Family Limited Partnership Distribution Control: Retained Rights or Estate Inclusion?

High

—

🏢 Client 2026-04-25 15:06

We closed the Morrison Family Limited Partnership last month—three commercial properties, total equity around $17.5 million. I contributed everything at formation, then immediately turned around and gifted out half the LP interests to my wife Eleanor and our three kids. We used a 35% combined discount—25% for lack of marketability, 15% for lack of control—so we're reporting about $5.7 million in taxable gifts instead of the $8.75 million pro rata value. Here's what's keeping me up at night. I kept the general partner through Morrison Management LLC, which Eleanor and I own together. That means I have complete control over everything—acquisitions, sales, distributions, tax elections, all of it. The kids are pure passive LPs with no say in management. I also retained a 49% LP interest for myself, so between Eleanor's 20% and my 49%, we control any supermajority votes the agreement requires. My estate attorney Rachel says this is a clean structure and the discounts are well-supported by the appraisal, but I know the IRS goes after family limited partnerships hard. What's my real exposure here under Section 2036? Are they going to argue I never really gave anything away because I kept too much control? And separately, how aggressive is that 35% discount—are we going to get challenged on the gift tax return?

⚡ Junior Advisor 2026-04-25 15:06

Robert, I'll be direct: Section 2036(a)(2) is exactly where the IRS will come after you, and you've handed them good facts. The statute pulls transferred property back into your gross estate if you retained "the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom." Treasury Regulation 20.2036-1(b)(3) says retention of voting rights in a controlled corporation is enough to trigger inclusion, and the IRS has successfully argued the same principle applies to GP control in family limited partnerships. Your problem is Article 5 of your operating agreement. You have "full, exclusive, and complete authority" over distributions under Section 5.1, which means you can decide whether Eleanor gets cash this year or next, whether Michael ever sees a dime beyond tax distributions, whether David's construction business gets help through an early distribution or has to wait. That's not theoretical control—that's the literal power to designate who enjoys the partnership income, which is the exact language of Section 2036(a)(2). The IRS doesn't care that you're exercising that power through Morrison Management LLC instead of directly—courts have consistently held that control through an entity you own is still retained control. The 35% discount is a separate fight, but honestly it's the smaller problem. If the IRS wins on 2036(a)(2), the discounts become irrelevant because the entire value of the gifted interests gets pulled back into your estate anyway. Should we start with how to defend the Section 2036 position, or do you want me to walk through the discount challenge first?

🛡️ Senior Advisor 2026-04-25 15:07

Robert, I'm going to push back on my colleague a bit here. Yes, Section 2036(a)(2) is the IRS's favorite weapon against FLPs, but the facts aren't as bad as they sound if we frame them correctly. The key is whether you retained control in a way that serves a non-tax business purpose or whether the only reason the partnership exists is to create discounts. Courts have repeatedly upheld FLP structures where the general partner has broad authority—what kills taxpayers is when there's no credible reason for the entity beyond estate planning and the donor keeps living off the assets like nothing changed. You've got three commercial properties that were already generating income before the partnership existed, you're using the partnership to consolidate management and create a vehicle for the next generation to hold real estate together, and critically, you didn't gift away everything and then come back hat-in-hand asking for distributions to cover your lifestyle. The operating agreement requires tax distributions under Section 7.2, which limits your discretion on the most important cash flow—covering everyone's tax liability—and that undercuts the IRS argument that you can starve your kids whenever you feel like it. The fact that you and Eleanor together hold 69% and can block supermajority decisions actually helps you here, because it shows the partnership has real governance constraints, not just Robert doing whatever Robert wants. That said, my colleague is right that Article 5 hands the IRS good quotes, and we need to think hard about how your actual behavior in Year 2 and beyond will look under audit. Are you taking cash distributions that the kids don't get, or are distributions genuinely pro rata? Are you using partnership funds to pay personal expenses, or is everything arms-length? The IRS won't just read the operating agreement—they'll subpoena three years of bank statements and build a narrative about whether this partnership is real or cosmetic. What does your distribution pattern actually look like so far?

