists only on paper for a tax discount, you’re asking for trouble. Setting up an FLP mere months before death, or shuffling assets into it with zero change in how they’re handled, looks suspicious. Mistake: Grandma is terminally ill, and the family attorney quickly forms an FLP weeks before she passes, just to claim discounts. The IRS (and courts) will likely deem this a sham. Avoidance: Establish your FLP well in advance and ensure it serves real purposes (asset consolidation, creditor protection, business succession, etc.). Be able to point to those reasons if questioned.
❌ Retaining Too Much Control/Benefit: An FLP can fail if the founder can’t let go at all. For example, if you transfer 99% to the kids but still treat the FLP assets like your personal piggy bank – e.g. you pay personal bills from the FLP account or live in an FLP-owned house rent-free – the IRS can argue the assets never truly left your estate. This is essentially the Section 2036 issue: if you retain possession or enjoyment of the assets or an ability to designate who can enjoy them, the tax code lets the IRS pull those assets back into your taxable estate. Avoidance: Only use FLP assets for partnership purposes. If you need to use an asset (say, live in a property), pay fair rent or compensation to the FLP. Don’t make unilateral decisions that violate the partnership agreement. Let the FLP be run as agreed (even if that means you as GP make decisions, follow the formal process).
❌ Skipping the Formal Valuation: Eyeballing a discount (“Eh, I’ll knock off 30%”) without a qualified appraisal is a big no-no. The IRS gives very little weight to self-serving valuations. Mistake: Gifting LP units to your daughter and valuing it at a nice round number with an arbitrary discount. Come audit time, you won’t have backup and could face a hefty valuation adjustment and penalties. Avoidance: Hire a credentialed business appraiser who has experience with FLP interests. Yes, it costs money, but it provides a defensible value and report that will be the first line of defense in any IRS inquiry.
❌ Ignoring State-Specific Issues: As discussed, certain states have add-back rules for gifts or treat entities differently. For instance, in New York, using a single-member LLC that’s disregarded wouldn’t avoid estate tax on real estate – NY would treat it as if you owned the real estate directly. Mistake: Not realizing your state has a one-year look-back for gifts (Pennsylvania for inheritance tax, or New York’s temporary add-back for large gifts) and making a last-minute transfer that doesn’t end up helping. Avoidance: Plan FLP transfers with knowledge of your state’s laws. Engage local estate counsel if needed to navigate state rules.
❌ Poor Drafting or Administrative Blunders: Sometimes the FLP is a good idea, but execution errors occur. Common ones: not actually retitling assets into the FLP (so legally they never left your name), failing to sign the partnership agreement or issue partnership units, or not following through with annual filings. Mistake: You form the FLP but keep the brokerage account in your own name “for convenience.” That undermines the whole structure. Avoidance: Be meticulous in funding and paperwork. Once the FLP exists, everything runs in its name. Keep records neat and separate from your personal matters.
❌ Unequal Treatment or Not Communicating to Family: If only some children are involved in the FLP or you place certain assets in it, make sure your overall estate plan is aligned. Lack of communication can cause family strife (“Why did Dad give you LP units and not me?”). Also, if a child isn’t prepared to handle being a limited partner (even a passive role) or doesn’t understand the restrictions, issues can arise. Avoidance: Discuss your plans with your family to the extent appropriate. Often, FLP interests are given in trust for children to keep control/protection until they’re older – consider that as well. Coordinate your will or living trust with the FLP (for example, if a child didn’t get FLP interests during life, you might leave them other assets or even some FLP interests at death to balance things).

By steering clear of these pitfalls, you greatly increase the chances your FLP will deliver the intended tax savings and smoothly accomplish your family’s goals. It’s wise to have your FLP reviewed periodically by your advisors, especially if laws change or if a significant life event happens (divorce, death of a partner, etc.), to ensure it’s still on track.

