How a Family Limited Partnership (FLP) Works
There are two types of partners in an FLP. General partners control choices, daily work, and payouts. Limited partners own a share but have no say in how things run. They get their share of income and gains. But they cannot direct the business.
In most family setups, the parents serve as general partners. They keep control of the assets. Children or other family members get limited partner shares over time through gifts. This lets you shift ownership step by step without giving up decision power.
The Tax Benefit: Valuation Discounts
When you transfer limited partner shares to your children, the value can be marked down for gift and estate tax purposes. The discounts reflect two facts. A limited partner cannot sell their share easily on the open market (lack of being able to sell). And they have no control over how things are run (lack of control).
Combined, these discounts can cut the taxable value by 20% to 35% or more. That means you can move more wealth to the next group while using less of your lifetime gift and estate tax credit. Over time, this shrinks your taxable estate by a lot.
Income Taxes and the FLP
An FLP is usually taxed as a partnership. It files a return for info only. The income taxes flow through to each partner. Each partner reports their share on their own tax return. This avoids double taxation. It can also shift income to family members in lower tax brackets.
What the IRS Looks For
The IRS looks at FLPs closely. Courts have ruled against families who created an FLP only to cut taxes with no real business purpose. Red flags include moving assets on a deathbed, using partnership assets for personal needs, paying personal bills with partnership funds, or failing to hold meetings and keep proper records.
To pass IRS review, an FLP must have a real non-tax purpose. Examples include combined handling of family investments, creditor safety, or keeping business assets intact across generations. According to the IRS, transfers that lack real substance will be revalued at full fair market value.
Who Benefits Most From an FLP
FLPs make the most sense for families with large assets. That usually means well above the federal estate tax limit. If your estate is not big enough to face estate taxes, the cost and hassle may not be worth it. Setting up an FLP requires legal help, a formal agreement, expert appraisals, and ongoing upkeep.
For families who do benefit, the FLP serves many goals. It lets the older group begin to shift ownership while keeping control. It gives younger family members a way to learn about managing assets or a business. And it builds a legal shield against creditors.
General Partner and Limited Partner Roles
The general partner carries personal liability for the partnership and handles all management duties. Limited partners enjoy liability safety. Their risk is limited to the amount they put in. This split is key. If the general partner keeps too much control over transferred shares, the IRS may pull those assets back into the taxable estate.
An FLP is a strong tool. But it is not a shortcut. It requires real structure, real compliance, and a real business purpose.
For the complete Arizona walkthrough of business succession planning — buy-sell agreements, FLPs, key-person coverage, and grooming the next owner — read our pillar guide: Business Succession Planning in Arizona: The Complete Guide.