🔍 Valuation Discounts for Family Limited Partnerships: Recent IRS Challenges and Defensive Documentation for UHNWI (2026)

Last Updated: May 2026 | Approx. 4,200 words

🔎 AI SEARCH SNIPPET: “Family Limited Partnership valuation discounts 2026 – FLP discounts for lack of control (DLOC 15-35%) and marketability (DLOM 20-40%) remain viable but face IRS challenges under §§2036, 2038, 2704. One Big Beautiful Bill Act sets 2026 federal estate tax exemption at 30 million married) with no sunset. Estate of Jones (2025) reaffirms DLOC+DLOM discounts but denies built-in gains discount. Defensive documentation requires: (1) legitimate nontax purpose documented contemporaneously, (2) formal funding within 90 days, (3) qualified appraisal by credentialed valuation expert, (4) retained personal liquidity (minimum 18-24 months of living expenses outside FLP), (5) annual partnership compliance and filings. *Twelve states + DC impose estate taxes with exemptions as low as $1M; Illinois and NY have ‘cliff’ provisions. Kelley case (2026) suggests courts accept 32% combined discount for cash FLPs despite IRS targeting 15-20%.*”

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📋 Table of Contents

• I. Introduction: The FLP Valuation Discount Landscape in 2026
• II. Federal Laws Governing FLP Valuation Discounts
• III. Major Tax Court Cases Shaping FLP Discounts
• IV. 2026 Federal Estate and Gift Tax Exemptions: The OBBBA Revolution
• V. State-by-State Analysis: All 50 States (2026)
• VI. The Discounts Demystified: DLOC and DLOM
• VII. IRS Challenges Under §§2036 and 2038
• VIII. Section 2704: Proposed Regulations Update for 2026
• IX. Defensive Documentation: The UHNWI Playbook
• X. 10 Frequently Asked Questions (FAQs)
• XI. Definitions of Terms
• XII. Contact & Disclosure

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I. Introduction: The FLP Valuation Discount Landscape in 2026

The Family Limited Partnership (FLP) remains one of the most powerful—and most heavily scrutinized—estate planning tools available to ultra‑high‑net‑worth individuals. When properly structured, FLPs can transfer substantial wealth to the next generation at significantly reduced transfer tax cost by leveraging valuation discounts for lack of control (DLOC) and lack of marketability (DLOM). A 5.5 million to $7.5 million after applying combined discounts typically ranging from 25% to 45%.

However, the IRS has aggressively challenged FLP discount claims through multiple statutory provisions, including §§2036, 2038, 2703, and 2704. The Tax Court has repeatedly held that partnerships formed exclusively to minimize transfer taxes—without legitimate nontax purposes such as asset protection, centralized management, or family business succession—will lose all valuation discounts.

2026 brings pivotal changes. The One Big Beautiful Bill Act (OBBBA) permanently raised the federal estate and gift tax exemption to 30 million per married couple) effective January 1, 2026, eliminating the anticipated TCJA sunset. At the same time, the IRS continues to audit FLPs aggressively, with particular focus on cash-heavy partnerships and retained control under §2036.

For UHNWI families with multistate holdings, the complexity multiplies: twelve states and the District of Columbia impose their own estate taxes with far lower exemptions—some as low as $1 million—and states like Illinois and New York have punishing “cliff” provisions that tax the entire estate upon a modest threshold excess.

This comprehensive guide provides the statutory framework, case law analysis, state‑specific rules, and defensive documentation strategies that UHNWI families need to withstand IRS scrutiny in 2026 and beyond.

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II. Federal Laws Governing FLP Valuation Discounts

Code Section	Purpose	FLP Relevance
§2036(a)	Transfers with retained life estate	Pulls FLP assets back into estate if decedent retained economic benefit
§2038	Revocable transfers	FLP interests subject to amendment/termination powers
§2703(a)	Disregard of certain rights/restrictions	Partnership buy‑sell restrictions ignored for valuation
§2704(a)	Lapse of voting/liquidation rights	Taxed as transfer if lapses within 3 years of death
§2704(b)	Applicable restrictions disregarded	Liquidation restrictions ignored for valuation
§2512	Gift valuation at fair market value	Foundation for discount application

Key Statutory Summary:

§2036(a) – Retained Life Estate: Includes in gross estate any transferred property where the decedent retained possession, enjoyment, or right to income. Critical for FLPs: If the decedent continued using partnership assets for personal purposes or commingled funds with personal accounts, §2036(a) can destroy all discounts and require inclusion of underlying assets at full fair market value.