Example: How the Smith Family Saved Millions with an FLP 🎯

Let’s bring all the concepts together in a concrete example. Imagine John and Mary Smith, a couple in their mid-70s with a substantial estate:

They own a rental real estate portfolio and investment accounts totaling $25 million in value.
They have two adult children. The Smiths want to keep these assets in the family, eventually passing them to the kids, but also want to reduce the 40% estate tax that would apply above the exemption (federal exemption is ~$28M for them as a couple in 2025, but after 2026 it could drop to ~$14M combined, which would mean a large chunk of their estate taxed).
They also live in Massachusetts, which has a $1M state estate tax exemption – so almost their entire estate would face a Massachusetts estate tax of up to 16% as well.

Solution: They set up Smith Family LP, with an LLC they own as the 1% general partner and John and Mary initially owning 99% as limited partners. They transfer their real estate properties and investment portfolio into the FLP, properly retitling everything. Over the next few years, they gradually gift 90% of the limited partnership interests to their children (45% to each child) using a combination of annual exclusion gifts and chunks of their lifetime exemption.

A professional appraisal was done, which determined a 30% combined discount on the limited partnership units. So, each 45% interest given to a child, representing about $11.25 million of underlying assets, was valued at roughly $7.9 million for gift tax purposes. The Smiths filed gift tax returns showing they used $15.8 million of their combined lifetime exemptions to give these interests away (instead of $22.5M without discounts).
Result: John and Mary have removed $22.5M of assets from their taxable estate, essentially freezing their estate at the remaining $2.5M (plus any future growth on that part).
The immediate estate tax saving is evident if the exemption drops – with no planning, say $11M might have been taxable in 2026 (if estate stayed $25M and exemption ~$14M). With the FLP gifts, their projected estate in 2026 is just ~$2.5M (plus maybe some retained cash), which would be below the exemption, meaning zero federal estate tax. That’s a potential federal tax saving of around $4 million (40% of ~$10M that would have been taxable).
For Massachusetts estate tax, the savings are also dramatic. MA would have taxed nearly all $25M without planning (which could be roughly a $3–4M state tax bill). But assets given away are no longer in John and Mary’s Massachusetts estate. The FLP interests given to the kids are out of their estate, and Massachusetts (like many states) does not have a gift tax. However, MA does have a rule that if you die within one year of making a gift, that gift is included in the estate. The Smiths smartly started this plan early, and both lived more than a year after the last gift – so none of those gifts are pulled back into the MA estate calculation. Their remaining $2.5M estate will owe some MA estate tax, but it’s minimal compared to what $25M would incur.
Control and income: John, through the GP LLC, still manages all the properties and investments in the FLP. The kids can’t force a sale or mismanage the assets. The FLP collects rents and investment income and distributes enough to John, Mary, and the kids as needed. Since John and Mary still own 10% of the LP (after gifting 90%), they do get a share of FLP income, which helps fund their retirement needs. If they need more, they, as GP, could decide on a larger distribution (and they’ll get 10% of whatever amount is distributed, plus any management fee if the GP LLC takes one). But they can’t just dip into FLP assets at will – they treat the FLP like a business, which keeps the IRS satisfied that it’s legitimate.
Outcome for heirs: When John and Mary eventually pass, their estate consists of a small GP interest (1%) and that remaining 9–10% LP interest (plus some personal assets like a home or bank account outside the FLP). The value is likely under the federal exemption and much lower for MA tax as well. The children already own 90% of the partnership (which by then could be worth even more than $22.5M underlying due to growth). The kids will take over as both GP and LPs (or a trust for them might become GP), seamlessly continuing the management of the family assets. There’s no probate or delay for those assets, and no huge liquidations needed to pay taxes. The family business and investments carry on uninterrupted.

This example shows how a family in a taxable estate situation can use an FLP to virtually eliminate estate taxes, all while keeping control during the parents’ lifetimes. It required planning, good advice, and proper execution, but the payoff is measured in millions saved. Of course, every scenario differs – perhaps your estate isn’t as large, or your asset mix is different – but the principles remain: use discounts, use exemptions, shift value out early, keep control as needed, and follow the rules.

