The IRS position on family limited partnerships is adversarial by default: the agency treats FLPs as one of the most aggressively scrutinized structures in estate planning and attacks them on four fronts — challenging whether the partnership has any purpose beyond saving tax, disputing the size of valuation discounts, pulling partnership assets back into the taxable estate under Section 2036, and disregarding restrictions under Sections 2703 and 2704 that inflate those discounts. For 2026, the basic exclusion amount is $15,000,000 per person, so FLPs matter most to families whose combined wealth exceeds that threshold or who expect the exemption to drop.1Internal Revenue Service. What’s New – Estate and Gift Tax Knowing where the agency draws its lines is the difference between a defensible transfer and one that triggers full estate inclusion plus penalties.
Why the IRS Scrutinizes FLPs
A family limited partnership pools assets under centralized management and lets the older generation transfer minority, non-controlling interests to younger family members. Because those interests carry restrictions — the recipient can’t force a sale, can’t control distributions, can’t easily sell on an open market — they’re worth less than a proportional slice of the underlying assets. That gap is the valuation discount, and it is the entire reason the IRS pays attention.
The agency’s concern is concrete. A family contributes $10 million in marketable securities to a partnership, transfers limited interests at a 35% discount, and reports $6.5 million in taxable gifts. If the partnership adds nothing beyond that tax benefit, the IRS sees $3.5 million of taxable value evaporating with no real economic change. From that starting point, every tool the agency uses is aimed at either shrinking the discount or eliminating it entirely.
The Non-Tax Purpose Requirement
Every IRS challenge begins with the same question: why does this partnership exist, other than to reduce tax? The agency demands a “legitimate and significant non-tax reason” for formation, and courts have backed that requirement. If the answer reduces to estate tax savings, the structure gets disregarded and the discounts disappear.
Courts have accepted several justifications as genuine:
- Centralized management of a diverse portfolio of real estate, operating businesses, or investment assets, particularly when family members lack individual expertise.
- Creditor protection for family assets against the future creditors of younger-generation partners, since a creditor typically cannot seize partnership assets directly.
- Orderly succession through a structured transfer of wealth over time rather than in a single event.
- Investment education for younger partners under the supervision of the general partner.
The IRS examines operational facts, not stated intentions. Two patterns draw immediate suspicion. The first is timing: forming a partnership shortly before the transferor’s death or during serious illness looks like a last-minute tax play. The second is the nature of the assets. A partnership holding only cash, certificates of deposit, or publicly traded securities faces skepticism because those assets don’t need a partnership structure — a brokerage account already provides centralized management and easy diversification.
An FLP holding actively managed real estate, a working ranch, or a private business defends its non-tax purpose much more easily. The IRS acknowledges that real property development, redevelopment, and management are legitimate operational activities.2Internal Revenue Service. Publication 925, Passive Activity and At-Risk Rules When the partnership agreement reflects those activities and the partners actually carry them out, the argument gains traction.
Commingling personal and partnership funds is the fastest way to destroy the non-tax purpose argument. If the transferor uses partnership accounts to pay personal bills, or if distributions flow disproportionately to fund the transferor’s lifestyle, the IRS argues the partnership was never a separate economic entity. The same goes for partnerships that never hold meetings, keep no minutes, and ignore their own distribution provisions. Every departure from the agreement hands the IRS evidence that the entity exists only on paper.
How the IRS Attacks Valuation Discounts
The IRS does not dispute that valuation discounts exist in principle. Federal regulations define fair market value as the price a willing buyer and willing seller would agree on, with neither under pressure to transact and both aware of the relevant facts.3eCFR. 26 CFR 20.2031-1 – Definition of Gross Estate; Valuation of Property A minority interest in a private partnership genuinely is harder to sell than the underlying assets, and a minority holder genuinely cannot control distributions or force liquidation. Both the Lack of Marketability Discount and the Lack of Control Discount reflect real economic limitations.
What the IRS challenges is the size. Taxpayers in litigated cases have claimed combined discounts roughly in the 35% to 45% range, and the agency often pushes for significantly lower figures. In the Grieve case the taxpayer’s appraiser argued for approximately 35%, and the Tax Court allowed that figure over the IRS’s objections. In Jones v. Commissioner the court approved a 40% combined discount. Outcomes vary widely based on the assets held, the specific restrictions in the partnership agreement, and the quality of each side’s expert appraisals.