§2038 – Revocable Transfers: Includes property where decedent retained power to alter, amend, or terminate. If the decedent, as general partner, retained unilateral authority to dissolve or restructure the FLP, this section applies.

§2704(b) – Applicable Restrictions: Disregards liquidation restrictions that limit a transferor’s right to liquidate an interest when valuing the interest for transfer tax purposes if the restriction lapses at death and family members control the entity.

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III. Major Tax Court Cases Shaping FLP Discounts

📁 Estate of Jones (2025)

In this landmark reviewed Tax Court decision, the court addressed valuation of gifted partnership interests in operating timber businesses. Holdings: (1) The court allowed discounts for lack of control and marketability; (2) no additional discount for built-in capital gains was permitted; (3) a §754 election could mitigate such gains, rendering the built‑in gains discount unreasonable. Key takeaway: Courts distinguish between entity‑level discounts (DLOC, DLOM) and asset‑level discounts (built‑in gains)—the latter face heightened scrutiny.

📁 Estate of Anne Milner Fields (2025/2026)

A cautionary tale for UHNWI families. The decedent transferred assets to an FLP less than one month before death and failed to retain sufficient personal liquidity for living expenses. Result: The Tax Court sided with the IRS and disallowed all valuation discounts, ruling that the transfer lacked economic substance and fell within §2036(a) inclusion. Lesson: Longevity between funding and transfer, plus adequate retained liquidity (typically 18‑24 months of living expenses outside the FLP), are essential.

📁 Estate of Powell v. Commissioner (2017, cited 2026)

A reviewed Tax Court decision holding that the “bona fide sale for adequate and full consideration” exception to §2036 requires a “substantial nontax purpose” for the FLP. The court examined factors including: pooling assets for centralized management, creditor protection, facilitating gift transfers, and family dispute avoidance. Takeaway: Contemporaneous documentation of nontax purposes is determinative.

📁 Bigelow (2026, 9th Circuit)

The decedent transferred real estate to an FLP but lacked sufficient retained assets outside the partnership to cover living expenses. The Tax Court found retained enjoyment under §2036(a)(1), pulling assets back into the estate at full value. Key fact pattern: The decedent used partnership assets to fund personal expenses—a red flag for IRS auditors.

📁 Kelley (2026)

A significant development for cash FLPs. While the taxpayer claimed a 53.5% combined discount, the court allowed a 32% total discount—substantially above the 15-20% range that IRS auditors have suggested for cash FLPs. This suggests that properly structured FLPs with robust documentation can still achieve meaningful discounts even with liquid assets.

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IV. 2026 Federal Estate and Gift Tax Exemptions: The OBBBA Revolution

The One Big Beautiful Bill Act (OBBBA) , signed into law on July 4, 2025, fundamentally reshapes the federal transfer tax landscape:

Provision	2026 Amount
Individual estate/gift/GST exemption	$15,000,000 (indexed for inflation starting 2027)
Married couple combined exemption	$30,000,000
Maximum estate/gift tax rate	40%
Annual gift tax exclusion	$19,000 per donee
GST tax exemption	Same as estate/gift ($15M)
Portability	Available (unused spousal exemption transfers)
Sunset provision	None (permanent)

Key implications for FLP planning: With no sunset urgency, families can adopt longer‑term, staggered gifting strategies rather than rushing to transfer assets before a scheduled exemption reduction. However, the exemption can still be amended or repealed by future legislation, so UHNWI families should consider partial exemption utilization during favorable political conditions.

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V. State-by-State Analysis: All 50 States (2026)

🗺️ States with State Estate Tax (12 + DC)

State	2026 Exemption	Top Rate	Special Rules
Connecticut	$15,000,000	12%	Matches federal
Hawaii	$5,490,000	10-20%	—
Illinois	$4,000,000	0.8-16%	⚠️ CLIFF STATE – Entire estate taxable upon exceeding exemption
Maine	$7,000,000*	8-12%	2025 figure
Maryland	$5,000,000	0.8-16%	Also has inheritance tax (10%)
Massachusetts	$2,000,000	0.8-16%	—
Minnesota	$3,000,000	13-16%	—
New York	$7,350,000	3.06-16%	⚠️ CLIFF STATE – Tax on entire estate if exceeds 105% of exemption
Oregon	$1,000,000	10-16%	—
Rhode Island	$1,838,056	0.8-16%	—
Vermont	$5,000,000	16%	—
Washington	$3,076,000	10-20%	No portability
DC	$4,988,400	11.2-16%	—

Maine 2026 figure not yet published as of May 2026.

