The saving comes from two valuation discounts applied in sequence, and it lasts only as long as the partnership is run as a real one.
A family limited partnership saves estate or gift tax by turning assets into partnership interests that an appraiser values below their share of net assets, because a limited partner has neither control nor a market to sell into. On an illustrative 40.0 million partnership, transferring the 99 per cent limited partner interest with a 15 per cent discount for lack of control and a 25 per cent discount for lack of marketability values it at 25.245 million, not 39.60: a combined discount of 36.25 per cent and 5.742 million of tax saved at 40 per cent, before costs and before the risk that the IRS undoes it.
Worked in full in The Family Office Professional by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Parents contribute a portfolio to a partnership, keep the 1 per cent general partner interest, and give or sell the limited partner interests to children or to trusts for them. Transfer tax is charged on the fair market value of what is transferred: not the assets, but an interest in a partnership the holder cannot manage, cannot force to distribute and cannot easily sell. Appraisers reflect that with two discounts, applied in sequence: a discount for lack of control, then a discount for lack of marketability on the minority value.
The saving only matters where the transfer would otherwise be taxed: the family has used its lifetime exemption, or the transfer is large enough to exceed it. The case below assumes the exemption is already used, so each dollar of value removed saves the 40 per cent top transfer tax rate.
| Input | Value |
|---|---|
| Assets contributed: diversified portfolio and real estate | 40.0 |
| Limited partner interest transferred | 99% |
| Discount for lack of control (illustrative) | 15% |
| Discount for lack of marketability (illustrative) | 25% |
| Transfer tax rate | 40% |
| Set-up cost, then annual cost of running the partnership | 0.08, then 0.06 |
The discounts are illustrative. In practice they come from a qualified appraisal of this partnership's agreement, assets and distribution history, and they are the first thing the IRS examines.
Pro rata NAV = assets × interest transferred
Value = pro rata NAV × (1 − DLOC) × (1 − DLOM)
Combined discount = 1 − (1 − DLOC) × (1 − DLOM)
Tax saved = (pro rata NAV − value) × tax rate Excel: =B2*B3*(1-(1-B4)*(1-B5))*B6
Step 1, pro rata value. 99 per cent of 40.0 is 39.60.
Step 2, lack of control. 39.60 × 0.85 = 33.66, the value of a minority interest that could be sold freely.
Step 3, lack of marketability. 33.66 × 0.75 = 25.245. The combined discount is 36.25 per cent.
Step 4, the saving. The transfer is reported at 25.245 instead of 39.60, removing 14.355 from the tax base: 5.742 of tax at 40 per cent.
Step 5, net of costs. Appraisals, legal work, separate accounts, partnership returns and annual valuations cost, on these assumptions, 0.08 to set up and 0.06 a year: 0.98 over fifteen years, undiscounted. Net saving 4.762.
| Lack of control | Lack of marketability | Combined discount | Value transferred | Tax saved at 40% |
|---|---|---|---|---|
| 0% | 0% | 0.00% | 39.60 | 0.00 |
| 5% | 15% | 19.25% | 31.98 | 3.05 |
| 10% | 20% | 28.00% | 28.51 | 4.44 |
| 15% | 25% | 36.25% | 25.24 | 5.74 |
| 20% | 30% | 44.00% | 22.18 | 6.97 |
Each point of combined discount is worth 0.1584 of tax here. The running costs of 0.98 absorb 6.19 points, so a partnership holding only listed securities, where appraisers and courts tend to allow modest discounts, may not pay for itself. Real estate and operating businesses support larger discounts because the underlying assets are themselves hard to sell. How the two discounts are evidenced is worked in how to calculate a discount for lack of control and how to calculate DLOM with the Finnerty model.
Adding the discounts. 15 plus 25 is 40 per cent, a value of 23.76. But the marketability discount applies to a value already reduced for control, so the correct combined figure is 36.25 per cent. Adding them understates the value by 1.485 and claims 0.594 of tax that is not there, which is the kind of error that undermines the whole appraisal on audit.
Ignoring section 2036. If the parents keep using the assets, take distributions as they need them, put in nearly everything they own, or keep the power to decide distributions together with others, the IRS can include the partnership's underlying assets in the estate at full value, as in Strangi and Powell. The discount then disappears, and so does the benefit of the transfer: at 6 per cent growth, the 39.60 is 94.90 after fifteen years and is taxed in the estate at that value. Against a plan that worked, where only the 25.245 was taxed as a gift, that is 27.86 more tax at 40 per cent: 22.12 on the growth the gift was meant to move out plus the 5.742 the discount saved. A legitimate non-tax purpose, separate accounts, pro rata distributions and enough assets kept outside the partnership to live on are what protect the structure.
Gifted interests also take the donor's income tax basis, so they lose the step-up at death. On appreciated assets that cost belongs in the comparison with the transfer tax saved.
The Family Office Professional covers how single-family and multi-family offices invest and operate; the free workbook for this case prices what running an office costs. For another way to move growth out of an estate, see how a sale to an IDGT works.
Multiply, do not add: combined discount equals one minus (one minus DLOC) times (one minus DLOM). A 15 per cent and a 25 per cent discount combine to 36.25 per cent, not 40. On the illustrative 39.60 million interest, adding them understates the value by 1.485 million and claims 0.594 million of tax that is not there.
Whatever a qualified appraisal of that partnership supports, which depends on its agreement and assets. In the illustrative sensitivity, combined discounts from 19.25 to 44.00 per cent save 3.05 to 6.97 million on a 39.60 million interest. Partnerships holding only listed securities tend to support smaller discounts than real estate or operating businesses.
Yes, under section 2036, if the transferors kept the use of the assets or control over distributions. The underlying assets are then included in the estate at full value: on the illustrative case, 39.60 million growing at 6 per cent becomes 94.90 million after fifteen years. Against a plan that worked, where only 25.245 million was taxed as a gift, that is 27.86 million more tax at 40 per cent.
This article is one calculation from The Family Office Professional. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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