Generational Wealth Transfers Using Valuation Discounts and Family Limited Partnerships
With federal gift and estate tax rates at 40%, high-net-worth individuals transferring their wealth to the next generation need effective strategies to minimize their tax burden. The concept of valuation discounts offers significant opportunities — recognizing that partial ownership stakes in privately held entities, like closely held businesses and family limited partnerships are worth less than their proportional share of the whole. Moreover, when making lifetime wealth transfers, which are generally more advantageous that transfers made at death (see related analysis here), and other planning techniques like GRATs and preferred partnerships (see related analysis here) and dynasty trusts (see related analysis here), these strategies can compound the tax efficiencies.
These valuation discounts reflect economic reality: a 25% interest in a private company isn't simply worth 25% of the company's net asset value. Instead, its market value is diminished by the minority owner's inability to control company affairs or readily convert the interest to cash, much like one could with a share of a publicly traded stock. For wealth transfer planning, this gap between proportional and actual market value creates legitimate tax advantages when properly structured.
Family Limited Partnerships (FLPs) and Limited Liability Companies (FLLCs) have become favored vehicles for implementing these strategies, as their structures can enhance available discounts. While the IRS closely scrutinizes family-controlled entities, decades of litigation have produced a substantial body of case law that provides clear guidance for high-net-worth individuals. These precedents establish a well-defined pathway for legitimately and legally transferring wealth to heirs while significantly reducing gift and estate taxes. Successful implementation requires careful navigation of complex regulations and adherence to the principles established through numerous court decisions that have repeatedly validated these approaches when properly structured.
The Rationale Behind Minority Interest Discounts
When valuing ownership interests in a closely held business (or a Family limited Partnership and Family Limited Liability Company), certain ownership positions carry inherent disadvantages that affect their market value. A minority interest discount recognizes that minority owners face several significant limitations. Minority owners cannot unilaterally liquidate the company to realize their proportionate share of the entity's net assets. Minority owners cannot dictate corporate policy, dividend distributions, executive compensation, or other critical business decisions. Controlling owners typically elect themselves or family members as directors and officers, allowing them to extract earnings through salaries and fees while maintaining control over all company affairs.
These limitations make minority ownership interests less valuable to potential buyers—whether insiders or outside investors—than a simple pro rata share of the company's total value would suggest. The applicability and appropriateness of these discounts have been the subject of many tax court cases and are included in IRS regulations, rulings and notices.
Let's consider a practical example that illustrates this principle. Imagine you're planning to transfer $1,000,000 worth of Apple stock to a family member. A direct transfer of 10% of your shares would result in a $100,000 taxable gift. However, if instead your Apples shares are held in an LLC that you solely own and control, and you make a gift of a 10% interest in that LLC to your family member, the relevant item that should be valued for purposes of determining the taxable amount of the gift is the interest in the LLC. Assuming the 10% LLC interest transferred has no associated control rights, the gift's value should be significantly less than $100,000. This reduction in value isn't just theoretical – it's a practical reality that business appraisers can substantiate.
In addition to the commonly used minority interest (or control) discount and the marketability discount, there are other types of valuation discounts that have prevailed in tax courts. Fractional interest discounts apply to undivided interests in property, reflecting the difficulties and costs associated with co-ownership, such as potential partition actions. Blockage discounts may be available when valuing a large block of property, such as real estate or artwork, where placing the entire block on the market at once would depress prices. Key person discounts may be allowable where a person's contributions to the business are so significant that there is a certainty that present earnings levels will be adversely affected by the individual's loss.
Distinguishing Minority Interest Discounts from Marketability Discounts
The two most commonly used discounts when making intra family gifts of investment and business interests are minority interest discounts and marketability discounts. Although some courts have conflated these concepts, they address distinct valuation issues. Minority interest discounts reflect the reduced value of ownership interests that lack control over a company's board, operations, dividend policy, and liquidation decisions. This discount acknowledges the less advantageous position of minority owners. Marketability discounts address the fact that ownership in privately held companies have a limited market of potential buyers and represent relatively illiquid investments. This discount also accounts for additional costs (such as accounting and legal fees) associated with selling an otherwise unmarketable interest.