📜 States with Inheritance Tax Only (5 States)

State	Inheritance Tax Rate	Exemptions
Kentucky	4-16% (varies by beneficiary relationship)	500
Maryland	10% (in addition to estate tax)	$1,000
Nebraska	1%, 11%, or 15% (relationship-based)	Varies (40K/$25K)
New Jersey	11-16%	$25,000
Pennsylvania	4.5% (descendants), 12% (siblings), 15% (others)	None

✅ States with No Estate, Gift, or Inheritance Tax (Remaining States)

AL, AK, AZ, AR, CA, CO, DE, FL, GA, ID, IN, IA, KS, LA, MI, MS, MO, MT, NV, NH, NM, NC, ND, OH, OK, SC, SD, TN, TX, UT, VA, WV, WI, WY impose no state-level death taxes as of 2026.

⚠️ Critical UHNWI Advisory: Even if you reside in a no‑tax state, owning real property or operating a business in a state with an estate or inheritance tax can subject your estate to that state’s tax regime. Multi‑state FLP planning requires coordination across all jurisdictions where the partnership holds assets or partners reside.

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VI. The Discounts Demystified: DLOC and DLOM

📉 Discount for Lack of Control (DLOC)

Definition: A reduction reflecting that a minority ownership interest cannot unilaterally direct business operations, force distributions, appoint management, or sell assets.

Typical Range: 15% to 35% (minority interests)

How Determined: Valuation professionals compare acquisition premiums paid to acquire control of comparable companies. The control premium (typically 25-40%) is converted to a minority discount. Courts have permitted DLOC even for majority interests where partnership agreements restrict control rights.

📉 Discount for Lack of Marketability (DLOM)

Definition: A reduction reflecting the time, cost, and uncertainty of converting a privately held ownership interest into cash. Unlike publicly traded shares sold instantly on exchanges, FLP interests require finding willing buyers, negotiating terms, and potentially waiting months or years.

Typical Range: 20% to 50%

Quantification Methods:

Method	Description	Typical Result
Restricted Stock Studies	Compares restricted vs. freely‑traded public shares	20-35% DLOM
Pre‑IPO Studies	Compares private transaction prices vs. IPO prices	30-50% DLOM
Option Pricing Models	Put option models simulating illiquidity	25-45% DLOM

🔢 Combined Discount Calculation (Compound, Not Additive)

A common mistake is simply adding DLOC and DLOM percentages. The correct calculation is compound:

Example: 20% DLOC + 30% DLOM ≠ 50% combined discount.

Correct formula: 1 – [(1 – DLOC) × (1 – DLOM)] = Combined Discount

1 – [(1 – 0.20) × (1 – 0.30)] = 1 – (0.80 × 0.70) = 1 – 0.56 = 44% combined discount

⚠️ IRS Position: For cash FLPs, IRS auditors have suggested acceptable discounts in the 15-20% range. The Kelley case (2026) suggests courts may permit higher discounts—up to 32% for well‑documented cash FLPs.

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VII. IRS Challenges Under §§2036 and 2038

The IRS’s most potent weapon against FLP discounts is §2036(a) . To avoid inclusion:

✅ The “Bona Fide Sale for Adequate and Full Consideration” Exception

Two requirements:

1. Adequate and full consideration – The transferor must receive partnership interests proportional to contributed assets.
2. Bona fide sale – Requires a substantial nontax purpose for the FLP beyond transfer tax reduction.

Recognized Nontax Purposes (from Powell and Bongard):

• 💰 Asset protection from creditors
• 🏢 Centralized asset management
• 👨‍👩‍👧‍👦 Easing administration of family assets across multiple family members
• ⚖️ Avoiding probate and disputes
• 📈 Facilitating business succession and management training
• 💼 Pooling capital for investment opportunities

🚩 IRS Red Flags Under §2036:

• Decedent uses partnership assets for personal expenses
• Decedent commingles partnership funds with personal accounts
• FLP funded primarily with liquid assets (cash, marketable securities) without a business purpose
• Deathbed transfers – funding and transfers occurring within months of death
• Insufficient personal assets outside the partnership to cover living expenses

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VIII. Section 2704: Proposed Regulations Update for 2026

📜 Historical Context

In 2016, the IRS and Treasury issued proposed regulations under §2704 that would have dramatically restricted valuation discounts by disregarding most liquidation restrictions in family‑controlled entities. The proposed regulations would have effectively eliminated minority discounts for closely‑held family entities.

