Direct Participation Programs
Syndication or "finders" fees for LP public offerings are limited to:
10% of the gross dollar amount of securities sold.
master limited partnerships (MLPs)
A small number of limited partnership interests are negotiable and trade on the OTC and exchanges. These partnerships are known as master limited partnerships (MLPs).
Subscription Agreement
All investors interested in becoming limited partners must complete a subscription agreement. The agreement appoints one or more GPs to act on behalf of the limited partners and is only effective when the GPs sign it.
When considering the purchase of a limited partnership interest, an investor should be most concerned with A. loss pass-through B. potential tax shelter C. economic viability D. short-term trading opportunities
Answer: C. Economic viability is the number one reason for the purchase of an interest in a limited partnership. Tax sheltering and loss pass-through are also considerations but should not be the primary motive to invest. Short-term trading opportunities do not exist. The investor should expect to hold the interest until the partnership is dissolved or liquidated.
A customer invests $10,000 in a DPP and signs a recourse note for $40,000. During the first year, the investor receives a cash distribution from the partnership in the amount of $5,000. At year end, he receives a statement showing that his share of partnership losses is $60,000. How much of that $60,000 can he deduct on his tax return?
Answer: The investor cannot deduct losses in excess of his year-end basis, $45,000 $10,000 + $40,000 - $5,000 = $45,000 basis Therefore, the customer can deduct $45,000 on his tax return. The remaining $15,000 is carried forward.
Lack of Profit Motive Penalties
Any DPP established without a profit motive or with the intention of only generating tax losses for investors may be determined abusive. Investors in abusive DPPs may be subject to: ■ back taxes; ■ recapture of tax credits; ■ interest penalties; or ■ prosecution for fraud.
Which corporate characteristic is the most difficult to avoid for a partnership?
Centralized management—no business can function without it.
Which two corporate characteristics are most likely to be avoided by a DPP?
Continuity of life and freely transferable interests—interests cannot be freely transferred; general partner approval is required to transfer shares.
Which corporate characteristic is the easiest to avoid for a partnership?
Continuity of life—there is a predetermined time at which the partnership interest is dissolved.
What is unique about DPPs compared to any other S7 related investment opportunity?
DPPs (limited partnerships) are the only investment opportunity that you will study that offer a pass-through of losses to the investor. Also, DPP passive losses shelter passive income, not ordinary income.
LP Depletion Allowances
Depletion allowances apply to the using up of natural resources, such as oil and gas. May be claimed only when income is being produced by the partnership.
Two types of depreciation over time:
Depreciation may be taken on a straight line (i.e., the same amount each year) or accelerated basis. Accelerated depreciation, known as modified accelerated cost recovery system (MACRS), increases deductions during the early years and decreases them during the later years.
LP Depreciation write-offs
Depreciation write-offs apply to cost recovery of expenditures for equipment and real estate (land cannot be depreciated). May be claimed only when income is being produced by the partnership.
Partnership Agreement
Each partner receives a copy of this agreement. It describes the roles of the general and limited partners and guidelines for the partnership's operation.
LP Deductions
Expenses of the partnership, such as salaries, interest payments, and management fees, result in deductions in the current year to the LPs. Principal payments on property are not deductible expenses.
Certificate of Limited Partnership
For legal recognition, this document must be filed in the home state of the partnership. It includes the: ■ partnership's name; ■ partnership's business; ■ principal place of business; ■ amount of time the partnership expects to be in business; ■ size of each LP's current and future expected investments; ■ contribution return date, if set; ■ share of profits or other compensation to each LP; ■ conditions for LP assignment of ownership interests; ■ whether LPs may admit other LPs; and ■ whether business can be continued by remaining general partners (GPs) at death or incapacity of a GP. If any material information on the certificate has changed, an update must be made within 30 days of the event.
Dissolving an LP (dissolution)
Generally, limited partnerships are liquidated on the date specified in the partnership agreement. Early shutdown may occur if the partnership sells or disposes of its assets or if a decision is made to dissolve the partnership by the LPs holding a majority interest.
LP Basis
In a limited partnership, the term basis defines the liability assumed by the LP. An LP can lose no more than his basis, and his basis puts a limit on how much he may deduct on his tax return. This ensures that an LP cannot deduct losses in excess of his basis. It is important to note that any up-front costs incurred by the LP will not affect beginning basis. Assume that an LP invests $50,000 in a partnership unit, and the broker-dealer selling the unit takes a commission of $3,000. Therefore, only $47,000 of the LP's investment goes into the partnership. However, the LP's beginning basis is $50,000, not $47,000.
Forming an LP (public offering)
In a public offering, limited partnerships are sold with prospectus to a larger number of limited partners, each making a relatively small capital contribution, such as $1,000 to $5,000. The syndicator oversees the selling and promotion of the partnership. The syndicator is responsible for the preparation of any paperwork necessary for the registration of the partnership. Syndication or "finders" fees are limited to 10% of the gross dollar amount of securities sold.
