Family Limited Partnerships and Valuation Discounts: Where They Hold and Where They Break

A family limited partnership, or its modern equivalent the family limited liability company, holds assets that a family wants to keep together — real estate, marketable securities, an operating business — and issues interests in the entity to family members instead of transferring the assets themselves.

The transfer tax appeal is that an interest in the entity is usually worth less than the same slice of the underlying assets. Two economic facts drive that gap: a limited or non-managing holder cannot force a sale, a distribution, or a liquidation, and no buyer is waiting to purchase a fractional interest in a family entity. Appraisers translate those facts into a discount for lack of control and a discount for lack of marketability.

What the discount is, and what it is not

A discount is not a tax election. It is a valuation conclusion about a specific interest, on a specific date, reached by a qualified appraiser applying recognized methods. Two entities holding identical assets can support very different discounts because their governing agreements, their state's default entity rules, and their distribution histories differ.

Two statutory limits sit on top of the appraisal. Section 2703 tells a valuer to ignore certain rights and restrictions unless they meet stated tests, including that the arrangement is comparable to arm's-length terms — which is why a family buy-sell agreement has to be built to real-world standards if it is going to affect value. Section 2704 disregards some lapsing rights and some restrictions on liquidation that are more restrictive than the applicable state law would impose. Treasury proposed regulations in 2016 that would have expanded section 2704's reach substantially, and withdrew them in 2017; as of mid-2026 the statute stands without those regulations, and practitioners should confirm the position rather than assume it.

Section 2036: the government's main line of attack

When the government challenges a family entity, it usually does not argue about the appraiser's percentages. It argues that the entity should be ignored altogether, and the vehicle for that argument is Internal Revenue Code section 2036.

Section 2036 brings back into the gross estate the value of property a decedent transferred during life while retaining possession or enjoyment of it, the right to its income, or the right to designate who enjoys it. If the government wins that argument, the estate reports the underlying assets at full value and the discount disappears entirely — a worse outcome than never forming the entity, because the family has also paid for the formation and the appraisals.

The statute has an exception for a bona fide sale for adequate and full consideration. Courts have read that exception, in the family entity setting, to require a legitimate and significant non-tax reason for the transaction that the record actually supports, plus a funding exchange in which each contributor received an interest proportionate to what they put in and capital accounts were properly credited. A stated purpose that appears only in a formation memorandum, with nothing in the entity's later conduct to back it up, does not carry the exception.

The last row deserves separate attention. Beyond retained enjoyment, section 2036 also reaches a retained right — alone or in conjunction with any person — to designate who enjoys the transferred property. The Tax Court has applied that branch where a decedent, acting with others, could have caused the entity to dissolve and distribute. It is not enough that the transferor lacked unilateral power.

Running the entity so the discount survives

1. Write the non-tax purpose down, then execute it

   Identify the specific management, succession, or protection problem the entity solves, and create the operating record that shows it being solved — leases negotiated, properties managed, an investment policy applied.

2. Fund correctly and completely

   Retitle deeds and accounts, record contributions, credit capital accounts, and keep the closing binder. Assets that were never actually transferred cannot be discounted.

3. Keep the transferor solvent outside the entity

   Model living expenses, income taxes, and planned gifts, and keep enough outside the entity to cover them without ever asking the entity for money.

4. Observe the formalities

   Separate accounts, annual entity returns, manager decisions recorded by minutes or written consent, and distributions made pro rata to all holders on the same date.

5. Get a defensible appraisal, and update it

   Engage a qualified appraiser who applies the governing agreement and the state statute, not a rule of thumb. Re-appraise for each gift year rather than reusing a stale report.

6. Disclose adequately on the gift tax return

   Reporting a gift with an adequate description of the transferred property and the valuation method starts the limitation period. Silence leaves the valuation open indefinitely.

Where the risk actually sits

• The estate cannot pay the tax without the entity. An illiquid estate holding a discounted interest still owes cash. Plan the liquidity source separately — insurance, a note, or a deferral election — rather than assuming the entity will distribute.
• The appraiser was given the wrong assignment. Valuing the underlying assets and applying a percentage is not the same as valuing the interest that was actually transferred under the actual agreement. The second is what the government tests.
• Income tax was ignored. Entity interests carry inside and outside basis, and assets contributed with built-in gain carry allocation consequences that outlast the transfer tax planning.
• Reporting obligations were missed. A closely held entity may face separate federal or state requirements to identify each beneficial owner, and a trust or tiered ownership chain makes that harder, not easier.
• The family fell out. Discounts come from restrictions, and restrictions bind family members who later want out. A dispute resolution mechanism, a valuation formula, and an exit path belong in the agreement from the start.
• Fiduciary conflicts were unmanaged. Where a trustee holds an entity interest and a family member manages the entity, the trustee's duty of loyalty to its beneficiaries can collide with the family's shared plan.

Questions the desk gets

How large a discount is reasonable?

There is no correct percentage, and any figure quoted without an appraisal should be treated as a warning sign. Reported outcomes vary widely with the asset mix, the agreement's restrictions, the entity's distribution history, and the appraiser's method. An entity holding only marketable securities generally supports far less than one holding an operating business or hard-to-divide land, because the assets themselves are liquid.

Does an entity holding only cash and securities work?

It is the weakest version of the structure. Courts have been skeptical where the only activity is holding a brokerage account that a professional manager already ran, because the family cannot point to a management problem the entity solved. Pooling to reach investment minimums or to apply a shared strategy has been accepted on specific facts, but the record has to show the pooling actually happening.

Is a family LLC treated differently from a limited partnership?

The transfer tax analysis is substantially the same; what changes is the state statute supplying the default rules on withdrawal, transferee rights, and dissolution, which feed directly into the appraisal. An LLC also avoids the general partner's personal liability, which removes one traditional non-tax reason for the partnership form. Choose the entity on state law grounds and value it on its own terms.

Can gifts be made using a formula rather than a fixed number of units?

Defined-value clauses, which transfer a dollar amount of interests as finally determined for tax purposes, have been accepted in some decisions and rejected in others depending on how the excess is redirected. This is contested ground. If a formula clause is used, it should be drafted with current authority in view and paired with adequate disclosure on the gift tax return.

How to use this brief

Treat the discount as the output of a well-run entity rather than the reason for creating one. If the family cannot articulate what the entity does other than reduce tax, the structure is fragile no matter how it is drafted. If it can, the work is operational: fund it properly, run it separately, distribute pro rata, appraise it annually, and disclose transfers on the gift tax return.

Related structures appear in our briefs on buy-sell agreements and business succession, grantor trusts and income tax, and succession for farms and illiquid real property. More sits on the Estate, Tax & Succession desk. This brief is general information about federal transfer tax law and state entity law, both of which change; it is not tax or legal advice, and no entity should be formed or valued without qualified counsel and an independent appraiser.