Tax Planning with Family Limited Partnerships (FLPs)

Authored by: Brian W. Sak, CFP®, CLU®, ChFC®

For successful business owners and wealthy families, few tools offer the combination of control, tax efficiency, and estate planning flexibility that a Family Limited Partnership (FLP) can provide. But with that power comes complexity—and more than a few misconceptions.

Used properly, FLPs enable families to retain control over significant assets, compress estate values through strategic discounts, and manage income and capital gains taxes over multiple generations. Yet the tax benefits of FLPs often hinge on technical details that are easy to overlook, such as inside versus outside basis, §754 elections, and substantive business purpose.

What’s more, many FLPs are set up in isolation—by a CPA or attorney—without coordination across the broader financial picture. This fragmentation often leads to missed opportunities, audit risk, and inefficient outcomes.

This article explores how FLPs can be used as a core planning tool, what mistakes to avoid, and why coordinated execution and continuity are essential for making these strategies work as intended—not just today, but for decades to come.

What a Family Limited Partnership Can Actually Do

At its core, an FLP is a limited partnership structure where senior family members act as general partners, managing the entity, while limited partnership interests are transferred over time are typically transferred to children or irrevocable trusts. The structure is often used to hold real estate, private business interests, marketable securities, or a combination of these assets.

When properly designed and maintained, FLPs offer:

• Centralized management of complex assets
• Liability protection for limited partners
• Gift and estate tax efficiency through valuation discounts
• Ongoing income distribution control by the general partner
• Asset protection from creditors and outside claims

But these advantages are only fully realized when the taxation of partnerships is well understood and proactively managed.

Partnership Taxation: Why Inside vs. Outside Basis Matters More Than You Think

One of the most powerful—but also most misunderstood—aspects of using Family Limited Partnerships (FLPs) is the flexibility and complexity of partnership taxation. Unlike corporations, partnerships offer pass-through taxation, custom profit allocations, basis tracking at two levels, and various elections that impact how income and gain are recognized.

At the center of all of this is the critical distinction between inside basis and outside basis.

Inside Basis vs. Outside Basis

• Inside Basis refers to the partnership's basis in its assets. This is determined at the partnership level and affects how the partnership calculates gain or loss when it sells assets.
• Outside Basis refers to each partner's basis in their interest in the partnership. This governs how much loss a partner can deduct, the taxability of distributions, and the gain or loss on the sale of the partnership interest.

Example:

• An FLP owns commercial real estate with a book value of $5 million, and a tax basis (inside basis) of $3 million.
• One partner has a 30% interest and an outside basis of $1 million.
• If that partner sells their interest for $2 million, they must recognize a $1 million gain, even though the FLP hasn’t sold the underlying property.

This disparity between inside and outside basis creates planning risks—but also opportunities, especially at death or upon transfer.

Adjustments on Transfer: §754 and §743(b)

When a partnership interest is transferred—either by sale or at death—the inside basis of the underlying assets does not automatically adjust to reflect the new partner’s outside basis. This mismatch can result in double taxation on unrealized gains.

To resolve this, partnerships can make a §754 election, which allows for a §743(b) adjustment to the inside basis of partnership assets attributable to the transferred interest.

Example at Death:

• An FLP owns appreciated real estate.
• A limited partner dies, and their 25% interest receives a step-up in outside basis to fair market value.
• Without a §754 election, that heir inherits the interest with a high outside basis, but no adjustment is made to the inside basis of the underlying property.
• When the FLP later sells the property, capital gain is recognized at the entity level, even though the partner’s outside basis might otherwise shield them.

With a properly filed §754 election, the FLP adjusts the inside basis upward under §743(b) for the successor partner—allowing depreciation to resume and gain to be reduced or eliminated.

Key Notes:

• The §754 election must be filed with a timely partnership return for the year of transfer (or sale or death).
• Once made, the §754 election is generally irrevocable unless revoked with IRS consent.
• This election adds complexity to the FLP’s accounting, but the tax benefits are significant—especially for high-value, appreciating assets like real estate or closely held business interests.

Capital Accounts, Basis, and Distributions

Another technical aspect of partnership taxation is the interaction between capital accounts, outside basis, and cash or property distributions.

Capital Account ≠ Tax Basis

Capital accounts track book equity, while outside basis tracks tax equity, which includes:

• Initial capital contributions
• Allocated income and gain
• Distributions received
• Allocated losses and deductions
• Liabilities allocated under §752

Because of this difference, a partner may have a positive capital account but insufficient outside basis, or vice versa—leading to unintended tax consequences.

Impact on Distributions

Under §731, distributions from a partnership are generally non-taxable to the extent of the partner’s outside basis. Distributions in excess of basis result in capital gain recognition.

Example:

• A partner has an outside basis of $500,000.
• The FLP makes a cash distribution of $700,000.
• The partner must recognize a $200,000 capital gain, even though their capital account may still show a positive balance.

This is particularly important in estate planning where distributions are used to fund tax liabilities, equalize gifts, or provide liquidity.

Special Allocations and §704(b)

FLPs can also utilize special allocations under §704(b)—allowing income, gain, loss, and deductions to be allocated in a manner disproportionate to ownership, provided the allocations have substantial economic effect.

This opens the door to planning strategies like:

• Allocating depreciation to older generations with higher income
• Allocating gain to beneficiaries with high basis
• Managing income exposure across trust structures

However, special allocations must follow complex regulatory requirements, including:

• Maintenance of capital accounts in accordance with §704(b)
• Compliance with the economic effect equivalence test
• Use of qualified income offset (QIO) provisions

Failure to respect these rules can trigger recharacterization of allocations, leading to audit exposure or unintended tax consequences.

