Family Limited Partnerships (FLP): The “Valuation Discount” Estate Fortress
Family Limited Partnerships (FLP): The “Valuation Discount” Estate Fortress
๐ WHO THIS IS FOR (Prerequisites)
- Required Profile: Families holding significant illiquid assets (Real Estate, Family Business, Private Equity) who wish to transfer wealth to the next generation while retaining control.
- Primary Objective: Estate Tax Reduction (Leveraging “Discounts” to transfer more wealth using less Lifetime Exemption).
- Disqualifying Factor: Families with only marketable securities (harder to justify discounts) or those who treat entity assets as a personal checking account (Section 2036 risk).
โ ๏ธ STRATEGY ELIGIBILITY CHECK
The FLP separates “Economic Value” from “Control.” You give away the value (LP interests) but keep the steering wheel (GP interest).
- โ๏ธ Asset Type: Works best with Real Estate, Operating Businesses, or Private Equity. Pure Cash/Stock FLPs attract higher audit risk.
- โ๏ธ Valuation Appraisal: Requires a “Qualified Appraisal” to determine the Discount for Lack of Marketability (DLOM) and Lack of Control (DLOC).
- โ๏ธ Structure: Parents typically own 1% GP (General Partner) interest (Control) and 99% LP (Limited Partner) interest (Equity) initially.
- โ๏ธ Timing: Form the entity first, fund it, wait (“seasoning”), then gift the LP shares. Rushing this sequence triggers the “Step Transaction Doctrine.”
EXECUTIVE SUMMARY
- The Premise: You want to give $10M of Apartment Buildings to your children. If you give the deed directly, the IRS values the gift at $10M.
- The Edge: You put the buildings in an FLP. You give your children 99% “Limited Partner” interests. Because they cannot sell these interests (illiquid) and cannot manage the property (no control), the market values them lower.
- The Result: Appraisers typically apply a 30-40% Discount. The IRS views the $10M gift as a $6M gift. You save $4M of your Lifetime Exemption.
- Control: You retain the 1% General Partner interest, meaning you still decide when to sell, refinance, or distribute cash.
In high-stakes estate planning, Fair Market Value is not a fixed number. By altering the legal wrapper (FLP), you legally alter the value for tax purposes. Source: American Bar Association (Real Property/Trusts)
- Asset: $20M Commercial Real Estate Portfolio.
- Objective: Transfer to Children (Trusts).
- Strategy: Direct Gift vs. FLP Gift (35% Blended Discount).
- Estate Tax Rate: 40% (Federal).
Performance Simulation (The Discount Arbitrage)
| Metric | Direct Gift (Deed Transfer) | FLP Gift (LP Interests) | Delta (Alpha) |
|---|---|---|---|
| Net Asset Value (NAV) | $20,000,000 | $20,000,000 | – |
| Valuation Discount | 0% | -35% (DLOC/DLOM) | Discounts applied |
| Taxable Gift Value | $20,000,000 | $13,000,000 | -$7.0 Million |
| Lifetime Exemption Used | ($20,000,000) | ($13,000,000) | Preserve Exemption |
| Potential Estate Tax Savings | $0 | $2,800,000 (40% of $7M) | +$2.8M Wealth |
*Chart Note: The “Alpha” here is purely actuarial. The underlying assets are identical, but the FLP structure allows $7M of value to vanish from the IRS’s radar, saving $2.8M in eventual taxes.
Advanced Mechanics: Asset Protection (Charging Orders)
*Why FLPs scare off creditors.
| Scenario | Without FLP | With FLP |
|---|---|---|
| The Lawsuit | Your child gets sued for $5M (Car accident/Divorce). | Your child gets sued. They own LP interests, not the assets. |
| The Seizure | Court orders seizure of the child’s bank account/property. Assets lost. | Court issues a “Charging Order.” Creditor gets rights to distributions, but cannot force a distribution. |
| The “Poison Pill” | N/A | The GP (You) stops distributions. The Creditor gets $0 cash but still gets the K-1 tax bill (Phantom Income). Creditor usually settles for pennies. |
Maximizing the Discount:
- Lack of Marketability (DLOM): “I can’t sell this LP interest on the NYSE.” (Typically 15-25% discount).
- Lack of Control (DLOC): “I can’t force the GP to sell the building.” (Typically 10-15% discount).
- Total Discount: These are multiplicative, not additive, but often result in a 30-40% reduction in taxable value for Real Estate entities.
โ BOUNDARY CLAUSE: Structural Limitations
- Section 2036 (The Death Star): If you form an FLP but continue to use the bank account to pay for your groceries, vacations, or personal bills, the IRS will argue there was an “Implied Agreement” to retain enjoyment. The FLP is ignored, and assets are pulled back into your taxable estate.
- Investment Company Rules: If the FLP holds >80% in marketable securities (Stocks/Bonds), you may trigger immediate gain recognition upon contribution unless diversified properly.
๐ค DECISION BRANCH (Logic Tree)
IF Assets = $50M Real Estate Empire:
โข Input: High value, easy to manage centrally.
โข Output: Mandatory FLP. Centralize management, protect from heirs’ divorces, and discount the gift value.
IF Assets = $5M Brokerage Account:
โข Input: Liquid, easy to divide.
โข Output: Skip FLP. The administrative cost ($15k setup + annual tax returns) and lower allowable discounts make it inefficient. Use a simple Trust instead.
An FLP is like a family vault. You hold the key (GP), and your children hold the receipt (LP). They own the value, but you own the destiny.