Application to Different Valuation Approaches
Typical Discount Ranges
While the specific discount depends on all facts and circumstances, courts have generally approved minority interest and marketability discounts in the range of 20-45%, though some cases have seen discounts as high as 66%. Courts have arrived at the discount amounts by looking at factors such as analysis of the company’s financial statements including the nature of the entity’s underlying assets, dividend policy, outlook for the company, company management, control in the transferred shares, restrictions on transferability, holding period of the stock, company redemption policy, and costs associated with a transfer of the ownership interest.
Minority Interest Discounts: Application and Legal Evolution
Defining Control for Discount Purposes
The application of minority interest discounts hinges on whether a block of shares or ownership interest constitutes a “control" interest. Courts have typically defined this concept by its absence—a minority interest exists where control is lacking. Importantly, even when no single shareholder owns a controlling block, a minority discount remains appropriate (albeit potentially at a lower rate) since each minority shareholder still lacks unilateral control over company decisions.
Generally, ownership of more than 50% of voting shares constitutes a controlling interest, while less than 50% represents a minority interest. An exactly 50% interest is typically treated as a minority interest as well. In some cases, control thresholds may be higher if state law requires a greater percentage for liquidation or the entity’s governing documents mandate a higher percentage for major decisions.
For estate tax purposes, the IRS takes the position that ownership interests included in an estate under different statutory provisions must be aggregated when determining control. However, the IRS has conceded that stock held in a qualifying marital deduction trust (included under §2044) is not aggregated with stock held outright by the decedent when determining control discounts.
Scenarios Affecting Minority Discount Application
When a controlling shareholder transfers minority interests that collectively diminish their control position, as in Estate of Heppenstall v. Commissioner, courts have historically respected each transferred minority interest as separate for valuation purposes. In this case, the donor made minority interest gifts to each of four family members and the applicability of the minority interest discount for each gift was sustained in court. The Tax Court has consistently cited the principle that gifts to separate people should not be aggregated for valuation purposes.
When a controlling interest is transferred through separate gifts to multiple recipients, as in Whittemore v. Fitzpatrick, courts have historically respected the separate nature of these gifts for valuation purposes, allowing minority discounts for each separate gift. Unlike the Heppenstall case, in Whittemore v. Fitzpatrick the separate gifts made to each of the donor’s three sons in aggregate represented a controlling interest in the entity. The IRS argued that the gifts should be aggregated for valuation purposes, however the court rejected this argument.
For many years, the IRS argued that family attribution should prevent minority discounts in transfers within families. Under this "unity of ownership" theory (formalized in Rev. Rul. 81-253), the IRS maintained that control value was never lost in intra-family transfers except when family discord could be proven. However, multiple court decisions rejected this approach and in 1993, the IRS officially conceded this position in Rev. Rul. 93-12, acknowledging that a shareholder who makes gifts of minority interests to family members is not precluded from taking minority discounts, even when controlling the corporation before the gifts.
Minority Interest Transferred to a Controlling Shareholder
When a minority interest is transferred to a shareholder who already has control or who gains control through the transfer, the proper tax treatment depends on the tax context. For estate tax purposes, the valuation is based on the interest that passes at death, without reference to the beneficiary's other holdings (TAM 9432001). For gift tax purposes, regulations suggest the identity of the donee is irrelevant, focusing instead on "the value of property passing from the donor." Despite theoretical arguments that the loss of control value should be taxable when a minority gift results in the donee gaining control, the IRS has not pursued this approach. For income tax purposes (e.g., compensation), courts have considered the recipient's existing holdings, as in Turner v. Commissioner, where a controlling shareholder receiving additional shares was not entitled to a minority discount.
The "Swing Vote" Consideration
The IRS has argued that minority interests should be accorded a premium when they represent potential "swing votes" that could control the corporation by aligning with other shareholders (TAM 9436005). In Estate of Winkler, the Tax Court recognized a 10% swing vote premium where a 10% interest could determine control by aligning with either of two family groups owning 50% and 40%, respectively. However, in In Estate of Simplot v. Commissioner, the 9th circuit overturned the Tax Court’s ruling, rejecting the IRS's premium valuation for a potential swing vote, citing errors such as using imaginary scenarios, pro rata division of the premium, valuing a minority block at a premium without showing that the block would grant control usable for economic advantage, and speculation about events after the valuation date.
