Family limited partnerships and family LLCs have been a cornerstone of estate planning for decades. The basic strategy is well known: a senior family member transfers assets—often marketable securities, real estate, or operating business interests—to a limited partnership, retains a general partner interest (often through an entity), and gifts or sells limited partnership interests to younger family members at a discounted value. The discount reflects the fact that a limited partner interest lacks control over partnership operations and cannot be readily sold on a public market. Combined lack-of-control and lack-of-marketability discounts of 25% to 40% or more have been common in practice.

The IRS has long challenged these arrangements, and the Tax Court has been a frequent battleground. The court’s decision in Estate of Smaldino v. Commissioner is the latest in a line of cases that illustrate both the continuing viability of FLP planning and the significant risks of overreaching.^[1]

The Valuation Framework

The starting point for any FLP valuation dispute is Treasury Regulation § 20.2031-1(b), which defines fair market value as the price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell, and both having reasonable knowledge of relevant facts. This hypothetical transaction standard requires the court to imagine a sale of the limited partnership interest in an arm’s-length market, divorced from the actual family relationships that characterize the real ownership structure.

In practice, the valuation inquiry proceeds in two steps. First, the appraiser determines the net asset value of the partnership—what the underlying assets would be worth if sold. Second, the appraiser applies discounts to the limited partner’s proportionate share of that net asset value to reflect the restrictions and disadvantages inherent in holding a minority, non-marketable interest. The discounts typically include a discount for lack of control (reflecting the limited partner’s inability to force distributions, liquidate the partnership, or control investment decisions) and a discount for lack of marketability (reflecting the absence of a public market for the interest and the difficulty of finding a buyer).^[2]

Where Smaldino Went Wrong

The Smaldino case illustrates several common pitfalls in FLP valuation. The estate’s appraiser claimed a combined discount of approximately 42%, which the Tax Court found excessive. The court’s analysis focused on several factors that reduced the credible discount.

First, the court examined the nature of the underlying assets. When an FLP holds primarily marketable securities—as was the case in Smaldino—the discount for lack of marketability is subject to greater scrutiny because the underlying assets themselves are liquid. A hypothetical buyer of the limited partnership interest knows that the partnership’s assets could be readily converted to cash if the partnership were dissolved. While the limited partner cannot unilaterally force dissolution, the liquidity of the underlying assets reduces the risk that a buyer would be unable to eventually realize value, which limits the appropriate marketability discount.

Second, the court considered the actual economic substance of the partnership arrangement. The Tax Court has been increasingly skeptical of FLPs that serve no meaningful business purpose beyond tax reduction. When the partnership was formed primarily for estate planning purposes, holds only passive investment assets, and the family members would have no reason to maintain the partnership structure but for its tax benefits, the court may view the claimed discounts as artificially inflated. In Smaldino, the court found that the partnership’s operations and purpose did not fully support the magnitude of discounts claimed.

Third, the court assessed the comparability of the market data used to support the discount. Valuation experts typically rely on studies of restricted stock transactions and closed-end fund discounts to support lack-of-marketability discounts, and on observations of minority interest transactions to support lack-of-control discounts. The court in Smaldino found that the estate’s expert had not adequately justified the selection of comparable transactions or explained why the chosen comparables were appropriate for the specific partnership at issue.

The IRS’s Approach

The IRS’s position in FLP cases has evolved over the years. In some early cases, the Service argued for no discount at all, contending that the partnership should be disregarded for tax purposes. That approach met with limited success, and the IRS now generally concedes that some level of discount is appropriate for bona fide FLP interests. Instead of seeking to eliminate discounts entirely, the Service focuses on reducing the magnitude of the discount by challenging the appraiser’s methodology, the comparability of market data, and the economic substance of the partnership.

The IRS also continues to argue, in appropriate cases, that the partnership should be included in the estate under IRC § 2036(a) on the theory that the decedent retained an interest in or control over the transferred assets. When § 2036 applies, the transferred assets are brought back into the gross estate at their full fair market value, eliminating the discount entirely. The courts have applied § 2036 in cases where the decedent continued to use the partnership assets for personal expenses, retained effective control over distributions, or transferred assets to the partnership shortly before death in a deathbed planning transaction.^[3]

Lessons for Practitioners

The Smaldino decision reinforces several practical lessons for attorneys and advisors who use FLPs and family LLCs in estate planning.

First, the partnership must have a legitimate, non-tax business purpose. Asset protection, centralized management of family investments, and succession planning for an operating business are all recognized purposes. But the partnership must actually function in accordance with its stated purpose. If the partnership agreement provides for centralized management but the general partner makes no meaningful investment decisions, or if the partnership agreement restricts distributions but the family informally distributes assets as needed, the asserted business purpose rings hollow.

Second, the valuation must be defensible. Appraisers should use methodologies that are appropriate for the specific partnership, supported by comparable market data, and sensitive to the characteristics of the underlying assets. Combined discounts in the 25% to 35% range are more likely to withstand scrutiny than discounts approaching 40% or higher, particularly for partnerships holding liquid assets. The appraiser’s report should thoroughly explain the basis for each component of the discount and address foreseeable IRS arguments.

Third, the partnership must be operated as a genuine entity. This means maintaining proper books and records, holding regular meetings (or at least documenting partnership decisions), making distributions in accordance with the partnership agreement, and ensuring that partnership assets are not commingled with personal assets. The Tax Court has repeatedly emphasized that the formalities of partnership operation matter—not as mere technicalities, but as evidence that the partnership is a real economic arrangement rather than a paper entity created solely for tax benefits.

Fourth, practitioners should be cautious about deathbed transfers. Transferring assets to a newly formed FLP when the senior family member is in declining health creates an inference that the transfer was motivated solely by estate tax reduction, which invites both § 2036 challenges and heightened scrutiny of the claimed discounts. The strongest FLP arrangements are those established well before any anticipated need for estate tax planning, with a clear business purpose that predates the tax motivation.^[4]