Many enterprising families have January 1, 2026, circled on their calendars.  Why?  Because the individual estate tax exemption reverts to $6 million (give or take, depending on inflation) in 2026 from its current level of $12 million.  As a result, many estates that are not currently large enough to be taxable will become so, and the effective tax rate for all estates will increase.

A recent Wall Street Journal article highlighted the benefits, and potential downsides, of family limited partnerships, or FLPs (and their close cousin, the family limited liability company).

The “magic” of the FLP is the ability to transfer assets to heirs, and out of taxable estates, at discounted values.  The WSJ article points out that the IRS is skeptical of many FLP planning strategies, noting that audit challenges may become more frequent as the IRS puts its new $80 billion enforcement budget to work.

While the valuation discounts applicable to FLPs may seem like estate planning magic, there really is no sleight-of-hand involved.  Instead, valuation discounts reflect economic reality.

Fair Market Value Is an Arm’s-Length Standard

Estate planning transfers must be accounted for using the “fair market value” of the subject interest.  Revenue Ruling 59-60 offers the following definition for fair market value: “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.”

Fair market value describes how a transaction involving the subject interest would occur between two “willing” parties, both of whom have reasonable knowledge of relevant facts

There’s a lot there, but for this post, we will simply highlight that fair market value is not determined with respect to a specific buyer or seller and therefore does not consider any familial relationship between the transferor and transferee in an exchange.  Rather, fair market value describes how a transaction involving the subject interest would occur between two “willing” parties, both of whom have reasonable knowledge of relevant facts.

Under this standard of value, business appraisers typically value interests in FLPs using a three-step approach.

The Market Value Balance Sheet

The first step is to compile a listing of all assets owned by the FLP, reduced by any liabilities.  FLPs hold all kinds of assets, some of which have more readily ascertainable values than others.  So, for some FLPs, the market value balance sheet can be constructed simply by referring to a brokerage statement, while other assets, like shares in a family business, will require a separate valuation process.  Once the market values of the assets and liabilities have been determined, the difference between the two, referred to as “net asset value” or “NAV,” provides the starting point of the valuation analysis.

It’s Nice to Be in Charge

If the subject interest possessed sole discretion over the operations of the FLP, net asset value would be an appropriate proxy for fair market value.  After all, rather than sell the interest at a discount, the holder of such an interest would instead liquidate the underlying assets and settle the liabilities of the FLP, thereby realizing the net asset value.

However, the FLP interests used in estate planning transfers rarely have such authority (as would be possessed by a sole general partner).  Small, limited partner interests lack the ability to direct the operations of the FLP or force the liquidation or distribution of the underlying assets.  Willing buyers operating under the fair market value standard are wary of such investments.  All else equal, they prefer to be the ones making the key investment and operational decisions.  When submitting to someone else’s decisions, they demand a higher return on their investment by applying a discount to the pro rata share of net asset value.

This reflects a simple economic reality: minority interests in asset portfolios are worth less than the corresponding share of net asset value.  There is ample real-world evidence supporting this conclusion in the market for shares in closed-end funds, which regularly trade at discounts to NAV.

It’s Even Better to Be Liquid

That is where the similarities between FLP interests and shares in closed-end funds end, however.  Unlike investors in closed-end funds who can quickly convert their shares to cash, there is little to no liquidity for most interests in FLPs.  All else equal, investors tend to prefer liquid assets to illiquid ones.  As a result, our “willing buyer” from the fair market value definition requires an additional discount to be convinced to buy a minority interest in an FLP.

The discount appropriate to your family limited partnership interest will be a function of four primary economic characteristics

Once more, this discount is no mere valuation parlor trick but instead reflects economic reality.  The discount appropriate to your family limited partnership interest will be a function of four primary economic characteristics:

• Duration of the expected holding period. Since investors prefer liquidity, the longer a willing buyer would expect to be stuck holding the FLP interest, the larger the discount.
• Magnitude of expected distributions. Even when not readily marketable, some FLP interests receive regular distributions (beyond those needed to pay pass-through tax liabilities), while others receive none.  The greater the magnitude of the expected interim distributions, the lower the discount.
• Expected capital appreciation of underlying assets. For the willing buyer, returns can only come from two sources: distributions (accounted for above) and capital appreciation.  All else equal, the faster the underlying FLP assets are expected to grow in value, the smaller the discount.
• Holding period risks. Return follows risk, and owning the subject FLP interest is riskier than owning the underlying assets outright.  The more incremental risk associated with the subject FLP interest, the greater the return required by the willing buyer, resulting in a larger discount.

Be Sure the FLP Structure Is Right for Your Family

Valuation discounts for FLPs are not convoluted mirror tricks on the part of appraisers but rather reflect the straightforward economic reality of FLP interests.  However, for these discounts to withstand IRS scrutiny, the economic reality we’ve described in this post must match, well, reality.  As noted in the WSJ article, families forming FLPs should be prepared to live with the economic reality of having an FLP, including identifying and adhering to a clear business purpose, formal meetings, and pass-through taxes.

We have valued minority interests in well over 1,000 FLPs over the past forty years.  We don’t know if an FLP is right for your family, but if you and your tax and legal advisors conclude that it is, give one of our valuation professionals a call to see how we can help you.