FLP vs. Other Estate Planning Tools 🔄

You might be wondering how an FLP compares to other common estate planning strategies. An FLP isn’t the only way to reduce estate taxes, and it’s often used in combination with trusts and other entities. Here’s a quick comparison:

FLP vs. Revocable Living Trust: A revocable trust is often used to avoid probate and manage assets, but it does not reduce estate taxes. Assets in a revocable trust are still considered owned by you (since you can revoke it anytime) and are fully included in your taxable estate. In contrast, assets you give away via an FLP (assuming you don’t retain prohibited control) are out of your estate. So, if your goal is tax reduction, an FLP is far more potent. That said, revocable trusts have their own benefits (privacy, incapacity planning). It’s common for high-net-worth individuals to use both: for instance, your will might pour into a trust, and that trust might even hold your remaining FLP interests upon your death, but during life the FLP is doing the tax work.

FLP vs. Irrevocable Trust: An irrevocable trust (for example, a grantor trust that you set up and cannot change) is another way to move assets out of your estate. You could simply gift assets into an irrevocable trust for your children. That, too, removes future appreciation and can use valuation discounts (e.g., you could put FLP units into the trust!). The main differences: transferring assets to a trust often means you lose control over them (since a trustee must manage for the beneficiaries’ benefit, and if you try to control it too much, it might be included in your estate). An FLP, on the other hand, allows you to keep control as GP. In fact, many robust estate plans use both: for example, parents set up an FLP for discounts and control, then gift the FLP limited partner units into an irrevocable dynasty trust for the kids. This way, you combine discounts with the trust’s ability to protect assets from estate tax for multiple generations (using generation-skipping tax exemption) and shield assets from the kids’ creditors or divorces. In summary, FLP vs. irrevocable trust isn’t either/or – they serve different roles and can be complementary.

FLP vs. Direct Gifting: You always have the option to just directly gift assets to your children (or others) without using an FLP. The downside is lack of control and no discount. If you give your son $5 million of stock, that uses $5M of your exemption. Give him a 99% FLP interest that owns $5M of stock, and maybe it uses only ~$3.5M of exemption (discounted) and you (via the GP) still control how that stock is managed. Direct gifts are simpler, of course – no entity to maintain – and for smaller amounts simplicity might be fine. But for large assets, the FLP’s advantages shine. Another note: direct gifting of certain assets can sometimes achieve a discount too (for example, gifting a minority interest in a closely-held business or a fractional interest in real estate can also qualify for a discount). However, an FLP lets you pool assets and structure the interests to maximize those discounts in a more flexible way.

FLP vs. Family LLC: A family LLC is very similar in concept to an FLP. In an LLC, you’d have managing members (akin to GPs) and non-managing members (akin to LPs). You can also restrict transfers and apply discounts to membership interests. Many people actually prefer the LLC form today because all members (even managing ones) have limited liability and LLCs are very flexible. From an estate tax perspective, an LLC can achieve the same valuation discounts and estate freeze benefits as an FLP if structured properly. The IRS doesn’t discriminate between partnerships vs LLCs; what matters are the control and marketability limitations on the interest being transferred. In fact, several tax court cases and IRS rulings dealing with “family limited partnerships” also apply to family LLCs. So why use an FLP at all? In some states, partnership law and decades of case precedent are well-established for FLPs in estate planning, so advisors stick to that terminology and structure. It can also be a matter of preference or specific legal features. But practically, you can think of an FLP and a family LLC as cousins – both are family entities that can produce discounts. Choose the structure that your attorney and advisers recommend for your situation (some opt for FLP with a corporate GP; others do an LLC with the parents as managing members or a separate manager LLC).

Other “Freeze” Techniques: FLPs are one tool in the estate planner’s toolkit. Others include Grantor Retained Annuity Trusts (GRATs), Qualified Personal Residence Trusts (QPRTs), installment sales to a grantor trust, charitable trusts, etc. Each has its uses. For example, a GRAT is great for temporarily shifting future appreciation to heirs with minimal gift tax, but it requires the grantor to survive the trust term to fully work. A QPRT is specifically for a house; you put a home in trust, live there for a term, then it passes to kids – it can also use a valuation discount due to the retained interest. Unlike these, an FLP is open-ended (no fixed term) and can hold all sorts of assets while allowing you to maintain control indefinitely. It also doesn’t require you to outlive a term or pay yourself an annuity. Think of an FLP as a foundational strategy – by itself, it can do a lot, and it also plays nicely with other strategies (e.g., you could put a QPRT house inside an FLP after the QPRT ends, or you could roll a GRAT payout into an FLP, etc.). The right mix depends on your needs, but establishing an FLP early gives you a flexible platform for many advanced planning moves.