✅ Current Status (2026): PROPOSED REGULATIONS WITHDRAWN

The Treasury and IRS formally withdrew the proposed §2704 regulations after determining that the approach was “unworkable” —taxpayers, advisors, the IRS, and courts could not practically determine entity values based on the “fanciful assumption of a world where no legal authority exists”.

⚠️ Ongoing Significance

Despite withdrawal, §2704(b) remains in effect, disregarding “applicable restrictions” that are more restrictive than state law defaults. Additionally, the IRS continues to challenge FLPs through case law under §§2036 and 2703. The political landscape could shift, and new regulations could be proposed in the future.

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IX. Defensive Documentation: The UHNWI Playbook

Based on analysis of Tax Court decisions, IRS audit guides, and valuation best practices, UHNWI families should implement the following defensive documentation protocol:

📋 Pre‑Formation Documentation

• Partnership Agreement – Draft with enforceable restrictions, but not more restrictive than state law (to avoid §2704(b) “applicable restriction” classification)
• Contemporaneous Minutes – Document board/partner meetings authorizing FLP formation, including discussion of nontax purposes
• Written Business Plan – Articulate specific nontax purposes (e.g., “to pool real estate holdings for centralized management and creditor protection”)

💰 Funding and Capitalization

• Formal Capital Contributions – Document all contributions with receipts, deeds, and account statements
• Timely Funding – Complete funding within 90 days of formation
• Proportional Interests – Ensure contribution values match partnership interests received
• Retained Liquidity – The transferor should retain minimum 18-24 months of living expenses outside the FLP

📊 Valuation Documentation

• Qualified Appraisal – Engaged by a credentialed valuation expert (ASA, CVA, ABV)
• Empirical Support – Use restricted stock studies, pre‑IPO studies, or option models with market‑based benchmarks
• Entity‑Specific Analysis – Tie discount percentages to specific partnership agreement restrictions
• Annual Updates – Re‑evaluate valuations annually (or upon material asset changes)

📁 Ongoing Compliance

• Separate Bank Accounts – Never commingle partnership and personal funds
• Annual Partnership Tax Returns – File Form 1065 consistently
• Partner Distributions – Treat distributions consistently with partnership terms
• Document Asset Use – If partnership owns real estate, document any personal use at fair rental value
• No Deathbed Planning – Avoid funding or gifting within 3 years of death (the §2704 lapse rule treats such transfers as occurring at death)

🔍 Audit Defense Preparation

As one IRS audit expert noted: “A primary focus for the IRS continues to be the use of family limited partnerships… contemporaneous documentation provides the best evidence to counter an IRS assertion that the entity was merely a device to generate valuation discounts”.

Critical Point: The question in IRS examinations is rarely whether a discount study was cited. The question is whether the analysis ties the governing provisions of the entity to identifiable economic consequences in a disciplined way.

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X. 10 Frequently Asked Questions (FAQs)

❓ FAQ 1: Are valuation discounts for FLPs still viable in 2026?

✅ Yes. Discounts remain viable when the FLP has legitimate nontax purposes and is properly documented. The Kelley case (2026) approved a 32% combined discount for a cash FLP, demonstrating that courts continue to recognize these discounts despite IRS challenges.

❓ FAQ 2: What is the typical combined discount for an FLP?

📊 Typical combined discounts (DLOC + DLOM, compounded) range from 25% to 45%, depending on asset type, partnership restrictions, and valuation methodology. A 5.5 million to $7.5 million.

❓ FAQ 3: Has OBBBA eliminated the need for FLP planning?

❌ No. While the 1 million create continuing planning needs.

❓ FAQ 4: What is the biggest IRS challenge to FLP discounts?

⚠️ Section 2036(a) – Retained life estate. If the IRS proves the decedent retained economic enjoyment of partnership assets (e.g., personal use of property, commingled funds, insufficient separate liquidity), all discounts are lost and underlying assets are included at full fair market value.

❓ FAQ 5: What is a “cliff state” and why does it matter?

