Family partnerships let you shift income to family members in lower tax brackets, transfer wealth at discounted values, and protect assets from creditors. When structured correctly, they’re one of the most effective tools for multi-generational tax planning.
But the IRS watches family partnerships closely. Get the structure wrong, and you’ll face challenges, penalties, and unwound transactions.
Key Takeaways: Family Partnership Tax Strategies
- Income splitting shifts partnership income to family members in lower tax brackets (37% to 22% potential savings)
- FLP valuation discounts typically range 25-40% for gift and estate tax purposes
- 2026 estate tax exemption is $15 million per person under the OBBBA
- Parents retain control as general partners while gifting limited partnership interests
- Kiddie tax limits income shifting to children under 19 (or 24 if students)
- IRS scrutinizes FLPs—legitimate business purpose and formalities are essential
This guide covers the income tax strategies, estate planning benefits, and compliance requirements that make family partnerships work.
Table of Contents
What Is a Family Partnership?
A family partnership is a partnership where the partners are family members. The most common structure is the Family Limited Partnership (FLP), but family members can also form general partnerships or LLCs taxed as partnerships.
Family Limited Partnership Structure
FLPs have two types of partners:
- General Partners (GPs): Typically parents or senior family members. GPs control the partnership, make management decisions, and control distributions. They have personal liability for partnership obligations.
- Limited Partners (LPs): Usually children, grandchildren, or trusts for their benefit. LPs own a financial interest but have no management control. Their liability is limited to their investment.
This structure lets parents maintain control while transferring ownership value to the next generation.
What FLPs Can Hold
Family partnerships can own:
- Real estate (investment or rental properties)
- Marketable securities
- Operating business interests
- Closely held company stock
- Other investment assets
The assets become partnership property. Partners own interests in the partnership, not direct ownership of the underlying assets.
For a complete overview of partnership taxation, see our partnership taxation guide.
Income Splitting: Shifting Income to Lower Tax Brackets
The core tax benefit of family partnerships is allocating income to family members who pay lower rates.
How It Works
Partnership income flows through to partners based on their ownership percentage (or special allocations in the partnership agreement). When children or other family members own partnership interests, their share of income is taxed at their individual rates, not the parents’ rates.
A parent in the 37% bracket can shift income to an adult child in the 22% bracket. Same income, 15% lower tax rate.
Requirements for Income Splitting
The IRS won’t respect allocations that exist only on paper:
- Ownership must be real. The family member receiving the allocation must actually own the partnership interest. Gift documentation, capital account records, and legal transfer documents matter.
- Capital or services must be contributed. Under Section 704(e), family members must either contribute capital or perform services to justify their share of income. You can’t just assign income to children who contribute nothing.
- Allocations must reflect economics. If a parent contributes all the capital and does all the work, allocating 50% of income to a child won’t hold up. Allocations should reflect what each partner contributes.
Kiddie Tax Limitations
Children under 19 (or under 24 if full-time students) face the “kiddie tax.” Unearned income above the threshold is taxed at the parents’ marginal rate.
Partnership income allocated to children is generally unearned income for kiddie tax purposes, unless the child provides substantial services to the partnership. This limits income shifting to young children.
Adult children outside kiddie tax age can receive allocations taxed entirely at their own rates.
Compensation for Services
If children work in the partnership, pay them reasonable compensation through guaranteed payments or wages. This is earned income, not subject to kiddie tax, and deductible by the partnership.
Estate Planning Benefits
Beyond income tax savings, family partnerships are powerful estate planning tools.
Valuation Discounts
When you transfer limited partnership interests to family members, those interests are often worth less than a proportional share of underlying assets. Two discounts typically apply:
Lack of Marketability Discount: LP interests can’t be sold on a public market. Finding a buyer takes time and effort. This lack of liquidity reduces value, typically by 15-25%.
Lack of Control Discount: Limited partners can’t control distributions, management decisions, or partnership dissolution. This powerlessness reduces value, typically by 10-20%.
Combined discounts often range from 25-40%, depending on partnership structure and asset liquidity.
Example: A partnership holds $1 million in assets. A 30% LP interest represents $300,000 of underlying value. But after valuation discounts, that interest might be appraised at $195,000-$225,000 for gift tax purposes.
You can transfer more value while using less of your gift tax exemption.
Using the Gift Tax Exemption
The annual gift tax exclusion for 2026 is approximately $19,000 per recipient ($38,000 for married couples giving jointly). You can gift LP interests up to this amount each year without using any lifetime exemption.
For larger transfers, the 2026 lifetime estate and gift tax exemption is $15 million per person. Valuation discounts stretch this exemption further.
Maintaining Control
Parents typically retain the general partner role, maintaining full control over:
- Whether to make distributions (and how much)
- Management of partnership assets
- Admission of new partners
- Major decisions
This lets you transfer economic value while keeping control during your lifetime.
For more on partnership dissolution and transfers, see our partnership liquidation guide.
Valuation Discounts: The FLP Advantage
Getting the discount right requires professional appraisal and proper structure.