Recourse Loan
In addition to a cash contribution, subscribers may assume responsibility for the repayment of a portion of a loan made to the partnership. This type of loan is called a recourse loan. Frequently, partnerships borrow money through nonrecourse loans; the GPs have responsibility for repayment of nonrecourse loans (not the LPs).
Combination oil/gas program
In this program, the partnership allocates dollars between income and exploratory drilling.
Basis is computed using the following formula:
Investment in partnership + share of recourse debt - cash distribution
Forming an LP (private placement)
LPs may be sold through private placements or public offerings. If sold privately, investors receive a private placement memorandum for disclosure. Generally, such private placements involve a small group of limited partners, each contributing a large sum of money. These investors must be accredited investors—that is, they must have substantial investment experience. The general public does not meet this description.
Tax basis
LPs must keep track of their tax basis, or amount at risk, to determine their gain or loss upon the sale of their partnership interest. An investor's basis is subject to adjustment periodically for occurrences such as cash distributions and additional investments. The tax benefits offered by the partnership should be of secondary importance to the economic viability it offers.
Oil and Gas Partnership Programs
Oil and gas programs include speculative drilling programs and income programs that invest in producing wells. Unique tax advantages associated with these programs include intangible drilling costs and depletion allowances.
Other Features to Analyze
Other important factors that investors should consider in their overall analysis of limited partnerships include the following: ■ Management ability and experience of the GP in running other similar programs ■ Blind pool or nonspecific program—in a blind pool, less than 75% of the assets are specified as to use; however, in a specified program, more than 75% have been identified ■ Time frame of the partnership ■ Similarity of start-up costs and revenue projections to those of comparable ventures ■ Lack of liquidity of the interest
What are "renewable assets" and what is an example?
Recognize that some assets are not depreciable nor can they be depleted. For example, farm crops fall into this category and are generally known to be renewable assets.
Tangible Drilling Costs (TDCs)
Tangible drilling costs are those costs incurred that have salvage value (e.g., storage tanks and wellhead equipment). These costs are not immediately deductible; rather, they are deducted (depreciated) over several years.
LP Tax Credits
Tax credits are dollar-for-dollar reductions of taxes due and are the greatest tax benefit available to taxpayers. Currently, there are few available. The limited partnership programs that offer them currently are government-assisted housing programs and historic rehabilitation programs. Formerly, tax credits were available through equipment leasing programs, but tax law changes discontinued this credit. The partnership reports its income and losses to the IRS and then reports to each partner their individual share of income, gains, losses, deductions, and credits.
Depletion Allowances
Tax deductions that compensate the partnership for the decreasing supply of oil or gas (or any other resource or mineral). Depletion allowances may be taken only once the oil or gas is sold.
oil/gas program Disproportionate Sharing arrangement
The GP bears a relatively small percentage of expenses but receives a relatively large percentage of the revenues.
oil/gas program Reversionary Working Interest sharing arrangement
The GP bears no costs of the program and receives no revenue until LPs have recovered their capital. LPs bear all deductible and nondeductible costs.
oil/gas program Net Operating Profits Interest sharing arrangement
The GP bears none of the program's costs but is entitled to a percentage of net profits. The LP bears all deductible and nondeductible costs. This arrangement is available only in private placements.
oil/gas program Carried Interest sharing arrangement
The GP shares tangible drilling costs with the LPs but receives no IDCs. The LP receives the immediate deductions, whereas the GP receives write-offs from depreciation over the life of the property.
DPP/LP crossover point
The crossover point is the point at which the program begins to generate taxable income instead of losses. This generally occurs in later years when income increases and deductions decrease.
oil/gas program Overriding Royalty Interest sharing arrangement
The holder of this interest receives royalties but has no partnership risk. An example of this arrangement is a landowner that sells mineral rights to a partnership.
oil/gas program Working Interest sharing arrangement
This operating interest in a mineral-bearing (oil and gas) partnership entitles a partner to a share of the income or revenues from production but also carries the obligation to bear a corresponding share of all costs to extract the minerals.
Required Documentation for forming a LP
Three important documents are required for a limited partnership to exist: ■ The certificate of limited partnership ■ The partnership agreement ■ The subscription agreement
Measuring Economic Viability of LPs/DPPs
Two methods applied to the analysis of DPPs are cash flow analysis and internal rate of return. ■ Cash flow analysis compares income (revenues) to expenses. ■ Internal rate of return (IRR) determines the present value of estimated future revenues and sales proceeds to allow comparison to other programs.
oil/gas program Functional Allocation sharing arrangement
Under this most common sharing arrangement, the LP receives the IDCs, which allow immediate deductions. The GP receives the tangible drilling costs, which are depreciated over several years. Revenues are shared.