Moreover, this concept presents analytical challenges under the willing buyer-willing seller standard, as noted by the Fifth Circuit in Estate of Bright. A hypothetical buyer would consider the relationships between other shareholders, which could either enhance or diminish the value of a potential swing vote.
Differential Valuation of Partner Interests
The distinction between general and limited partner interests creates significant valuation disparities. Limited partners and non-managing members lack management authority regardless of their ownership percentage—a fundamental limitation justifying substantial discounts even for large economic interests. While legal control in a partnership with a 1% general partner and 99% limited partner resides with the general partner, valuation experts must consider whether the limited partner might exert de facto control in family settings. Additionally, general partners often retain redemption rights unavailable to limited partners. Although these rights may carry early withdrawal penalties, the IRS frequently attempts to disregard such constraints in family-controlled entities under §2704(b), as discussed below.
Advantages of Family Limited Partnerships and LLCs
Since minority discounts reflect disadvantages related to lack of control, these discounts can be reduced or eliminated when the state laws governing the entity provide enhanced protections for minority owners or impose fiduciary obligations on controlling owners. Courts generally recognize such protections as relevant factors when determining the appropriate level of minority discounts.
As a result, when properly structured, Family Limited Partnerships (FLPs) and Limited Liability Companies (LLCs) can generally provide more substantial valuation discounts than corporations due to their unique structural characteristics and the evolution of state laws governing these entities. The strategic selection of entity type and state jurisdiction can significantly impact the magnitude of allowable discounts for transfer tax purposes.
Selection of governing state law
The jurisdiction governing a family entity significantly impacts available valuation discounts. Under §2704(b), the IRS will disregard liquidation or other restrictions that the transferor or any member of her or his family can remove or alter after the transfer has occurred, that lapse after the transfer has occurred, or that are more restrictive than state default rules. However, when state law itself imposes withdrawal or liquidation limitations, these restrictions remain valid for determining valuation discounts.
Many states have modernized their business entity laws in ways that enhance discount opportunities. Numerous jurisdictions have eliminated default withdrawal rights for limited partners and LLC members, ensuring that such restrictions represent inherent limitations rather than tainted restrictions under §2704(b).
Several states have also established entity continuation as the default rule upon a partner withdrawal or death, protecting liquidation restrictions in governing documents from §2704(b) challenges. While traditional partnership law often allowed dissolution upon a general partner's withdrawal, modern statutes increasingly permit continuation with remaining partners' consent.
To optimize valuation discounts and bolster support for their applicability with respect to this particular challenge, it is advisable to form entities in states explicitly prohibiting limited partner withdrawal. One should select jurisdictions with default rules favoring entity continuation, consider using an entity with perpetual existence as the general partner, include continuation provisions ensuring multiple general partners, and craft entity agreements that align with supportive state laws.
The strategic intersection of carefully designed entity structures and favorable state law creates sustainable valuation discounts based on genuine economic limitations rather than artificial constraints vulnerable to §2704(b) challenges. The less likely an entity is to be dissolved, the larger the lack-of-control valuation discount an appraiser might apply to an interest in that entity because the interest owner is less likely to receive a pro rata share of the liquidation value of the entity in the near future.
IRS Challenges to Valuation Discounts
The IRS regularly employs a handful of approaches to contest perceived aggressive applications of valuation discounts in wealth transfer planning. These challenges manifest through several distinct but complementary approaches, each designed to address different aspects of the planning strategies.
Perhaps the IRS's most successful strategy involves bringing transferred assets back into the transferor's estate by demonstrating continued benefit, control, or enjoyment under the retained interest inclusion rules of IRC Section 2036(a). Courts have been particularly receptive to these arguments when transferors maintain possession or economic benefit from assets nominally transferred to family entities. See our analysis here for a further explanation of how these rules can be navigated where the donor wants to retain some rights over the transferred assets after the transfer.
The IRS may assert that an entity lacks economic substance, thereby treating transfers of interests as direct transfers of the underlying assets themselves. This approach bypasses the entity structure entirely, neutralizing the very foundation upon which discounts are built.
As previously discussed, when entity agreements contain liquidation constraints exceeding state law limitations, the IRS invokes §2704(b) to disregard these restrictions for valuation purposes. This provision specifically targets arrangements where family-controlled entities use artificial constraints to suppress transfer tax values.
