What Has the IRS Said About Family Limited Partnerships?

A Family Limited Partnership (FLP) is a business entity where family members transfer assets in exchange for ownership. Senior members often act as general partners with management control, while heirs receive limited partnership interests. This structure helps centralize management of family assets and can offer protection from creditors. A primary use for FLPs is estate planning. When senior members gift limited partnership interests, the value of these gifts may be discounted for lack of control and marketability. This allows more wealth to be transferred without triggering gift or estate taxes, which is why the Internal Revenue Service (IRS) subjects these arrangements to scrutiny.

The IRS’s Primary Concerns with FLPs

The IRS’s foundational concern with FLPs is their legitimacy. The agency often contends that many are created solely to generate valuation discounts and reduce taxes, rather than for a genuine business purpose. To withstand an IRS challenge, the partnership must have been formed for a “legitimate and significant nontax reason.”

Several operational red flags attract IRS attention. One of the most significant is the transfer of personal-use assets, such as a family’s primary residence, into the partnership. If the family continues to live in the home without paying fair market rent to the FLP, the IRS views this as evidence that nothing has truly changed and the original owner has retained the benefit of the property.

Another point of scrutiny is the commingling of funds, where personal and partnership expenses are paid from the same account. This behavior suggests that the partners do not respect the FLP as a separate legal entity. The IRS looks for strict separation between personal assets and those belonging to the partnership.

The circumstances surrounding the FLP’s formation are also examined. An FLP created when the senior family member is elderly or in poor health is often viewed as a “deathbed” transaction. Similarly, if the founder transfers nearly all personal assets into the FLP, leaving insufficient funds for living expenses, the IRS will argue an implicit agreement existed for the partnership to cover personal needs, negating the transfer’s validity.

Key IRS Arguments and Code Sections Invoked

When the IRS challenges an FLP, it relies on specific sections of the Internal Revenue Code. A primary tool is Section 2036, which addresses transfers with a retained life estate. This allows the IRS to include the full, undiscounted value of transferred assets back into a senior member’s taxable estate if it finds the individual retained the possession, enjoyment, or right to income from the property. This is often called the “retained enjoyment” argument. For example, transferring a family vacation home to an FLP but continuing to use it rent-free constitutes retained enjoyment. The section is also invoked if the general partner retains sole discretion over partnership distributions, effectively controlling the economic benefits of other partners.

Another argument is found in Section 2703, which concerns the valuation of assets. The IRS uses this to disregard restrictions on the sale or use of partnership interests if it believes these limitations are not commercially reasonable. If partnership agreement restrictions are more prohibitive than what unrelated business partners would agree to, the IRS can claim they were created artificially to depress the value of the partnership interests.

The agency also utilizes Section 2704 to attack valuation discounts related to “lapsing rights” and other restrictions. This section targets “applicable restrictions,” which are limitations on the ability to liquidate the partnership that are more restrictive than the default laws of the state where it is formed. If a family can remove such a restriction, the IRS is empowered to disregard it for valuation purposes.

Factors That Strengthen an FLP Against IRS Challenges

A well-structured FLP must be operated with diligence and respect for its status as a separate legal entity. The most fundamental defense is the establishment and documentation of a legitimate, significant nontax purpose. This could include the centralized management of a diverse investment portfolio, pooling family capital for new ventures, or providing for the orderly succession of a family business. Documenting these goals in meeting minutes is an important step.

Adherence to partnership formalities is a direct countermeasure to an IRS challenge. This means maintaining completely separate bank accounts for the FLP and its partners, ensuring no commingling of funds occurs. The partnership should hold regular meetings with formal minutes kept to document business decisions and distribution policies. If a partner uses a partnership asset, they must pay fair market rent or lease payments to the FLP.

The nature of the partnership’s activities also contributes to its legitimacy. An FLP that actively manages its assets—for example, by running a business or actively trading a securities portfolio—presents a much stronger case than one that merely holds passive assets. Active management demonstrates a genuine business purpose.

The structure of the partnership itself can bolster its defense. When limited partners contribute their own assets to the FLP, it helps characterize the entity as a true joint enterprise rather than a vehicle for a single individual’s estate plan. This shows that other family members have a vested interest and have pooled their resources for a common business goal.

Reporting and Valuation Requirements

The procedural aspects of forming and gifting interests in an FLP are as important as its structure. A “qualified appraisal” is required to determine the fair market value of the partnership interests being transferred. The appraisal must be conducted by an independent, qualified appraiser who meets specific IRS standards. The appraiser must provide a detailed report explaining the methodology used, which is attached to the tax filing to substantiate any valuation discounts claimed.

When a gift of a partnership interest is made, the donor is generally required to file a federal gift tax return, Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. This filing is required for gifts exceeding the annual exclusion amount, which is $19,000 for 2025.

Filing Form 709 begins the three-year statute of limitations, the period during which the IRS can challenge the valuation of the gift. If a gift tax return is not filed, or if the gift is not “adequately disclosed” on the return, the statute of limitations never begins to run. This means the IRS can question the valuation of that gift at any point in the future, such as during an audit of the donor’s estate. Adequate disclosure requires providing detailed information about the transfer, including the qualified appraisal.