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Family Limited Partnerships (FLP): The “30% Discount” Estate & Protection Vault
Family Limited Partnerships (FLP): The “30% Discount” Estate & Protection Vault
โ ๏ธ STRATEGY DECLARATION
This strategy is widely accepted in professional practice, but its success depends entirely on establishing a bona fide “Non-Tax Business Purpose.” If the FLP is treated as a personal checking account or set up merely to recycle marketable securities on a deathbed, the IRS will disregard the entity and tax the full value of assets.
This strategy is widely accepted in professional practice, but its success depends entirely on establishing a bona fide “Non-Tax Business Purpose.” If the FLP is treated as a personal checking account or set up merely to recycle marketable securities on a deathbed, the IRS will disregard the entity and tax the full value of assets.
* Note: This is an L3 ($10M+) entity framework.
Core Definition: “An FLP is a partnership where family members pool assets. Parents (GPs) retain 1% control, while children (LPs) receive 99% economic interest. Because LPs have no vote and cannot sell their shares, the value of their gift is discounted for tax purposes.”
* Warning: Do not transfer your personal residence into an FLP if you live in it. Use a QPRT (#570) instead.
Core Definition: “An FLP is a partnership where family members pool assets. Parents (GPs) retain 1% control, while children (LPs) receive 99% economic interest. Because LPs have no vote and cannot sell their shares, the value of their gift is discounted for tax purposes.”
* Warning: Do not transfer your personal residence into an FLP if you live in it. Use a QPRT (#570) instead.
๐ WHO THIS IS FOR (Prerequisites)
- Required Profile: Families holding significant illiquid assets (Real Estate Portfolios, Operating Businesses) or large diversified portfolios seeking centralized management.
- Primary Objective: Valuation Discounting (Paying Gift Tax on $70 for every $100 transferred) + Asset Protection (Creditor shielding).
- Disqualifying Factor: Transferring nearly 100% of personal assets (leaving no money to live on), forcing distributions from the FLP for personal bills (Implied Agreement).
โ ๏ธ STRATEGY ELIGIBILITY CHECK
This strategy works only if the entity is respected as a legitimate business enterprise. It fails if:
- โ๏ธ IRC 2036(a) Trap: If the parent (General Partner) retains the right to determine who gets distributions and when, without fiduciary constraints, the IRS argues the assets never left the parent’s estate. (See Estate of Powell).
- โ๏ธ Commingling Funds: Paying for your daughter’s wedding or your grocery bill directly from the FLP account pierces the corporate veil immediately.
- โ๏ธ Valid Appraisal: The “Discount” (e.g., 30%) is not a fixed number. It must be determined by a “Qualified Appraiser” citing Lack of Control (DLOC) and Lack of Marketability (DLOM).
EXECUTIVE SUMMARY
- The Premise: You own a $20M Apartment Complex. You want to give 50% ($10M) to your kids. A direct deed transfer triggers Gift Tax on the full $10M.
- The Structure: You move the building into an FLP. You keep 1% GP (Control). You give 99% LP units to kids (or trusts).
- The Mechanism: The LP units have no voting rights and cannot be sold to outsiders. A buyer would not pay $10M for that. They might pay $7M.
- The Result: The IRS accepts the “Fair Market Value” of the LP units as $7M. You saved Gift Tax on $3M of “Phantom Value.” Plus, creditors cannot seize the building; they only get a Charging Order.
“Control is separate from Ownership.” The FLP allows parents to give away the equity (ownership) while keeping the steering wheel (control), all while shrinking the tax bill. Source: American Bar Association (ABA) / IRS Revenue Ruling 93-12
๐ MODEL METHODOLOGY & ASSUMPTIONS
- Asset: $10,000,000 Commercial Real Estate.
- Action: Transfer 99% Limited Partner Interests to Kids.
- Discount Rate: 30% (Combined DLOC + DLOM).
- Tax Rate: 40% (Federal Estate/Gift Tax).
Performance Simulation (The Disappearing Tax Base)
| Metric | Direct Gift (Deed Transfer) | FLP Unit Transfer (Discounted) | Delta (Wealth Shift) |
|---|---|---|---|
| Underlying Asset Value | $10,000,000 | $10,000,000 | – |
| IRS Taxable Value | $10,000,000 | $7,000,000 | $3M Vanishes |
| Exemption Used | ($10,000,000) | ($7,000,000) | Save $3M Exemption |
| Potential Tax Savings (40%) | $0 | $1,200,000 | Instant Tax Equity |
| Control of Asset | Lost (Kids own it) | Retained (Parent is GP) | Governance Win |
*Chart Note: The $3M reduction in taxable value is permanent. If the asset appreciates to $20M later, that growth occurs outside the estate. The “Discount” creates a leverage effect on the Lifetime Exemption.
Advanced Mechanics: The “Charging Order” Protection
*Why creditors hate suing FLP owners.
| Scenario | Outcome | Why it works (The Poison Pill) |
|---|---|---|
| Direct Ownership | Creditor wins lawsuit -> Seizes the building -> Sells it -> Takes cash. | Total Loss. |
| FLP Ownership | Creditor wins lawsuit -> Court issues Charging Order on LP units. | The Creditor gets the right to distributions, but cannot force a sale. Poison Pill: The GP (Parent) decides NOT to distribute cash. The Creditor receives a K-1 tax bill for the profit (phantom income) but gets $0 cash to pay the tax. Creditors usually settle for pennies. |
Strategic Mechanics: “Step Transaction” Risk
Funding Timing is Critical:
- The Mistake: You form the FLP on Monday, fund it on Tuesday, and gift the LP units to kids on Wednesday.
- The IRS View: “This is a pre-packaged gift disguised as a partnership.” They collapse the steps and deny the discount.
- The Fix: Fund the FLP. Wait (“Season”) for at least 3-6 months. Allow the assets to operate inside the entity. Then gift the units.
โ BOUNDARY CLAUSE: Operational Limits
- Investment Company Rules (Section 721): If you contribute only diversified marketable securities (stocks/bonds) to an FLP, you might trigger immediate capital gains tax upon contribution unless carefully structured to avoid “Investment Company” status.
- Deathbed Transfers: Creating an FLP while the grantor is in hospice care is almost always challenged successfully by the IRS. (See Estate of Strangi).
๐ค DECISION BRANCH (Logic Tree)
IF Asset = Personal Residence / Vacation Home:
โข Input: Personal use asset.
โข Output: Use QPRT (#570). FLPs are for business/investment assets, not personal enjoyment.
IF Asset = Commercial RE / Operating Biz:
โข Input: Income generating, professional management needed.
โข Output: Execute FLP. Establish GP/LP structure, appraise discounts, and begin gifting LP units.
“The FLP is the fortress. The discount is the moat.” Without a business purpose, the fortress is made of paper.
Disclaimer: This content is for educational purposes only. FLP discounts are high-audit items. Valuation must be performed by a qualified independent appraiser. “Implied Agreement” (using FLP funds for personal use) is the #1 reason FLPs fail in court. Consult an Estate Planning Attorney specializing in entity formation.