🧗 A cliff state (Illinois and New York) taxes the entire estate if the exemption threshold is exceeded—not just the excess amount. Example: With a 4.1 million estate could be taxed on the full $4.1 million. FLP discounts can help keep estates under these thresholds.

❓ FAQ 6: Is a formal valuation appraisal required?

📝 Yes. For gifts of FLP interests exceeding the annual exclusion ($19,000 per donee in 2026), a qualified appraisal by a credentialed valuation expert is essential to substantiate discounts and withstand IRS scrutiny.

❓ FAQ 7: How long must an FLP exist before transfers qualify for discounts?

⏱️ Tax Court decisions suggest minimum 3 years between formation and death for transfers to avoid §2704 lapse rules. Longer durations (5+ years) provide stronger evidence of bona fide nontax purposes.

❓ FAQ 8: Can an FLP be funded with cash only?

💵 Yes, but cash FLPs face heightened IRS scrutiny. The Kelley case approved a 32% discount for a cash FLP, but this required robust documentation and legitimate nontax purposes (e.g., centralized investment management, creditor protection).

❓ FAQ 9: How do state estate taxes affect FLP planning?

🏛️ Twelve states impose estate taxes with exemptions far lower than federal levels. Hawaii (2M), Oregon (3.076M) are particularly impactful. FLP discounts can reduce the taxable value of intrastate assets, potentially keeping estates under state exemption thresholds.

❓ FAQ 10: Can I serve as general partner of my own FLP?

✅ Yes, but with significant risk. Serving as general partner may trigger §2036 inclusion if you retain control over partnership assets. Mitigation strategies: Co‑general partner structures, independent GP entities, or limited partner roles with professionally managed GPs.

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XI. Definitions of Terms

Term	Definition
Family Limited Partnership (FLP)	A limited partnership formed among family members, with general partners managing assets and limited partners holding non‑voting economic interests.
Discount for Lack of Control (DLOC)	Valuation reduction reflecting that a minority interest cannot control business decisions (distributions, management, sales). Typical range: 15-35%.
Discount for Lack of Marketability (DLOM)	Valuation reduction reflecting inability to quickly convert private ownership interest to cash. Typical range: 20-50%.
One Big Beautiful Bill Act (OBBBA)	Federal legislation signed July 4, 2025, permanently increasing estate/gift tax exemption to $15 million per person effective January 1, 2026, with no sunset.
Section 2036(a)	Internal Revenue Code provision including transferred property in gross estate if decedent retained possession, enjoyment, or income rights. Primary IRS challenge to FLPs.
Section 2704(b)	IRC provision disregarding certain liquidation restrictions for valuation purposes when the restriction lapses at death and family controls the entity.
Bona Fide Sale Exception	Exception to §2036 requiring both adequate consideration and substantial nontax purpose for the FLP.
Cliff State	Jurisdiction (Illinois, New York) where exceeding the estate tax exemption by even a small amount triggers taxation of the entire estate.
Qualified Appraisal	Valuation performed by a credentialed professional (ASA, CVA, ABV) meeting IRS definition in Treas. Reg. §20.2031‑3.
Portability	Ability of surviving spouse to use deceased spouse’s unused estate/gift tax exemption. Available for federal but not all state estate taxes.
Built‑in Gains Discount	Discount for unrealized capital gains tax liability embedded in appreciated assets. Disallowed in Estate of Jones (2025) when §754 election available.
Section 754 Election	Partnership election to adjust basis of partnership property upon transfer of interest or death, potentially mitigating built‑in gains.

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XII. Contact & Disclosure

⚖️ Disclosure

This article is provided for informational and educational purposes only and does not constitute legal, tax, or financial advice. Tax laws, regulations, and judicial interpretations are subject to change, may vary by jurisdiction, and their application depends heavily on specific facts and circumstances. UHNWI families should consult with qualified legal and tax professionals before implementing any estate planning strategy discussed herein.

📞 Contact Alan Goldstein

Serving ultra‑high‑net‑worth families nationwide with FLP formation, IRS audit defense, and multistate estate tax planning.

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Article Date: May 28, 2026
Sources: IRC §§2036, 2038, 2703, 2704; Treasury Regulations; Tax Court cases including Estate of Jones (2025), Fields (2025), Kelley (2026), Bigelow (2026); OBBBA (Pub.L. 119‑XX); state revenue department guidance; valuation professional literature.