The underlying assets drive much of the IRS’s argument. When a partnership holds only publicly traded securities or cash equivalents, the agency contends that any marketability discount should be minimal, because wrapping liquid assets in a partnership shouldn’t manufacture a substantial new discount. Partnerships holding undeveloped land, closely held business interests, or commercial real estate face less pushback.
The partnership agreement’s actual restrictions also matter. If partners can readily redeem their interests or vote to liquidate the entity, the Lack of Control Discount loses its foundation. The IRS reviews whether restrictions are economically meaningful or window dressing designed to inflate a discount that doesn’t reflect how the partners behave in practice.
Appraisal Quality
A poorly supported appraisal is the easiest target. The IRS’s own experts frequently use a net asset value approach, working from the actual market value of the partnership’s holdings and applying narrower discounts tied to the entity’s specific characteristics. They look for appraisals that lean on boilerplate industry data without adjusting for the facts of the partnership — generic restricted-stock studies applied without modification are a common point of attack. A defensible appraisal comes from a qualified appraiser who details the methodology step by step, explains why the comparables chosen are genuinely comparable, and accounts for the specific terms of the agreement.
Penalties for Valuation Misstatements
Getting the discount wrong does not just mean paying more tax. If the value claimed on a gift or estate tax return is 65% or less of the correct value, the IRS imposes a 20% accuracy-related penalty on the resulting underpayment. If the claimed value is 40% or less of the correct amount, the penalty doubles to 40% of the underpayment.4Office of the Law Revision Counsel. 26 U.S. Code 6662 – Imposition of Accuracy-Related Penalty on Underpayments These penalties apply on top of the additional tax owed. The penalty kicks in only when the underpayment attributable to the misstatement exceeds $5,000, which is a low bar in the context of transfers typically involving millions of dollars.
Estate Inclusion Under Section 2036
Section 2036 is the IRS’s most powerful weapon. When successfully applied, it pulls the full date-of-death value of transferred assets back into the taxable estate, wiping out every dollar of discount the original transfer claimed. The statute covers any transfer where the decedent retained either the enjoyment of the property or the right to control who else enjoys it.5Office of the Law Revision Counsel. 26 U.S. Code 2036 – Transfers with Retained Life Estate The IRS attacks FLPs under both prongs.
Retained Enjoyment
The agency rarely needs to find explicit language in the partnership agreement granting the transferor continued use of the assets. It looks instead for an “implied agreement,” a pattern of behavior showing that despite the legal transfer, nothing actually changed for the transferor. The transferor kept living off the partnership assets, kept spending from partnership accounts, kept treating the entity as a personal piggy bank.
Specific behaviors that trigger this argument include using partnership funds to pay personal expenses like mortgage payments, country club dues, or medical bills. Disproportionate distributions that flow primarily to the transferor are another red flag, especially when younger partners receive little or nothing. If the transferor contributed nearly all the assets and continued to benefit from nearly all the income, the IRS argues the “transfer” was a legal fiction.
Retained Control Over Distributions
When the transferor serves as general partner and retains discretion over whether and when to make distributions, the IRS invokes the second prong of Section 2036, the right to designate who enjoys the property or its income. Even when that discretion is subject to a fiduciary duty, the agency argues that the practical power to turn the income spigot on or off is enough to constitute retained control.
The Bona Fide Sale Exception
Section 2036 contains one critical escape hatch: it does not apply to transfers made as a “bona fide sale for an adequate and full consideration in money or money’s worth.” For FLPs, this exception requires two things. The formation must serve a legitimate and significant non-tax business purpose, and the value of the partnership interest received must be roughly equal to the value of the assets contributed.
The IRS reads the exception narrowly. Contributing assets and receiving a proportional partnership interest does not automatically qualify. Courts have emphasized that the transaction must resemble something unrelated parties would agree to at arm’s length. If the primary motivation was reducing estate taxes, and the partnership added nothing of economic substance, the exception fails and Section 2036 pulls everything back into the estate. Most FLP cases are won or lost here.
Sections 2703 and 2704: Restrictions the IRS Ignores
Even when the IRS cannot collapse the entire partnership under Section 2036, it has two tools to attack the specific restrictions that inflate discounts. Both sit in Chapter 14 of the Internal Revenue Code, and both let the agency value transferred interests as if certain restrictions don’t exist.
