Using Family Limited Partnerships in Estate Plans

What are Family Limited Partnerships and how can they enhance estate planning?

A Family Limited Partnership (FLP) is a common estate-planning entity families use to consolidate ownership of family assets, preserve centralized management, and transfer wealth across generations in a controlled way. Properly structured, an FLP can help with estate-tax planning, business succession, and limited creditor protection. However, they are not a one-size-fits-all solution: state laws, IRS scrutiny, and family dynamics all affect whether an FLP will accomplish your objectives.

This article explains how FLPs work, the practical steps to implement one, pros and cons based on real-world experience, and how to avoid common pitfalls. It is educational in nature; consult an estate attorney and tax advisor for tailored advice.

Sources cited in-line include the IRS (partnership filing and gift/estate tax rules) and consumer-facing resources for selecting advisors (Consumer Financial Protection Bureau). For related estate-planning tools, see our pieces on Estate Planning for Small Business Owners: Keeping the Business Running and Estate Planning: Funding Your Estate Plan — Practical Steps.

Background and brief history

FLPs became widely used in the late 20th century as families sought a flexible structure to hold concentrated assets—real estate, family businesses, and investment portfolios—while transferring interests to heirs over time. The structure leverages partnership law to separate management (general partners) from passive ownership (limited partners).

Over the decades, the IRS has closely examined transactions involving FLPs to ensure they reflect genuine business purpose and economic substance rather than solely tax avoidance. Courts and IRS guidance have emphasized that valuation discounts and transfers must be defensible and that ordinary business and partnership formalities must be observed (IRS guidance on partnerships and transfer transactions).

How an FLP works: roles, ownership, and transfers

Basic structure:

• General partner(s) (GPs): Typically one or more senior family members. GPs control management, make investments, and have fiduciary duties to the partnership. In many FLPs the GPs hold a small percentage of the capital but retain control through partnership agreements.
• Limited partners (LPs): Typically children and more junior family members. LPs own partnership interests but do not participate in day-to-day management.

Common steps when using an FLP in estate planning:

1. Transfer assets into the FLP. Family members contribute property (real estate, securities, business interests) to the partnership in exchange for partnership interests.
2. Retain control through GP interests. Founders keep GP units to manage assets and make distribution decisions.
3. Make gifts of LP interests to heirs. Over time, founders gift limited partnership interests to children or trusts, often using annual gift-tax exclusions and/or portions of lifetime gift-tax exemption.
4. Apply valuation discounts. LP interests may be worth less than pro rata shares of the underlying assets because they are minority, non-managing, and not readily marketable. Those valuation reductions can reduce taxable gift and estate values—but they are closely scrutinized by the IRS and must be supported by credible appraisals.
5. File partnership tax returns. A domestic FLP treated as a partnership must file Form 1065 annually and issue Schedule K-1s to partners (IRS, Form 1065 instructions).

When FLPs are most useful

FLPs are a fit when you need to combine these goals:

• Concentrated family assets that will be transferred over time (real estate, private business, a securities portfolio).
• A desire to centralize management while distributing economic benefits.
• Legitimate creditor-protection needs—holding assets in a partnership can add a layer of protection for partnership equity, though it is not a full shield against creditors or aggressive litigation.
• Estate- and gift-tax planning where valuation discounts are realistic and defensible.

They are not typically appropriate for small, liquid holdings where the costs and complexity outweigh the benefits.

Tax and legal considerations (what to watch for)

• Gift and estate tax rules: Gifts of limited partnership interests reduce your taxable estate, but the transfer is reported on gift-tax returns when required. Lifetime exemptions and annual exclusions affect how much you can transfer tax-free; those thresholds change over time—confirm current limits with your advisor and the IRS (IRS, Gift Tax and Estate Tax pages).

• Valuation and IRS scrutiny: The IRS examines valuation discounts for lack of control and marketability. Documentation is essential—use independent, qualified appraisals, and maintain a clear business purpose for the FLP. Courts will look at substance over form; if the limited partners retain too many rights or the partnership does not observe formalities, discounts and tax benefits can be denied.

• Partnership audits and tax reporting: FLPs file Form 1065 as partnerships and report partnership income and allocations to partners (Form 1065 instructions). Partnership audits can raise issues about whether distributions or transfers were disguised gifts or compensation.

• State law differences: Partnership law varies by state. Some states have strong asset protection features; others do not. Select the partnership’s jurisdiction carefully and involve counsel familiar with both the state law and federal tax law ramifications.

