Family Limited Partnerships: Discounts, Section 2036 and Selling

How it works

Parents contribute assets (a business interest, real estate, a portfolio) to a limited partnership or LLC in exchange for interests. They usually keep the general partner or manager role and then give or sell limited interests to children or trusts over time. A limited interest has no control over distributions or liquidation and no ready market, so an appraiser values it below its share of the underlying assets. Those discounts reduce the value reported for gift tax now and for estate tax later.

Future growth on the transferred interests also leaves the parents' estates. The partnership agreement can centralize management, restrict transfers outside the family and give some creditor protection.

Who it fits, and who it does not

Good fit: families with estates above the federal basic exclusion of $15,000,000 per person in 2026 (Section 2010(c)(3)), or living in a state with an estate tax that starts much lower, such as Oregon at $1,000,000 or Massachusetts at $2,000,000. Families with real non-tax reasons: keeping a business or property portfolio under unified management, bringing the next generation in gradually, or protecting assets from a child's divorce or creditors.

Poor fit: estates well under the exemption, where a gift at a discount mainly lowers the heirs' income tax basis (gifts carry over the donor's basis under Section 1015) and saves no estate tax. Parents who need the assets to live on, or who will treat partnership money as their own. Anyone forming it in the last weeks of life.

Worked example

Qualitative, because the engine does not model gift and estate tax or appraisal discounts. Assumptions: a married couple with a $40,000,000 estate, including a $20,000,000 commercial real estate portfolio. They form an LLC, keep managing it, and over several years give non-voting interests to trusts for their children, each gift supported by an independent appraisal that applies discounts for lack of control and lack of marketability. Each gift uses part of their combined exemptions. At death, they own only the remaining interests, valued with the same type of discounts, and the growth on the gifted interests is outside their estates.

Two things decide whether this works: whether the IRS accepts the discounts, and whether the IRS can pull the full undiscounted assets back into the estate under Section 2036. If the parents kept living off partnership cash and paid personal bills from it, Section 2036 likely wins and the discounts disappear. And because the children received the gifted interests with carryover basis, if the LLC sells a building later the children's share of gain is still taxed.

IRS stance and audit risk

Family partnerships are lawful and widely used, but the IRS litigates them often. The main weapons:

• Section 2036(a)(1), retained enjoyment. If the decedent kept the right to possession, enjoyment or income of the transferred assets, they are included at full value. In Estate of Strangi (5th Cir. 2005), the decedent's continued use of partnership funds and an implied agreement to provide for his needs led to inclusion.
• Section 2036(a)(2), retained control. In Estate of Powell, 148 T.C. 392 (2017), the Tax Court included partnership assets because the decedent, as a limited partner acting with others, could dissolve the partnership, and applied Section 2043 to avoid double counting. The partnership was formed about a week before death under a power of attorney.
• Bona fide sale exception. Section 2036 does not apply to a bona fide sale for adequate and full consideration. Courts look for a legitimate and significant non-tax reason for forming the partnership, with interests proportionate to contributions.
• Sections 2703 and 2704. Certain buy-sell restrictions and liquidation restrictions in family-controlled entities are disregarded for valuation. Proposed regulations under 2704 that would have curtailed discounts were withdrawn in 2017.
• Penalties. In Estate of Fields, T.C. Memo. 2024-90, the Tax Court included partnership assets under Section 2036 and also upheld an accuracy-related penalty.

Practices that hold up: formation well before any health crisis, real non-tax purposes in writing, parents keep enough assets outside to live on, no commingling or personal use, pro rata distributions, separate accounts and books, and independent qualified appraisals.

Income tax: what a family partnership does not do

A family partnership does not defer or reduce income tax on a sale. If the partnership sells a property, the gain flows through to the partners. Built-in gain on property a partner contributed is allocated back to that partner under Section 704(c). Gifted interests carry the donor's basis. Assets included in the estate under Section 2036 do get a step-up at death (Section 1014), which is the one income tax silver lining of losing a 2036 case.

Costs and fees

Legal formation and a carefully drafted agreement, retitling assets, a qualified appraisal for every gift or sale of interests, gift tax returns (Form 709), annual partnership returns and K-1s, separate bank accounts and bookkeeping, and ongoing legal reviews. For a modest estate these costs can exceed any tax benefit.

How it compares with a Section 453 installment sale

A Section 453 installment sale spreads income tax on a sale. A family partnership shifts value for gift and estate tax. They can work together: a partnership can sell a property to an outside buyer on an installment note, spreading the income tax across the partners' returns, and parents can transfer partnership interests before a sale is negotiated so the future proceeds and growth sit with the children. Transfers made after a deal is already agreed raise assignment of income issues (see gifting shares before a sale). Note that an unpaid installment note held at death is income in respect of a decedent and gets no step-up, while an included partnership interest does.

Frequently asked questions