Under the gift on formation approach, the IRS contends that a taxable gift occurs at entity formation, measured by the difference between the value of the contributed assets and the discounted partnership interests received in return. This theory recognizes that diminished value must flow somewhere—typically to other family members—triggering immediate gift tax consequences.
Deathbed Transfers and Substance-Over-Form Challenges
While abandoning family attribution theories, the IRS continues to challenge minority discounts in certain scenarios using substance-over-form, step transaction, and sham transaction principles.
Deathbed transfers: In Estate of Murphy, the Tax Court denied a minority discount where the sole purpose of transferring a small percentage of stock 18 days before death was to obtain tax advantages, with no substantial change in beneficial interest.
Integrated transactions: The IRS may treat sales and redemptions as integrated transfers when they appear designed primarily to create artificial discounts (TAM 9504004).
However, in Estate of Frank, the Tax Court allowed minority discounts for stock transferred two days before death, declining to apply substance-over-form principles and distinguishing this case from Murphy. In Frank, there were no letters or other written evidence that the purpose of the transfer was to achieve a discount, and a significant block of stock was transferred. In Murphy, on the other hand, there were a number of letters from the family accountant urging Mrs. Murphy to make the transfers in order to obtain the minority interest discount at her death, and the amount of stock transferred was relatively small.
Avoiding IRS Challenges
It is essential to follow established formalities to ensure that your planning strategies hold up against challenges from tax authorities. These measures not only enhance defensibility but also align planning structures with substantive economic principles that courts have consistently respected.
Strategic Jurisdiction Selection Form the entities whose ownership interests are to be transferred subject to the valuation discounts in states with default rules limiting withdrawal rights for limited partners and LLC members, thereby aligning entity restrictions with state law to avoid §2704(b) scrutiny.
Legitimate Business Purpose Establish and document genuine non-tax objectives for forming the entity subject to the valuation discounts. A benefit of the myriad IRS challenges in this context is the many rulings that offer examples of valid non-tax reasons for forming such entities. Courts have ruled favorably for taxpayers that have formed FLP and FLLC entities for the purposes of: centralized asset management, preserving a family's investment philosophy, creditor protection, and family governance. However in all cases where the taxpayers prevailed, they were generally able to demonstrate that they operated consistently with whatever the stated non-tax purposes were for forming the entity.
Financial Segregation Maintain strict separation between personal and entity finances through dedicated accounts and meticulous record-keeping. Commingling of funds presents a critical vulnerability.
Pro-Rata Distributions Ensure all economic benefits flow proportionally to ownership interests, as disproportionate distributions (especially to transferors) suggest implied agreements that courts routinely reject.
Formal Documentation Maintain comprehensive records of entity formalities, including meeting minutes, resolutions, and compliance with governing documents to substantiate legitimate operation.
Books and Records Maintain accurate books that reflect the underlying operations and that are consistent with the associated provisions in the entity’s operating agreement. Routinely issue financial statements to the entity’s members.
Precise Capital Accounting Maintain capital accounts in accordance with the operating agreement and governing documents with ongoing accuracy to reinforce the economic substance of the arrangement.
Substantial Minority Interests Ensure family members other than the transferor hold meaningful ownership stakes to avoid the appearance of artificial fragmentation.
Avoiding overlapping roles When structuring family entities, it is important to avoid situations where an individual has multiple roles, such as general partner and attorney-in-fact for a parent.
Third-party involvement Having third parties involved in the structure, especially as minority owners of the general partner, can add credibility and infuse fiduciary accountability. The presence of unrelated minority shareholders can help ensure the enforcement of fiduciary duties and bolster support that the entity was formed with the intent to achieve non-tax objectives.
Careful review of governing documents The governing documents should be carefully reviewed to ensure that they reflect the actual operation of the FLP or FLLC and do not grant excessive control to any one individual. The distribution provisions and standards under the operating agreement should limit the general partner's discretion to make distributions.
Senior family members should avoid GP interests Senior family members should avoid holding general partner or managing member (GP) interests in family entities, ideally never acquiring them or divesting them during their lifetime. Courts have increasingly ruled against taxpayers by including the full, non-discounted value of transferred interests in donors' estates when they retained ownership positions that could have enabled entity liquidation or distributions. Taxpayer arguments that fiduciary duties constrained GP powers have proven largely ineffective, with courts characterizing such duties as "illusory" in family contexts. A more effective approach involves bifurcating powers—separating the tainted powers associated with GP interests (e.g., distribution and liquidation authority) that may trigger estate inclusion from investment decision-making powers that senior family members might safely retain.
