IRS-Proof Wealth Transfer: The Family Partnership Hack Most Lawyers Don't Share

Let's talk about a structure the ultra-wealthy have used for decades to shield assets and pass fortunes to the next generation: the Family Limited Partnership, or FLP. On paper, it’s a brilliant strategy for transferring wealth while keeping control. In reality, it’s a minefield. The IRS watches these like a hawk, ready to dismantle any that don't follow the rules to the letter.

This isn't a simple trust fund; it's a complex financial vehicle that demands precision. Here, we'll break down the mechanics, the real-world benefits, and the traps that can turn a smart plan into a costly tax nightmare, so you can understand your options.

Insights

• An FLP allows senior family members to gift assets to heirs at a discount for tax purposes, but only if structured with a legitimate business purpose beyond just tax savings.
• The General Partner retains absolute control over all assets and decisions, even after gifting away the majority of the economic interest to Limited Partners.
• Limited Partners gain a layer of asset protection, shielding family wealth from their personal creditors through what's known as a charging order.
• The IRS is winning more cases against poorly managed FLPs, often using Section 2036 to pull assets back into a taxable estate if formalities are ignored.
• Gifting FLP interests during your lifetime means the recipients lose the step-up in basis, potentially creating a large capital gains tax bill for them down the road.

What Exactly Is a Family Limited Partnership?

Think of an FLP as a private family company you create to hold and manage your assets—real estate, investment portfolios, or a family business. It’s a formal legal entity, not just an agreement on a napkin. The structure splits the family into two distinct roles, and this division is the entire key to how it works.

First, you have the General Partners (GPs). These are typically the parents or senior family members who contribute the assets. They own a small piece of the partnership—often between 1% and 5%—but they hold 100% of the voting power and management control. They call all the shots.

Then you have the Limited Partners (LPs). These are the children, grandchildren, or other heirs. They receive the majority of the ownership, commonly between 90% and 99% of the partnership interests, usually through gifts over time. Their role is completely passive. They have no say in management, can't force a sale of assets, and can't demand a cash distribution.

"An FLP is not a set-it-and-forget-it vehicle; ongoing compliance, proper valuations, and professional advice are essential."

Michael J. Kitces Financial Planner and Industry Thought Leader

The Upside: Why Bother With All the Hassle?

People don't go through the trouble and expense of setting up an FLP for fun. The potential benefits are significant, but they come with strings attached.

Tax-Efficient Wealth Transfer

This is the main event. Because Limited Partners have no control and their shares aren't easily sold, their ownership interests are considered less valuable than the raw assets they represent. This allows a qualified appraiser to apply valuation discounts for "lack of control" and "lack of marketability."

These discounts, often between 25% and 35%, mean you can gift partnership interests with a lower taxable value. For 2025, the federal gift and estate tax exemption is a generous $13.61 million per person. Discounts let you transfer wealth far exceeding that amount over time without triggering taxes.

"Valuation discounts for lack of control and marketability are the cornerstone of the tax advantages in Family Limited Partnerships."

Mark L. Ascher Law Professor and Estate Planning Expert

Iron-Clad Control and Centralized Management

The FLP structure allows the General Partners to gift away economic value while giving up zero control. You can transfer 99% of the partnership's value to your children, but you still decide when to sell property, how to invest the portfolio, and whether to distribute any cash. This prevents the family farm from being sold off by a spendthrift heir or a family business from being fractured by disagreements.

A Shield Against Creditors

FLPs offer a degree of asset protection, particularly for the Limited Partners. If your son or daughter gets into financial trouble or a lawsuit, their creditors can't just seize their share of the family's real estate portfolio.

In most states, the creditor's only remedy is a charging order. This means they can only receive distributions made to that partner. Since the General Partner controls distributions, they can simply choose not to make any, leaving the creditor with nothing but a worthless IOU.

The Downside: The IRS Is Watching You

If an FLP sounds too good to be true, that's because the IRS thinks so, too. They view many of these structures as little more than schemes for tax minimization and challenge them constantly. Getting it wrong can be financially devastating.