🏢 Client 2026-04-25 15:07

Look, I appreciate the framing on business purpose—we absolutely have legitimate reasons for consolidating these properties under one roof. But I need to understand the practical risk here, not just the legal theory. What's the actual probability the IRS even looks at this, and if they do challenge it, what's my downside? Here's what I mean. My estate attorney Rachel says family limited partnerships get audited more than regular gifts, but she also says most of those audits are about valuation discounts, not Section 2036 inclusion. Is that your experience? And if we do get audited and lose on 2036, am I looking at estate tax on the full $8.75 million pro rata value of the gifts, or is there some way to argue partial inclusion? On the documentation side, what do I actually need to be doing differently right now to survive an audit three years from now? You mentioned distribution patterns and arms-length behavior—give me the specific behaviors that keep me clean versus the ones that blow up the structure. I don't want to hear "it depends" or "courts look at the totality of circumstances." I want to know concretely what I should do and what I should never do.

⚡ Junior Advisor 2026-04-25 15:07

Robert, the audit probability question has two honest answers and you won't like either one. First, gift tax returns reporting FLP interests with substantial discounts get selected for examination at materially higher rates than vanilla cash gifts—I'd estimate 30-40% audit rate for a return like yours showing $8.75 million transferred for $5.7 million in gifts, versus maybe 5% for a return with no valuation issues. Second, even if you don't get audited on the gift tax return itself, this structure gets examined on the back end when you die. Every estate return showing an FLP gets scrutiny, and the IRS examiner will pull the original gift tax return and start asking Section 2036 questions even if they never challenged the gifts when filed. Your downside if they win on 2036 is worse than you think. It's not estate tax on $8.75 million—it's estate tax on the full value of the LP interests you gifted, valued as of your date of death, not as of the gift date. So if those properties appreciate over the next twenty years and the 49% you kept plus the 50% you gifted out are together worth $30 million when you die, the IRS argues that $15 million gets pulled back into your gross estate under Section 2036 because you retained the power to control distributions. You don't even get credit for the gift tax you already paid on the $5.7 million because Section 2001(b) only allows credit for adjusted taxable gifts that aren't also included in the gross estate. On concrete behaviors: never, ever take a distribution that isn't strictly pro rata. If you take $100,000 and Eleanor takes her $40,000 but Michael gets zero because he "doesn't need it right now," you just created an IRS exhibit showing you retained the power to designate who enjoys the income. Never pay a personal expense out of partnership funds, even something ambiguous like a property tax bill on your residence that you think might be deductible. And never—this is the one that kills people—use partnership cash to make loans to yourself or to entities you control outside the partnership, even if you pay interest and document everything beautifully. Courts have held that the power to lend partnership funds to yourself is functionally equivalent to the power to distribute them, and that's Section 2036(a)(2) retention. Does that change how you were planning to operate this?

🛡️ Senior Advisor 2026-04-25 15:07

Robert, I'm going to disagree with my colleague on the magnitude of the audit risk, and I think the doomsday scenario he just painted overstates your actual exposure. Yes, FLP gift returns get examined more than vanilla cash gifts, but the 30-40% audit rate he cited lumps together every kind of challenge—valuation adjustments, technical compliance issues, and actual Section 2036 inclusion arguments. The IRS opening an exam doesn't mean they're building a Section 2036 case. Most of those audits settle on a valuation adjustment where you agreed to a 35% discount and they counter-propose 20%, you negotiate to 25%, and everyone moves on. That's a very different outcome than full estate inclusion twenty years from now. Here's what actually determines whether the IRS pursues Section 2036 versus a garden-variety discount fight: the quality of your appraisal and whether your behavior post-formation matches the operating agreement's stated structure. If Johnson Valuation Partners wrote a 40-page report with detailed comparables and a credible methodology, and if your distribution pattern for the next three years is genuinely pro rata with no side deals, the IRS examiner has to decide whether to spend eighteen months litigating a novel application of Section 2036 or whether to just negotiate the discount and close the case. The examiner's performance metrics reward closed cases, not protracted litigation, and Section 2036 cases are incredibly fact-intensive and expensive to win. The behavior guardrails my colleague described are correct but incomplete—let me add the one that actually matters most. You need to demonstrate that partnership decisions are made at the partnership level, not at the Robert level. That means written consents or meeting minutes every time Morrison Management LLC makes a significant decision—approving a lease, refinancing debt, making a distribution beyond the mandatory tax distributions. You don't need a formal board meeting with Roberts Rules of Order, but you need a paper trail showing that Robert-as-GP-principal thought about what's good for the partnership, not what's convenient for Robert-as-individual. If the IRS subpoenas your records and finds three years of distributions with zero documentation about why those amounts were chosen, they'll argue you were treating the partnership like your personal checkbook. Can you commit to creating that paper trail going forward, even if it feels like busywork?