In short, an FLP is often better than a trust for purely reducing estate value (thanks to discounts and retained control), but it’s usually used alongside trusts to harness the strengths of each. And compared to doing nothing or simple gifting, an FLP provides more control and leverage. Just be mindful that the IRS is aware of these tactics, which brings us to our next topic: how FLPs have fared under IRS and court scrutiny. 👀

IRS Scrutiny and Key Court Rulings on FLPs 🚨

FLPs have been around for decades, and naturally the IRS has challenged abusive cases to prevent people from abusing the tax benefits. The legal landscape today is shaped by numerous court decisions that draw lines between legitimate FLP planning and sham transactions. Here’s a brief recap of the major points from IRS enforcement and courts:

IRS’s Stance: The IRS does not oppose FLPs outright – but they closely examine them. The agency’s main weapon is Section 2036 of the Internal Revenue Code, which basically says if you transfer assets but retain an interest or ability to control the enjoyment of the assets, those assets can be included back in your estate. In FLP audits, the IRS often argues that despite the formal transfer to a partnership, the deceased person effectively kept the economic benefit or control of the assets (e.g., they used FLP funds for personal expenses, or the timing and manner of formation suggest it was just to avoid tax). If the IRS wins on a 2036 claim, the result is no discount at all – the full value of the underlying assets goes back in the estate. Additionally, the IRS can challenge the size of the discount used, arguing the appraisal was too aggressive. They might accept a discount but at a lower percentage.

Over the years, the IRS even tried to tighten the rules. In 2016, proposed regulations under Section 2704 sought to limit certain valuation discounts for family-controlled entities, which could have greatly curbed FLP discounts. There was a huge backlash from the estate planning community, and those regulations were withdrawn in 2017. As of 2025, there’s no specific regulation disallowing FLP discounts – each case is facts and circumstances.

Court Rulings: Courts have delivered a mix of outcomes, some favoring the IRS and some the taxpayer. The key theme is “business purpose and actual change in behavior”. Let’s highlight a couple landmark cases:

Estate of Strangi (2003): Mr. Strangi contributed most of his assets to an FLP shortly before he died, retaining a small GP interest but also effectively benefiting from the assets after the transfer. The Tax Court (and later an appellate court) agreed with the IRS that under Section 2036, the assets should be included in his estate. They saw that the FLP lacked a non-tax reason and that Mr. Strangi (through his son-in-law acting as GP) still had enjoyment of the assets (the FLP paid some of his expenses, etc.). Lesson: Last-minute deathbed FLPs or ones where the senior retains too much benefit won’t hold up.
Estate of Bongard (2005): This case provided a clearer framework. The court ruled that for an FLP transfer to avoid 2036 (i.e., not be pulled back into the estate), it must be a bona fide sale for full consideration and not a mere device for tax avoidance. Bongard involved a business purpose – the FLP was used to consolidate family business interests ahead of a possible liquidity event. The court partially allowed discounts on some transfers where a genuine investment reason existed, but disallowed on others that lacked substance. Lesson: If you can show a legitimate motive (asset protection, centralizing management, etc.) and that you received partnership interests proportionate to what you contributed (so it’s a real pooling of assets, not just a gift to kids in disguise), you’re in a stronger position.
Estate of Kelly (2012): An example where the taxpayers won. The court upheld significant discounts for an FLP that was formed not just for tax reasons but also to protect family assets from potential lawsuits and to allow centralized management. The family observed all formalities, and the senior member didn’t commingle personal funds. The IRS’s 2036 argument failed here because the decedent did not retain enjoyment or control beyond the rights any GP had as per the agreement. Lesson: Properly run FLPs with economic substance can withstand IRS attack.
Estate of Powell (2017): A more recent Tax Court case with a cautionary outcome. Mrs. Powell’s sons formed an FLP when she was incapacitated, essentially moving her assets in and giving her a 99% LP interest and a nominal GP interest (held by one son). She died shortly after. The court not only applied 2036 (no bona fide sale, as she clearly didn’t personally partake in a meaningful non-tax transaction), but also a subsection 2036(a)(2) argument – that as an LP, in conjunction with the other partners, she could have agreed to dissolve the partnership, meaning she retained a kind of control to designate who got the property. The court included the FLP assets at full value in her estate, with no discount. This case was a wake-up call because it suggested even just being an LP with certain state law rights (the right to agree to dissolve) could trigger estate inclusion if there’s no countervailing purpose. Lesson: Don’t form an FLP when death is imminent; and if you do, consider relinquishing even the LP interest to an irrevocable trust or something so the decedent truly has no rights. Better yet, plan far ahead, and consider limits in the partnership agreement on certain rights.