Section 2703: Restrictive Agreements
Section 2703 directs that the value of transferred property be determined without regard to options, agreements, or restrictions on the right to sell or use the property below fair market value.6Office of the Law Revision Counsel. 26 U.S. Code 2703 – Certain Rights and Restrictions Disregarded In practice, this targets buy-sell agreements, transfer restrictions, and liquidation provisions — the exact provisions taxpayers point to when justifying larger discounts.
A taxpayer can preserve those restrictions for valuation purposes only by meeting a three-part safe harbor. The restriction must be a bona fide business arrangement serving a legitimate economic function. It cannot be a device to transfer property to family members below fair market value. And its terms must be comparable to what unrelated parties would agree to in a similar transaction. Failing any one of the three lets the IRS disregard the restriction entirely. The arm’s-length comparison tends to be the hardest element to prove, because the agency demands market data from comparable entities showing that similar restrictions appear in real-world deals between unrelated parties.
Section 2704: Liquidation Restrictions
Section 2704(b) targets restrictions that limit a family-controlled entity’s ability to liquidate. When a family holds control of a partnership immediately before a transfer, and the transfer goes to another family member, any “applicable restriction” on liquidation is disregarded for valuation purposes.7Office of the Law Revision Counsel. 26 U.S. Code 2704 – Treatment of Certain Lapsing Rights and Restrictions
An applicable restriction is one that limits the entity’s ability to liquidate and that either lapses after the transfer or can be removed by the transferor or family members acting together. The logic: if the family could eliminate the restriction whenever it wanted, the restriction isn’t a genuine economic constraint, and valuing the interest as though it limits worth gives credit for an impediment that doesn’t actually exist.
Two exceptions protect legitimate restrictions. Commercially reasonable restrictions arising from financing with an unrelated lender survive, as do restrictions required by federal or state law. The statute also grants the Treasury authority to expand the class of disregarded restrictions by regulation. In 2016, the IRS proposed regulations that would have dramatically broadened Section 2704 to eliminate most valuation discounts for family-controlled entities, including active businesses. Those proposed regulations were withdrawn in October 2017 after intense opposition. The current statutory framework remains in effect, but the fact that the IRS pursued those regulations signals continued interest in narrowing FLP discounts further.
Gift Tax Reporting and Adequate Disclosure
Transferring FLP interests triggers gift tax reporting obligations that carry serious consequences if mishandled. Every transfer of a partnership interest to a family member, whether as an outright gift or a sale at a discounted value, should be reported on Form 709.8Internal Revenue Service. Instructions for Form 709 (2025)
Reporting itself is only half the battle. The IRS applies an “adequate disclosure” standard that determines whether the statute of limitations ever starts running on a reported gift. If a transfer is not adequately disclosed, the agency can assess gift tax on it at any time, with no expiration.9eCFR. 26 CFR 301.6501(c)-1 – Exceptions to General Period of Limitations on Assessment and Collection For an interest transferred decades ago, the IRS could challenge the valuation long after records have been lost and memories have faded.
Adequate disclosure for a transfer of an interest in a non-publicly-traded entity requires all of the following on the return or an attached statement:
- A description of the property transferred and any consideration the transferor received in return.
- The identity of the transferor and each transferee and the relationship between them.
- A detailed explanation of the valuation methodology, including underlying financial data like balance sheets, any adjustments made, and a description of every discount claimed.
- Either a qualified appraisal or enough supporting information that the IRS can evaluate the valuation without one.
A one-line entry on Form 709 saying “5% limited partnership interest, valued at $200,000” does not start the statute of limitations clock. The Form 709 filing is a defensive document, not an administrative formality.
What Actually Determines Outcomes: Operational Formality
One theme runs through every IRS position: the agency looks at what the partnership actually does, not what the agreement says it should do. A beautifully drafted document means nothing if the partners ignore it. The families that survive scrutiny treat the FLP like a real business, because that is exactly what the IRS demands.
At minimum, that means holding regular partner meetings and documenting them with minutes that include the date, attendees, and a summary of decisions. Distribution decisions should follow the partnership agreement’s terms and be recorded. Partnership bank accounts should be completely separate from personal accounts, with no paying personal expenses from partnership funds and no depositing personal income into partnership accounts.
Financial records should be maintained as if an auditor could appear tomorrow, because in the FLP context that is not far from reality. Annual financial statements, capital account records, and documentation of any transactions between the partnership and its partners are baseline requirements. The general partner’s investment decisions, property management activities, and portfolio changes should be documented in writing. Each piece of evidence that the partnership operates as a genuine economic entity weakens the IRS’s argument that it exists only on paper.