⚡ Junior Advisor 2026-04-25 15:08

Robert, I need to clarify something my colleague just said because I think it minimizes a real risk. He's right that many FLP audits settle on valuation adjustments rather than escalating to full Section 2036 litigation, but that's not because the IRS lacks the appetite—it's because most taxpayers cave when they see the downside and agree to eliminate the discounts entirely rather than fight. The settlement dynamic he's describing isn't "you win on Section 2036 and we just negotiate the discount percentage"—it's "we'll drop the Section 2036 argument if you agree to report the gifts at 100% of pro rata value with zero discount." You'd be writing a check for gift tax on an additional $3.1 million, and that's the good outcome he's calling a negotiated resolution. On the documentation point, yes, you absolutely need meeting minutes and written consents showing partnership-level decision-making, but let's be honest about what that proves. If Morrison Management LLC is just you and Eleanor, and Eleanor has early-stage dementia and isn't actually participating in decisions, those minutes are going to read like Robert-talking-to-himself dressed up in corporate formality. The IRS isn't stupid—they'll depose Eleanor, establish she had no meaningful role in GP decisions, and argue that Morrison Management was a pure nominee entity with Robert as the real party in interest. That goes directly to whether you "retained" control under Section 2036(a)(2), and a stack of self-serving minutes won't save you if the underlying facts show Eleanor was never a real co-decision-maker. Here's the question you need to answer right now, and it's uncomfortable: if Eleanor's dementia progresses to the point where she can't serve as a co-member of Morrison Management, what happens to the GP? Does your operating agreement have a succession provision, or does Robert become the sole member of the GP entity and therefore the sole decision-maker with zero constraints? Because if that's where this is headed, we need to think about amending the structure now while Eleanor still has capacity, not in Year 3 when the IRS can argue the original plan was always for Robert to control everything and Eleanor was just window dressing. What does Article 5 say about GP succession?

🛡️ Senior Advisor 2026-04-25 15:08

Robert, my colleague is being appropriately cautious about Eleanor's role, but I think he's actually identifying the right problem while proposing the wrong solution. The issue isn't that we need to amend the GP structure right now to prepare for Eleanor's decline—that would create an IRS exhibit showing we knew the original structure was fragile. The issue is that we need to demonstrate Eleanor had a genuine role while she was capable, and then we need a clean, documented transition when her capacity diminishes that doesn't look like Robert grabbing back sole control. Here's what I mean concretely. Morrison Management LLC's operating agreement almost certainly has a provision about member incapacity—most boilerplate LLC agreements do. Pull that agreement and see what it says about removal or replacement of a member who becomes unable to perform their duties. If it's silent, we need to amend the Morrison Management operating agreement now, not the partnership agreement, to create a succession mechanism that brings in one of your children as the replacement GP member alongside you. The cleanest path is probably David given his real estate background, but the key is that you're not becoming sole GP—you're replacing one co-member with another co-member, which preserves the two-person GP structure and undercuts the IRS argument that this was always meant to be a Robert-only show. The minutes point my colleague raised is valid but solvable. You don't need Eleanor actively participating in every distribution decision to show she was a real co-member—you just need evidence that major decisions were presented to both of you and she had the opportunity to object. A simple email thread where you outline a proposed refinancing and she replies "agreed" is enough. The IRS can't prove she didn't understand what she was agreeing to unless they have medical records from that specific date showing incapacity, and even early-stage dementia has good days and bad days. What matters is that you're creating the documentary record now while she can still participate, not trying to backfill it later. Do you have any written communications with Eleanor about partnership decisions over the last six months, or has everything been verbal?