Intense IRS Scrutiny

The tax code gives the IRS powerful weapons, like Section 2036(a), to ignore the FLP structure and pull all its assets back into your taxable estate. This happens when the partnership isn't run like a real business. Red flags for an audit include funding the FLP with personal-use assets (like your primary residence), forming it right before death, or failing to keep separate bank accounts and hold formal meetings.

"Without a legitimate business purpose, an FLP risks being recharacterized by the IRS as a mere tax avoidance scheme."

Lawrence A. Hamermesh Tax Attorney and Author

Serious Costs and Complexity

This is not a DIY project. A properly structured FLP requires a team of expensive professionals: attorneys, accountants, and certified appraisers. Setup costs typically range from $10,000 to $30,000, with annual maintenance costs of $3,000 to $10,000 or more, depending on the complexity of the assets and state filing requirements.

The Step-Up in Basis Trap

This is a critical, often misunderstood trade-off. When you gift FLP shares during your lifetime, the recipient takes on your original cost basis. If they later sell the underlying assets, they could face a massive capital gains tax bill.

Conversely, assets held in the FLP that pass to heirs upon your death generally do receive a step-up in basis to their current market value, wiping out the embedded capital gain. You have to weigh the estate tax savings now against the potential income tax hit for your heirs later.

Phantom Income

An FLP is a pass-through entity. This means the partnership itself doesn't pay income tax, but all profits are "passed through" to the partners' personal tax returns. If the FLP has a profitable year but the General Partner decides not to distribute any cash, the Limited Partners still owe tax on their share of that undistributed income. This can create a cash crunch for heirs who have a tax bill but no cash from the partnership to pay it.

Analysis

The game has gotten harder. For years, families could set up an FLP, get an appraisal for a hefty discount, and file the gift tax returns. The IRS simply didn't have the resources to challenge most of them. That era is over. Recent court decisions and a more aggressive IRS posture mean that the "why" behind your FLP is now just as important as the "how."

You must be able to prove a legitimate, non-tax business purpose. Was it to consolidate management of a fragmented real estate portfolio? To protect assets from future lawsuits? To educate younger family members on managing wealth? These reasons must be documented and, more importantly, reflected in how you actually operate the partnership.

Simply stating a business purpose isn't enough. You have to act like it. This means no co-mingling of personal and partnership funds. It means holding actual meetings with minutes. It means the General Partner can't just dip into the FLP account to pay for personal vacations.

The IRS is looking for any sign that you don't respect the integrity of the partnership structure you created. If they find it, they will argue you retained an implicit right to the assets, and the entire structure will collapse for tax purposes.

State laws also add another layer of complexity. The strength of charging order protection varies significantly from one state to another. A structure that is bulletproof in Nevada or Delaware might have holes in California or New York. Choosing the right jurisdiction for your partnership is a strategic decision that shouldn't be overlooked.

Final Thoughts

A Family Limited Partnership is a precision instrument, not a blunt object. When structured and managed correctly, it can be an incredibly effective tool for multigenerational wealth preservation, control, and tax management.

But it is not a passive strategy. It demands meticulous record-keeping, professional oversight, and a genuine business-like operation from day one.

The biggest mistake families make is treating the FLP as a personal piggy bank or a mere paper-shuffling exercise to save on taxes. The IRS has gotten very good at spotting these arrangements, and the courts are increasingly siding with them.

Before you even consider an FLP, you must be prepared to respect the formalities and run it like the legitimate entity it is. This approach helps families hit their targets while sidestepping common, costly mistakes.

"Maintaining separate bank accounts and holding formal meetings are not optional; they are critical to defend FLPs under IRS audit."

Natalie B. Choate Estate Planning Attorney and Author

Did You Know?

In the landmark case Estate of Powell v. Commissioner, the U.S. Tax Court sided with the IRS and included nearly all of an FLP's assets in the deceased's estate. The court found that the partnership was formed just days before death and lacked a legitimate non-tax purpose, serving as a clear warning against last-minute estate planning maneuvers that ignore operational formalities.