§751: Ordinary Income Traps on Sale of Partnership Interests

Another often-overlooked issue in FLPs is the §751 "hot asset" rule, which recharacterizes a portion of gain on the sale of a partnership interest as ordinary income—not capital gain—if the partnership holds certain assets like:

• Depreciation recapture property
• Inventory
• Unrealized receivables

If, for example, a family FLP owns depreciated real estate, the gain attributable to past depreciation deductions may be taxed at ordinary rates, even if the interest is sold for a capital gain.

This is another reason why structuring and timing of transfers and sales must be carefully coordinated—especially if the FLP holds mixed-asset classes or is preparing for a liquidity event.

Summary: Why These Details Matter

FLPs are more than estate planning vehicles. They are dynamic tax entities, governed by highly nuanced partnership tax rules. When proactively managed, these rules can provide:

• Customized income allocations
• Strategic gain recognition
• Valuation discounts for estate purposes
• Step-up opportunities that reduce long-term capital gains

But when misunderstood—or ignored—they can result in:

• Phantom income
• Unintended gain recognition
• IRS challenges on discounts or allocations
• Liquidity constraints at the worst time

In other words: It’s not just about the entity—it’s about how it’s managed.

Valuation Discounts: The Real Lever for Estate Tax Efficiency

Perhaps the most well-known benefit of FLPs is the ability to reduce the taxable value of gifted or transferred interests using:

• Minority interest discounts, because limited partners lack control
• Lack of marketability discounts, because interests in private entities can’t easily be sold

These discounts are real, defendable, and quantifiable when supported by an independent valuation and a properly maintained partnership structure.

For example, a family might hold $20 million in marketable securities through an FLP. If they gift a 40% non-controlling interest to irrevocable trusts, and the valuation discounts total 30%, they may use only $5.6 million of exemption instead of $8 million.

But to claim those discounts with confidence, the FLP must:

• Have a clear business purpose beyond tax savings
• Hold regular meetings and document decision-making
• Maintain formal agreements and separation of assets
• Avoid commingling or personal use of FLP property

The IRS regularly challenges FLPs that lack these features, especially if the partnership was created late in life, isn’t operated as a real business, or lacks economic substance.

Objection: “What’s the Business Purpose of My FLP?”

This is a common and valid concern.

Fortunately, a legitimate business purpose does not require an operating company or commercial revenue. Common, defensible purposes include:

• Consolidating and professionally managing family investment assets
• Planning for generational succession and transition of control
• Streamlining recordkeeping and reporting for complex portfolios
• Establishing a governance structure to train younger generations
• Protecting assets from personal liability and creditor claims

The key is that the FLP must be structured and operated to reflect these purposes—not merely drafted on paper and ignored in practice.

Where Most FLP Strategies Break Down

While FLPs can be incredibly effective, they are also fragile in the hands of disconnected advisors or inattentive administrators.

We often see the following problems:

• Lack of a §754 election, missing basis step-up on death or sale
• No business purpose documentation, weakening the IRS defense
• Uneven or undocumented gifting, causing future disputes or valuation issues
• Failure to update partnership agreements, despite changing assets or family needs
• Poor recordkeeping, making it difficult to support discounts or defend in audit

These mistakes often stem from good intentions—but siloed execution. A CPA recommends an FLP for tax savings. An attorney drafts documents. A financial advisor manages the assets. But no one is coordinating the parts.

Coordination as a Strategic Advantage

At Granite Harbor Advisors, we frequently work with families who already have trusted attorneys and CPAs. Our value is not in replacing them—but in ensuring everyone is aligned around a unified, forward-looking strategy.

That includes:

• Ensuring that FLPs and related trusts are structured to support both estate and income tax goals
• Coordinating timing of gifts and valuations with market performance
• Reviewing basis step-up opportunities and triggering §754 elections as needed
• Managing cash flow planning to avoid issues with illiquid distributions
• Periodically reviewing the business purpose, operations, and documentation of the FLP

This coordination is not about compliance—it’s about control. It helps ensure that the structure you put in place will function as intended, regardless of changes in tax law, market conditions, or family dynamics.

Emotional ROI: Relieving the Burden of Acting as Quarterback

Many families come to us frustrated not by the tax code, but by the experience of managing it. They’re tired of being the go-between among multiple advisors. They’re concerned that something critical is being overlooked. And they sense that, despite having smart professionals involved, the pieces aren’t working together.

That’s not a tax issue. That’s a coordination issue.

Our role is to relieve that burden, to manage the complexity, and to give families confidence that their FLPs and other structures are being maintained and monitored over time—not just created and filed away.

Continuity of Execution: Who Will Carry It Out?

FLP strategies are rarely executed all at once. More often, they unfold over 10, 20, or 30 years—across generations and life events. Which raises the most practical and overlooked question:

Who will carry this out when the original advisor retires, passes away, or changes firms?

At Granite Harbor, we’ve built our business to answer that question with confidence:

• We are a multi-advisor team, not a single point of failure
• We maintain institutional memory, not just personal relationships
• We have continuity protocols, ensuring your strategy is managed over decades
• We coordinate with your outside professionals, so your plan survives change

The best FLP strategy is one that can withstand not only IRS scrutiny—but time itself.

Your FLP Strategy Deserves a Closer Look

If your Family Limited Partnership was created years ago and hasn’t been reviewed recently—or if it was designed without clear integration across your financial, legal, and tax planning—it may not be serving you as well as it could.

At Granite Harbor Advisors, we specialize in helping families refine and optimize their FLPs as part of a broader strategy that includes tax planning, estate design, investment oversight, and long-term continuity.

Let’s start with a conversation. We’ll review your structure, identify any gaps, and offer insight into how it could better support your legacy.

Because strategy isn't just about documents -- it's about outcomes.