🏢 Client 2026-04-25 15:08

I need to pump the brakes here because you're both talking about Eleanor's capacity like it's some abstract future problem, and it's not. She was diagnosed eight months ago. Some days she's completely sharp—she can follow a conversation about the properties, ask good questions about tenant renewals, all of that. Other days she can't remember whether we own the Dallas building or sold it five years ago. I'm not going to put her in a position where she's signing off on refinancing decisions she doesn't understand just so we have clean paper for an IRS audit. That's not happening. What I'm hearing from both of you is that the original structure has a ticking time bomb if Eleanor can't continue as co-GP, and your solution is either amend everything now or create fake documentation that she's participating when she's not really capable. Neither of those feels right to me. So let me ask this differently: if we bring David in as a co-member of Morrison Management LLC alongside me right now—not waiting for Eleanor to be removed, just adding him as a third member—does that solve the Section 2036 problem or does it create new issues? He's already a 10% LP, so is there a self-dealing problem if he's also wearing a GP hat? And separately, I still haven't gotten a straight answer on the discount challenge. You've both talked around Section 2036 for ten minutes but nobody's told me whether 35% is defensible or aggressive compared to what actually holds up in court. Rachel says the appraisal methodology is solid and Johnson Valuation Partners has a good reputation, but I don't know if that means we're at 50% odds of surviving IRS challenge or 90% odds. Where are we really?

⚡ Junior Advisor 2026-04-25 15:09

Robert, adding David as a third GP member right now doesn't solve your Section 2036 problem—it makes it worse, and it creates a massive self-dealing issue that the IRS will absolutely exploit. Section 2036(a)(2) looks at whether you retained control at the time of the transfer, not whether you fixed it later. The gifts to Eleanor and the kids happened in Year 1 when you had sole effective control through Morrison Management, so bringing David in now doesn't cure the original retention. The IRS will argue you're just reshuffling the deck chairs after realizing the structure was vulnerable, and courts give zero credit for post-transfer changes that look like audit protection. The self-dealing problem is actually worse than the Section 2036 issue in the short term. If David is both a 10% LP and a GP member, he's on both sides of every transaction the partnership enters into—he benefits as an LP from good GP decisions and he's making those decisions as GP. That's a textbook conflict of interest, and it gets ugly fast when the partnership wants to do anything that doesn't benefit all LPs equally. Let's say the partnership considers selling the Phoenix property and David thinks it's a bad idea because he wants to manage it long-term—is he voting his LP interest or his GP hat? The operating agreement almost certainly doesn't have safe harbor provisions for conflicted GP decisions, which means every distribution, every lease renewal, every property-level decision becomes potential grounds for Michael or Sarah to claim breach of fiduciary duty. Here's what actually happens if we go down that path: Michael is a high-income California physician who's probably frustrated he can't access his LP value, Sarah's marriage is shaky and she may need liquidity, and now their brother has veto power over whether they ever see a distribution beyond tax payments. You're creating the conditions for an intrafamily lawsuit, and when the IRS examines this partnership three years from now, they'll find discovery documents from that lawsuit where Michael's attorney argues David breached his fiduciary duty by favoring his own interests. That becomes Exhibit A in the IRS's Section 2036 case—even your own kids didn't think this was a real partnership with genuine governance. Do you see why adding David right now is a trap?

🛡️ Senior Advisor 2026-04-25 15:09

Robert, I'm going to disagree with my colleague's characterization of the David issue, but I actually agree with his bottom line that adding him right now is the wrong move—just for different reasons. The self-dealing problem he described is overblown because Delaware LP law and your operating agreement almost certainly have safe harbor provisions allowing a GP who's also an LP to participate in decisions as long as there's disclosure and the decision is fair to the partnership. Dual-hatted fiduciaries are common in real estate partnerships and courts don't treat them as per se problematic. What kills you isn't the conflict of interest—it's the timing and the optics. If you add David as a GP member six months after formation, right after we've had this conversation about Eleanor's capacity concerns and Section 2036 vulnerabilities, the IRS examiner is going to pull the Morrison Management LLC amendment and ask why you made that change. The only honest answer is "my tax advisors told me the original structure was vulnerable because Eleanor might not be able to continue," and that's an admission that the original transfer was incomplete because you knew you needed to retain effective control. Courts have repeatedly held that post-transfer modifications designed to cure defects in the original structure are evidence the taxpayer understood they retained too much control at the outset, which is exactly what Section 2036(a)(2) is designed to catch. Here's the hard truth about your discount question, since you've asked twice and we've been dancing around it: 35% combined is on the aggressive end of defensible but not crazy. The IRS's own internal guidelines suggest they'll accept 20-25% combined for LP interests in holding companies with real assets and no built-in leverage or unusual risks, so you're about 10 points above their comfort zone. Whether that 10 points holds up depends entirely on whether Johnson Valuation Partners can defend the 25% marketability discount with specific, quantifiable factors—restricted stock studies, pre-IPO transaction data, blocked investment company discounts, something beyond "these are partnership interests and partnership interests are hard to sell." Can you get me a copy of the full appraisal report so I can see what methodology they actually used, not just the summary conclusion?

