Family Limited Partnerships: Gifting, Valuation Discounting and Asset Protection

What Is a Family Limited Partnership?

A family limited partnership (FLP) is a limited partnership in which the partners are members of the same family. The partnership holds family assets — real estate, investment portfolios, business interests, or a combination — and the family members hold partnership interests rather than direct interests in the underlying assets.

The FLP has two classes of partners:

• General partner (GP): Manages the partnership, makes investment decisions, controls distributions, and has unlimited personal liability for partnership obligations. The GP interest is typically 1-2% of the total partnership.
• Limited partners (LPs): Passive investors who have no management authority and whose liability is limited to their capital contribution. LP interests constitute 98-99% of the partnership.

The senior generation (parents) typically acts as the GP (or controls a corporate GP), retaining full management authority. LP interests are gifted or sold to the younger generation, transferring economic value while preserving control.

Valuation Discounts: The Core Tax Benefit

The primary tax advantage of an FLP is the ability to transfer wealth at a discounted value. When LP interests are gifted, their fair market value is less than the proportionate share of the underlying assets because LP interests carry inherent limitations:

Lack of Marketability Discount

LP interests in a family partnership cannot be sold on a public exchange. There is no ready market, and finding a buyer requires significant effort, time, and transaction costs. Courts and the IRS have accepted discounts for lack of marketability (DLOM) in the range of 15-35%.

Lack of Control Discount

Limited partners cannot manage the partnership, compel distributions, or liquidate assets. This lack of control reduces the value of the LP interest relative to the underlying assets. Discounts for lack of control (DLOC) typically range from 10-25%.

Combined Discount

The combined discount (DLOM plus DLOC) on gifted LP interests typically ranges from 25-40%. This means a GP transferring USD 10 million of underlying assets via LP interests may report the gift as having a value of only USD 6-7.5 million for gift tax purposes.

Example: A parent establishes an FLP with USD 20 million of marketable securities. The parent gifts a 49% LP interest to children. The proportionate share of assets is USD 9.8 million. After a combined 35% discount, the gift tax value is approximately USD 6.37 million — well within the lifetime gift tax exemption of USD 13.99 million (2025).

Legal Framework

US Domestic FLPs

FLPs are typically formed under the Revised Uniform Limited Partnership Act (RULPA) or its successor, the Uniform Limited Partnership Act (2001), as adopted by the state of formation. Delaware, Nevada, and Wyoming are popular choices due to their flexible partnership statutes and favourable asset protection provisions.

The Delaware Revised Uniform Limited Partnership Act (6 Del. C. sections 17-101 to 17-1111) provides:

• Freedom of contract in the partnership agreement
• Charging order as the exclusive remedy for a judgment creditor of a limited partner
• Ability to restrict transfer of partnership interests
• Series provisions allowing segregation of assets within a single partnership

Offshore FLPs

For families with international assets or non-US members, offshore limited partnerships provide additional advantages:

• Cayman Islands Exempted Limited Partnership (ELP): Governed by the Exempted Limited Partnership Law (2021 Revision). No Cayman tax on partnership income. Widely used for fund structures.
• BVI Limited Partnership: Governed by the Limited Partnership Act, 2017. No BVI tax. Flexible formation and administration.
• Jersey Limited Partnership: Governed by the Limited Partnerships (Jersey) Law 1994. Well-regulated jurisdiction with strong judicial infrastructure.

Asset Protection Through the Charging Order

The most significant asset protection feature of an FLP is the "charging order" remedy. In most US states and offshore jurisdictions, a judgment creditor of an individual partner cannot seize partnership assets or compel a distribution. The creditor's exclusive remedy is a charging order, which:

• Entitles the creditor to receive distributions that would otherwise be made to the debtor-partner
• Does not give the creditor the right to participate in management, vote, or compel a distribution
• Does not transfer the debtor-partner's interest — only the right to receive distributions

If the GP decides not to make distributions, the creditor receives nothing. Meanwhile, under IRC section 702, the creditor may be liable for income tax on the partnership's allocable income — even though no cash is distributed. This "phantom income" problem makes the charging order an unattractive remedy for creditors and provides significant leverage in settlement negotiations.

IRS Challenges to FLPs

The IRS has challenged FLP valuation discounts aggressively, particularly where the FLP lacks a legitimate non-tax business purpose. Key cases include:

Estate of Strangi v Commissioner (T.C. 2003)

The Tax Court disregarded an FLP formed by a decedent shortly before death, finding that the partnership assets were includable in the estate under IRC section 2036(a) because the decedent retained the right to enjoy the property through distributions.

Estate of Powell v Commissioner (T.C. 2021)

The Tax Court applied section 2036(a)(2) to include FLP assets in the decedent's estate because the decedent, as GP, retained the right to designate who would enjoy the partnership income through distribution decisions.

Estate of Mirowski v Commissioner (T.C. 2008)

The Tax Court allowed valuation discounts where the FLP served legitimate non-tax purposes, including consolidated investment management, creditor protection, and education of the next generation in wealth management.

Best Practices to Survive IRS Scrutiny

• Document legitimate business purposes: Consolidated investment management, asset protection, family governance, and education of younger family members
• Maintain partnership formalities: Annual meetings, written minutes, separate bank accounts, formal partnership accounting
• Avoid deathbed transfers: FLPs established shortly before the transferor's death are vulnerable to section 2036 challenges
• Do not commingle personal and partnership assets: The GP must not use partnership assets to pay personal expenses
• Obtain a qualified appraisal: An independent, qualified appraiser must determine the fair market value of the LP interests
• Retain sufficient personal assets: The transferor must not transfer substantially all assets to the FLP

Gifting Strategy

A typical FLP gifting programme operates over multiple years:

1. Year 1: Form the FLP and fund it with assets. The senior generation holds 100% (1-2% GP + 98-99% LP).
2. Years 2-5: Gift LP interests to the next generation, using the annual gift tax exclusion (USD 19,000 per donee in 2025) and a portion of the lifetime exemption.
3. Ongoing: The GP makes distributions as appropriate for partnership expenses and tax obligations. The senior generation retains control through the GP interest.
4. At death: Only the GP interest (1-2% of partnership value) is included in the senior generation's estate.

For families with assets exceeding the estate tax exemption, this strategy can save tens of millions in estate tax.

Offshore FLP Planning for International Families

For non-US families using offshore FLPs:

• No US gift or estate tax applies to transfers between non-US persons (unless the partnership holds US-situs assets)
• The offshore partnership provides a consolidation vehicle for assets in multiple jurisdictions
• Charging order protection varies by jurisdiction — Cayman and BVI provide strong protection
• CRS reporting applies to the partnership if it holds financial assets as a financial institution or is classified as a passive non-financial entity

Key Takeaways

• FLPs allow the senior generation to transfer economic value to the next generation at a 25-40% discount while retaining full management control
• Valuation discounts are based on lack of marketability and lack of control inherent in LP interests
• The charging order remedy provides significant asset protection by limiting creditors to distributions that the GP chooses to make
• The IRS scrutinises FLPs aggressively — legitimate business purposes, formalities, and qualified appraisals are essential
• Offshore FLPs provide additional benefits for international families, including tax neutrality and multi-jurisdictional asset consolidation
• FLP planning must be implemented well in advance of any anticipated estate tax event or creditor claim