Bona Fide Transactions For a partnership interest transfer to receive favorable tax treatment, it must constitute a bona fide transaction with substantive economic reality. The cornerstone requirement is that the transferee must gain genuine control over the transferred interest. Transfers where the donor retains significant incidents of ownership are unlikely to prevail if challenged by the IRS.
Courts examine several factors to determine whether a donee has acquired meaningful control, including: whether the donee has the ability to liquidate or sell their interest without significant financial penalty, whether the donor retains control over assets essential to partnership operations, the presence of management powers retained by the donor that exceed normal partner relationships, the extent of the donee's actual participation in partnership management, whether partnership income distributions flow to the donee for their unrestricted use, and recognition of the donee as a partner in day-to-day business operations. These factors collectively establish whether the transfer represents genuine economic substance or merely a paper transaction designed primarily for tax advantages.
Active Management Demonstrate genuine stewardship through substantive management activities rather than passive asset holding, as actively managed entities receive greater judicial deference.
Using FLPs With a Family Office Structure:
Due to the non-deductibility of investment related expenses, such as fees paid to investment managers, which are typically paid based on a percentage of assets under management, many high net worth individuals have established a family office structure that can mitigate this issue and result in obtaining the benefit of a tax deduction for such fees. In this context, the FLP’s assets are managed by a family office which receives a "profits interest" as compensation rather than a set fee (or a percentage of AUM). Such a structure can support the FLP's business purpose so that the entity’s expenses qualify as deductible business expenses rather than nondeductible investment expenses. Moreover, this aligns the family office's incentives with those of the FLP’s owners and strengthens the argument that the family office is engaged in a trade or business for income tax purposes. You can read more about this structure here.
The Strategic Value of Valuation Discounts
Valuation discounts represent one of the most powerful and well-established tools for efficient estate planning. When properly implemented, these strategies allow high-net-worth individuals to transfer significantly more wealth to future generations while minimizing transfer tax burdens. However, as our analysis demonstrates, effective implementation requires careful attention to entity structure, jurisdiction selection, operational formalities, and ongoing management practices.
The extensive body of case law in this area provides both warnings and roadmaps. Failed planning often stems from rushed implementation, casual disregard for formalities, or excessive retention of control by senior family members. Conversely, successful planning manifests through meticulous documentation, genuine business purposes, proper segregation of assets, and transparent governance.
For families with substantial wealth, the benefits of these strategies extend beyond mere tax savings. Well-structured and maintained entities can provide meaningful governance frameworks for family assets, protect wealth from creditors, and create platforms for educating younger generations about wealth stewardship. When combined with other advanced planning techniques like GRATs, preferred partnerships, and dynasty trusts, the compounded benefits can preserve generational wealth far more effectively than traditional planning approaches.
As with all sophisticated planning, valuation discount strategies should be implemented with the guidance of experienced advisors who understand both the technical requirements and the practical operational considerations. By following the principles outlined in this article and drawing lessons from the established case law, families can confidently utilize these powerful tools as part of a comprehensive wealth transfer plan that serves both tax efficiency and broader family objectives.
About the Author
Jordan Toplitzky is a CPA, a member of the AICPA, and earned an MBA from the University of Michigan and a Master of Business Taxation from the University of Southern California.
Jordan began his career as a CPA serving ultra-high net worth individuals and their closely-held businesses at Andersen. He has helped companies raise debt and equity capital, led companies through two successful exits, and scaled businesses for 100%+ year over year growth. He has devised estate transfer plans and structured investment and business transactions that attained significant tax savings and guided clients’ finances to sustained growth.
Jordan was the Audit Committee Chair on the Board of Directors of Ceres Acquisition Corp., a publicly listed SPAC, and is involved in various philanthropies, including at his alma mater the University of Michigan, Ann Arbor, and Jewish Big Brothers Big Sisters of Los Angeles. He currently serves as the Audit Committee Chair of Campbell Hall Episcopal School.
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This Toplitzky&Co publication provides information and comments on tax issues and developments of interest to our clients and friends. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide tax advice. Readers should seek specific tax advice before taking any action with respect to the matters discussed herein.
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