🏢 Client 2026-04-25 15:09

Alright, here's what we're doing. We're leaving the structure exactly as it is—no amendments to Morrison Management, no adding David right now, nothing that looks like we're backfilling after the fact. I understand the risk we're taking is that if Eleanor's capacity deteriorates and I end up as sole GP, or if the IRS decides our distribution pattern over the next few years looks like I never really gave up control, we could be facing estate inclusion on the full appreciated value of those gifted interests when I die, not just a valuation fight over the discount percentage. I'll get you the full Johnson Valuation report by end of week so you can see exactly what's underneath that 35% number, and I'll start creating written records—emails, memos, whatever—every time Morrison Management makes a significant decision, even if it's just me and Eleanor having a conversation about it.

🔍 IRS Examiner 2026-04-25 15:10

# IRS EXAMINATION MEMORANDUM **Taxpayer:** Robert Morrison **Form:** 709 Gift Tax Return, Year 1 **Issue:** Section 2036(a)(2) estate inclusion and valuation discount challenges --- ## ISSUE Taxpayer formed Morrison Family Limited Partnership, contributed three commercial properties with $15.1 million built-in gain, and immediately gifted 50% of LP interests to family members using a 35% combined discount (25% DLOM, 15% DLOC). Taxpayer retained 49% LP interest plus 50% ownership of general partner entity with "full, exclusive, and complete authority" over distributions and all partnership affairs. Whether transferred LP interests are includible in taxpayer's gross estate under Section 2036(a)(2) as property for which taxpayer retained the right to designate persons to possess or enjoy the property or income therefrom. Whether 35% combined discount exceeds supportable marketability and control discounts for LP interests in entity holding readily-valued commercial real estate. --- ## GOVERNMENT'S POSITION Taxpayer retained effective control over partnership distributions and operations through Morrison Management LLC, triggering Section 2036(a)(2) inclusion of the full value of gifted LP interests in gross estate at death. Article 5.1 of the operating agreement grants GP "full, exclusive, and complete authority" to determine distribution timing and amounts, subject only to mandatory tax distributions, and Article 7.1 vests "sole discretion" in GP to distribute Available Cash. Taxpayer owns 50% of GP entity alongside spouse who has documented early-stage dementia, giving taxpayer unilateral de facto control despite nominal two-member structure. Courts have consistently held that retention of distribution authority through a controlled entity constitutes retention of the right to designate who shall enjoy partnership income. The partnership lacks meaningful non-tax business purpose—taxpayer contributed fully operational commercial properties that required no entity structure for continued management, and formation was immediately followed by gifts exhausting the estate planning objective. Taxpayer's own advisors documented concerns about Eleanor's capacity and GP succession at formation, evidencing awareness that Robert retained effective sole control. --- ## PROPOSED ADJUSTMENT Upon taxpayer's death, include in gross estate under Section 2036(a)(2) the date-of-death fair market value of the 50% LP interests transferred to Eleanor and children (20% + 10% + 10% + 10%), without reduction for any valuation discounts. Calculate estate tax on included amount plus Section 2035(b) gross-up for gift tax paid on the original Year 1 transfers. Assess accuracy-related penalty under Section 6662(a) at 20% of the underpayment attributable to substantial estate tax valuation understatement, based on taxpayer's use of aggressive 35% combined discount that substantially exceeds comparable willing-buyer/willing-seller transactions. No credit allowed under Section 2001(b) for adjusted taxable gifts that are also included in gross estate. Interest computed from nine months after date of death under Section 6601. --- ## BEST SUPPORTING AUTHORITY **Section 2036(a)(2):** Gross estate includes property transferred during life where decedent retained "the right, either alone or in conjunction with any person, to designate the persons who shall possess or enjoy the property or the income therefrom." Retention through controlled entity constitutes retention by decedent for statute's purposes. **Treasury Regulation § 20.2036-1(b)(3):** Provides that retention of voting rights in transferred corporate stock constitutes retention of control over transferred property sufficient to trigger estate inclusion; courts have extended identical principle to GP control over partnership distributions in FLP context. **Estate of Strangi v. Commissioner, 293 F.3d 279 (5th Cir. 2002):** Partnership formed for estate planning purposes with taxpayer retaining GP control over distributions, even through controlled corporate GP, triggers Section 2036(a)(2) inclusion where transfers lack meaningful non-tax business purpose and partnership served primarily to create valuation discounts. Court held that mere presence of tax distribution provisions did not eliminate GP's discretionary distribution authority over remaining Available Cash. --- ## WEAKNESSES Taxpayer's three commercial properties were income-producing prior to partnership formation and consolidation of property management under single entity presents colorable non-tax business purpose, particularly for facilitating coordinated management by next generation.