• Required formalities: Keep formal partnership records, hold regular meetings, maintain separate bank accounts, and treat the FLP as a legitimate business entity. Failure to follow formalities can lead courts or the IRS to collapse the partnership for tax or creditor claims.

Practical setup steps and documentation

1. Work with an experienced estate attorney to draft a clear partnership agreement that spells out capital accounts, cash distributions, management powers, transfer restrictions, buy-sell provisions, and valuation methods.
2. Obtain independent valuations for contributed assets (especially illiquid items such as real estate or business interests) and keep appraisal records.
3. Fund the partnership formally: execute deeds for real estate, transfer securities formally, and document the contributions in meeting minutes and capital-account ledgers.
4. Use appropriate gifting strategies: apply annual exclusion gifts, consider gifting to family-member trusts, and ensure compliant gift-tax reporting when required (IRS Form 709 for gift reporting).
5. File Form 1065 annually and provide K-1s to partners; maintain good tax and accounting records.

In my practice, the most defensible FLPs are the ones where:

• The partnership has a documented non-tax business purpose (managing a rental portfolio, operating a family business, consolidating investments),
• Management duties are carried out consistently by the GPs, and
• Gift and valuation work is done up front and documented.

Real-world examples (anonymized)

Example 1 — Real estate portfolio: A family moved their rental properties into an FLP and gifted 20% of the limited interests to adult children over several years using the annual gift exclusion and lifetime exemption. The parents retained GP control to manage leasing and maintenance. Appraisals supported reasonable valuation discounts for minority and lack-of-marketability interests.

Example 2 — Family business succession: Founders placed the operating company shares into an FLP. Over time they sold or gifted limited interests to an irrevocable trust for heirs while maintaining GP control to ensure continuity of management.

Caveat: Results vary by facts. The IRS will test whether transfers were done at arm’s length and whether discounts were justified.

Common mistakes and misconceptions

• Treating an FLP as a mere tax shield without a real business purpose.
• Failing to observe entity formalities (no separate bank account, no minutes, commingling personal and partnership funds).
• Expecting large, automatic valuation discounts without proper appraisals or documentation.
• Assuming FLPs protect against all creditor claims—protection is limited and fact-specific.

Professional tips and strategies

• Start with clear goals: Are you optimizing for control, tax reduction, asset protection, or a combination? Your objectives determine the right design.
• Use qualified appraisers: A credible valuation report is essential if you rely on discounts for gifting.
• Stagger gifts: Annual exclusion gifts can move interests over time without using large amounts of lifetime exemption in a single year.
• Revisit the structure: Tax rules, family circumstances, and business needs change—review the FLP every few years.
• Keep records and follow formalities: The strongest defense in litigation or audit is documentation and consistent operation.

Related planning steps and internal resources

• If you own a family business, combine your FLP planning with succession and operational planning. See our article: Estate Planning for Small Business Owners: Keeping the Business Running.
• If part of the goal is to provide liquidity for estate taxes or transfer expenses, review practical funding steps in: Estate Planning: Funding Your Estate Plan — Practical Steps.

Short FAQ

Q: Do limited partners lose their assets when creditors come after the family?
A: Not automatically. LP interests are often harder to reach than direct ownership, but whether they are protected depends on state law, the type of creditor, and whether transfers were made to hinder creditors. FLPs are not absolute shields.

Q: Can I be both a general and a limited partner?
A: Technically you can hold both types of interests, but combined roles can complicate valuation and creditor-protection analyses. Discuss specifics with counsel.

Q: Will an FLP reduce estate taxes automatically?
A: No. FLPs can reduce estate tax exposure through legitimate gifts and valuation discounts, but benefits depend on how the partnership is structured, documented, and defended in return or litigation.

Sample table of common FLP features

Professional disclaimer

This article is educational and reflects general practice considerations as of 2025. It is not legal, tax, or investment advice and does not create an advisor-client relationship. For personal recommendations and structuring, consult a qualified estate attorney and tax professional licensed in your state.

Authoritative sources and further reading

• IRS — Partnership Tax Filing (Form 1065) and instructions (see IRS guidance on partnerships and annual filing requirements).
• IRS — Gift and Estate Tax overview (see current rules and reporting requirements).
• Consumer Financial Protection Bureau — resources on choosing financial and legal advisors.
• American Bar Association — estate planning resources and model rules for fiduciaries.

If you’d like, I can help summarize the documents an attorney will ask for when setting up an FLP or provide a checklist of records most useful in defending valuation discounts during a gift-tax audit.