A father owns an $18 million manufacturing business. A straight gift burns his entire $15 million exemption and triggers gift tax on the $3 million excess. Intra-family transfer techniques solve this by compressing the taxable value through valuation discounts and shifting future appreciation out of the estate.
Families face a tension: they want to pass ownership of an operating business or investment portfolio to the next generation but cannot afford to surrender management control or pay transfer tax on the full undiscounted value. The Family Limited Partnership and Family LLC structures resolve both problems by separating economic ownership from management and by creating legal restrictions that compress the transfer-tax value of the gifted interests.
A senior family member contributes assets to a limited partnership or LLC. She retains a small general partner interest (typically 1-2%) and gifts limited partnership interests to children or trusts.
The tax advantage comes from two built-in limitations on limited partnership interests:
- Lack of control (minority interest) discount: a limited partner cannot control management, distributions, or liquidation
- Lack of marketability discount: interests cannot be sold on an open market and the partnership agreement restricts transfers
Common mistakes
- Adding FLP discounts instead of multiplying. A 20% minority discount plus a 15% marketability discount is not 35%. You multiply: (1 - 0.20) x (1 - 0.15) = 0.68, or a 32% combined discount. Trap: you will see 35% as an answer choice.
- Calculating the FLP discount but ignoring Section 2036. The exam frequently presents an FLP scenario and asks which fact creates the greatest inclusion risk. The discounted value looks like the right estate tax answer, but if Section 2036 applies, the full undiscounted value is included.
- Treating an IDGT sale as a taxable event. In a standard installment sale, the seller recognizes gain and interest income. In a sale to an IDGT, the sale is invisible for income tax. Trap: "Margaret recognizes $3.5 million in capital gain" is the standard installment sale answer, not the IDGT answer.
Bottom line
- FLP discounts apply multiplicatively: lack of control times lack of marketability, never added together
- Section 2036 claws back FLP assets if the transferor retains disproportionate income, commingles funds, or lacks a legitimate business purpose
- IDGT sale produces zero income tax because the grantor trust is invisible for income tax purposes
- SCIN cancels at death: the remaining note balance exits the estate, but unreported gain accelerates on the final return
Exam shortcut
When the exam presents a closely held business transfer, identify the technique first, then match its unique tax consequence. FLP questions hinge on Section 2036, look for retained control, personal use, or commingled funds. IDGT questions test whether you know the sale produces zero income tax. SCIN questions test whether the note vanishes at death but triggers final-return gain. "Recapitalization" with preferred and common stock = Section 2701.
The full lesson (about 2,912 words, 19 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- G.61
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