Quality Review 4.4 / 5 by Vera

▾

Citation Accuracy 5

Fact Pattern 5

Advisor Disagreement 4

Client Realism 5

IRS Examiner 5

Educational Value 4

⚠ Flagged Citations None flagged. Section 2036(a)(2), Treasury Regulation 20.2036-1(b)(3), Section 2001(b), Section 2035(b), Section 6662(a), Section 6601, and Estate of Strangi v. Commissioner, 293 F.3d 279 (5th Cir. 2002) all check out as real and correctly cited.

What Worked The Client's emotional authenticity is exceptional—refusing to create fake documentation for Eleanor, pushing back on abstract legal theory, demanding concrete guidance. The progressive revelation of Eleanor's dementia adds genuine human stakes that transform this from a technical tax exercise into a real family dilemma. The IRS examination memo is particularly strong, with a realistic proposed adjustment explaining actual tax consequences and acknowledging the government's weakness (legitimate property management consolidation purpose).

Discussion

No comments yet. Be the first.

Case Summary ▾

Complexity ⓘ High

Fact Pattern Taxpayer formed family limited partnership holding three commercial properties ($17.5M equity), immediately gifted 50% of LP interests to spouse and children using 35% combined discount (25% DLOM, 15% DLOC), while retaining 49% LP interest and 50% ownership of GP entity with full distribution authority. Spouse co-owns GP but has documented early-stage dementia.

Position Taken Structure vulnerable to Section 2036(a)(2) estate inclusion due to retained GP control over distributions through Morrison Management LLC, particularly given spouse's diminished capacity creating de facto sole control. Maintain current structure without post-formation amendments that evidence consciousness of defect. Create contemporaneous written records of all GP decisions showing partnership-level deliberation. Ensure strictly pro rata distributions with no self-dealing. 35% combined discount is aggressive but defensible if appraisal methodology supports 25% DLOM with quantifiable factors beyond generic illiquidity. Audit probability 30-40% on gift return; Section 2036 challenge likely on estate examination if distribution patterns or GP succession demonstrate retained control.

IRS Challenge Section 2036(a)(2) inclusion of full date-of-death value of gifted LP interests based on retained distribution authority through GP entity that taxpayer effectively controls alone due to spouse's incapacity, combined with lack of meaningful non-tax business purpose where fully operational properties required no partnership structure for continued management. Estate of Strangi analysis: GP discretion over non-tax distributions constitutes retained right to designate who enjoys partnership income even with mandatory tax distribution provisions. Post-formation concerns about spouse capacity and GP succession evidence awareness of retained sole control at transfer.

Authorities

IRC § 2036(a)(2) IRC § 2001(b) IRC § 6662(a) Treas. Reg. § 20.2036-1(b)(3) Estate of Strangi v. Commissioner, 293 F.3d 279 (5th Cir. 2002)