Factors Affecting Discount Size
Not all FLPs get the same discounts. Factors include:
- Asset liquidity: Partnerships holding illiquid assets (real estate, closely held businesses) get larger discounts than those holding publicly traded securities.
- Distribution history: Partnerships that regularly distribute income may see smaller discounts.
- Transfer restrictions: Stronger restrictions on selling or transferring interests justify larger discounts.
- Partnership term: Longer required holding periods support higher discounts.
Appraisal Requirements
The IRS requires qualified appraisals for transfers of partnership interests. The appraiser must be independent, qualified, and follow established valuation methods.
Appraisals should be done at the time of each gift. Using old appraisals or self-valuations invites challenge.
What the IRS Looks For
The IRS has successfully challenged discounts when:
- The partnership was formed shortly before death (suggesting tax avoidance as the primary purpose)
- Assets were transferred to the partnership just before gifting interests
- The partnership didn’t operate like a real business
- Partners commingled personal and partnership assets
Asset Protection Considerations
FLPs may provide some asset protection benefits, but this is a legal matter requiring attorney guidance. Here’s the general concept from a planning perspective.
Charging Order Protection
If a partner is sued individually, creditors generally can’t seize partnership assets directly. Instead, they may be limited to a “charging order,” which is a claim on distributions that would otherwise go to the debtor partner.
But the charging order doesn’t force the partnership to make distributions. If the general partner chooses not to distribute, the creditor may have to wait.
Limitations
Asset protection shouldn’t be the primary purpose of FLPs. Courts have rejected FLPs formed primarily to shield assets from existing or anticipated creditors. Fraudulent transfer rules apply.
FLPs should be formed before any known claims arise, with legitimate non-tax purposes documented.
State Law Matters
Charging order protection varies significantly by state. If asset protection is important to your planning, work with an attorney experienced in your state’s partnership and creditor law. This is outside the scope of tax advice.
IRS Scrutiny: How to Structure Your Family Partnership Correctly
The IRS audits FLPs more aggressively than other partnerships. Avoid common mistakes.
Establish Legitimate Business Purpose
The partnership must have a purpose beyond tax savings. Document purposes such as:
- Centralized management of family investments
- Asset protection
- Business succession planning
- Keeping family assets together
- Teaching younger generations about wealth management
Maintain Partnership Formalities
Treat the partnership as a real business:
- Hold annual meetings and document them
- Maintain separate partnership bank accounts
- Keep accurate books and records
- File partnership tax returns (Form 1065) on time
- Issue K-1s to all partners
Timing Matters
Don’t gift interests immediately after forming the partnership. The IRS views this as a step transaction, collapsing the formation and gift into a single transfer of underlying assets.
Wait at least several months between formation, asset contribution, and gifting interests.
Pro-Rata Treatment
All assets should be contributed to the partnership and treated consistently. Don’t cherry-pick which assets go in. Don’t treat some assets as partnership property and others as personal.
Avoid Deathbed Transfers
FLPs formed shortly before death face intense scrutiny. The IRS has successfully argued that such partnerships should be disregarded, including all assets in the decedent’s estate at full value.
For more on partnership agreement provisions, see our partnership agreement tax clauses guide.
Frequently Asked Questions
Can I give my children partnership interests?
Yes. You can gift limited partnership interests to children using the annual gift tax exclusion or your lifetime exemption. Interests may qualify for valuation discounts reducing the taxable gift value. The children receive their share of partnership income, taxed at their individual rates.
How does the kiddie tax affect family partnership income?
Children under 19 (or 24 if full-time students) may have partnership income taxed at their parents’ rate under kiddie tax rules. This limits income shifting benefits for young children. Adult children outside these age limits receive allocations taxed entirely at their own rates.
What is the estate tax exemption in 2026?
The 2026 estate and gift tax exemption is $15 million per person under the OBBBA. Amounts transferred during life or at death above this exemption are subject to 40% estate or gift tax. Valuation discounts on FLP interests can stretch how far this exemption goes.
Can I maintain control if I give away partnership interests?
Yes. As general partner, you maintain management control even while gifting limited partnership interests. You decide whether to make distributions, how to invest partnership assets, and all operational matters. Limited partners have no control rights.
How long should I wait before gifting partnership interests?
There’s no specific safe harbor, but waiting at least 6-12 months after formation demonstrates the partnership has legitimate purposes beyond tax reduction. The longer the partnership operates before gifting, the stronger the position against IRS challenge.
Is a Family Partnership Right for You?
Family partnerships work best when you have:
- Significant assets to transfer
- Adult children or other family members in lower tax brackets
- A need to maintain control while transferring value
- Time to operate the partnership legitimately before making transfers
- Tolerance for appraisal costs and compliance requirements
They’re not appropriate for:
- Assets you need full access to without partnership constraints
- Situations where the primary purpose is hiding assets from known creditors
- Last-minute estate planning
Professional guidance from both a CPA and an estate planning attorney is essential. The tax benefits are real, but so is IRS scrutiny. FLP formation and gifting involve legal documents that require attorney drafting.
If you want to explore whether a family partnership fits your situation, we work with family businesses and multi-generational wealth on partnership tax services.