In summary, courts have shown that form over substance won’t fly. To safely get the tax benefits: set up the FLP early, have legitimate reasons, adhere to all partnership formalities, and don’t keep secret strings that indicate you still treat the assets as yours.

The IRS has lost cases too when taxpayers did it right, so FLPs are not illegal or inherently abusive. They just require diligence. As an aside, Congress and the IRS periodically consider changes to valuation discount rules, especially as the large federal exemption might drop in 2026 and more estates become taxable. As of now, FLP discounts are alive and well. But it’s wise to keep an eye on tax law updates – a future law could potentially restrict discounts (for example, disallowing discounts on interests in entities that just hold passive assets). Engaging knowledgeable advisors is key, since they’ll be up-to-date on any such developments.

Closing Thoughts: A Family Limited Partnership can indeed reduce estate taxes significantly, but its success depends on proper planning and execution. Use it as a tool to not only save taxes, but also to achieve meaningful family financial goals. When done right, an FLP can help preserve your legacy for future generations, cutting the IRS’s share and keeping more wealth in the family. Below, we address some frequently asked questions that often come up about FLPs and estate tax planning:

FAQ: Family Limited Partnerships & Estate Tax Planning

Can a family limited partnership avoid estate taxes entirely? No. An FLP can reduce estate taxes by lowering asset values and moving wealth out of your estate, but it cannot completely eliminate estate tax if your estate remains above exemption limits.
Are FLP valuation discounts allowed by the IRS? Yes. The IRS permits valuation discounts for FLP interests (for lack of control and marketability) as long as they are legitimate and backed by a professional appraisal. Proper documentation is critical.
Should I use an FLP if my estate is below the tax exemption? No. If your total estate is comfortably under federal (and state) estate tax thresholds, an FLP primarily for tax reasons isn’t necessary. It could add complexity without significant tax benefit in that case.
Can I still control my assets if I use an FLP? Yes. By being the general partner, you maintain management control over the FLP’s assets even after gifting limited partnership interests to family. Just avoid retaining total control that negates the transfer.
Does a family limited partnership help protect assets from creditors? Yes. An FLP provides some asset protection. Creditors of a limited partner cannot seize FLP assets directly; they typically only get a charging order (right to distributions). This can deter lawsuits, though it’s a side benefit to the tax strategy.
Is a family limited partnership better than a trust for reducing estate tax? Yes. For pure estate tax reduction, an FLP often yields greater discounts and lets you retain control. Trusts offer other benefits (like probate avoidance and asset protection), and many plans use both in tandem.
Can a family LLC give the same estate tax benefits as an FLP? Yes. A family LLC can be structured similarly to an FLP and typically achieves the same valuation discounts and estate tax benefits. What matters is the lack of control/marketability of the interest, not the specific entity type.
Do FLPs also reduce state estate taxes? Yes. In states with an estate tax, an FLP’s discounts and ability to transfer assets out of your estate apply to the state’s calculations as well. Additionally, non-residents holding in-state property via an FLP may avoid that state’s estate tax on those assets.