Depreciation Recapture
When a partnership unit is sold, recapture may apply if the partnership has been depreciating its fixed assets using accelerated depreciation. If, at the time of sale, the limited partner had taken depreciation deductions in excess of what would have been taken had the partnership been using the straight line method, that difference is subject to ordinary income tax. Clearly, depreciation recapture is not a tax advantage.
Intangible Drilling Costs (IDCs)
Write-offs for the expenses of drilling are usually 100% deductible in the first year of operation. These include costs associated with drilling such as wages, supplies, fuel costs, and insurance. An intangible drilling cost can be defined as any cost that, after being incurred, has no salvage value.
LPs are liable for:
a proportionate share of recourse loans assumed by partnerships. LPs have no liability for nonrecourse loans, except in real estate partnerships.
A partnership must avoid what?
corporate characteristics. The easiest of the corporate characteristics to avoid is continuity of life. Typically, partnerships have a predetermined date of dissolution when they are established.
Equipment Leasing Programs
created when DPPs purchase equipment leased to other businesses. Investors receive income from lease payments and also a proportional share of write-offs from operating expenses, interest expense, and depreciation. Tax credits were once available through these programs but were discontinued by tax law changes. The primary investment objective of these programs is tax-sheltered income.
Three types of oil and gas programs:
exploratory, developmental, and income.
DPP Tax reporting
generally structured as limited partnerships or subchapter S corporations. These business forms are not tax-paying entities like corporations; instead, they only report income and losses to the IRS, and then the partners (in a limited partnership) or shareholders (in a subchapter S corporation) have the responsibility to report income and losses individually and pay the taxes due. By contrast, in a typical corporation, taxes must be paid on the earnings of the corporation before a dividend is distributed. Then the shareholder is taxed again on the dividend received. Since an investment in a DPP is not taxed first at the level of the business, double taxation is avoided. The term flow-through (or pass-through) means that all the income and losses and corresponding tax responsibilities go directly to the investors with no taxation to the business entity.
Blind pool or nonspecific program
in a blind pool, less than 75% of the assets are specified as to use; however, in a specified program, more than 75% have been identified
An organization is classified as a partnership for federal tax purposes if:
it has two or more members and is none of the following: ■ An organization formed under a federal or state law that refers to it as incorporated or as a corporation, body corporate, or body politic ■ An organization formed under a state law that refers to it as a joint-stock company or joint-stock association ■ An insurance company ■ Certain banks ■ An organization wholly owned by a state or local government ■ An organization specifically required to be taxed as a corporation by the Internal Revenue Code (e.g., certain publicly traded partnerships) ■ Certain foreign organizations ■ A tax-exempt organization ■ A real estate investment trust ■ An organization classified as a trust or otherwise subject to special treatment under the Internal Revenue Code ■ Any other organization that elects to be classified as a corporation by filing Form 8832
Cash flow
net income or loss plus noncash changes (such as depreciation).
If a partner's basis is $25,000 at year end and the investor has losses of $35,000, what may be deducted against passive income?
only $25,000 of the losses may be used to deduct against passive income. The remaining $10,000 may be carried forward.
If sold privately, LP investors receive what for disclosure?
private placement memorandum
When do LPs have liability for nonrecourse loans?
real estate partnerships.
Limited partnerships (LPs)
unique investment opportunities that permit the economic consequences of a business to flow through to investors. These programs offer investors a share in the income, gains, losses, deductions, and tax credits of the business entity. Limited partners in DPPs enjoy several advantages: ■ An investment managed by others ■ Limited liability ■ Flow-through of income and certain expenses The greatest disadvantage to limited partners is their lack of liquidity. The secondary market for limited partnership interests is extremely limited; investors who wish to sell their interests frequently cannot locate buyers (i.e., the shareholder's interest is not freely transferable).
Real estate limited partnerships provide investors with the following benefits:
■ Capital growth potential—achieved through appreciation of property ■ Cash flow (income)—collected from rents ■ Tax deductions—from mortgage interest expense and depreciation allowances for "wearing out the building" and capital improvements ■ Tax credits—for government-assisted housing and historic rehabilitation (reduce tax liability dollar for dollar but are subject to recapture)
Other important tax concepts of DPPs
■ DPPs were formerly known as tax shelters because investors used losses to reduce or shelter ordinary income (by writing off passive losses against ordinary income). ■ Tax law revisions now classify income and loss from these investments as passive income and loss. Current law allows passive losses to shelter only passive income, not all ordinary income as before. Many programs lost their appeal because of this critical change in tax law. ■ Investors should not purchase DPPs primarily for tax shelter; they should be economically viable and offer investors the potential of cash distributions and capital gains.
When dissolution occurs, the GP must cancel the certificate of limited partnership and settle accounts in the following order:
■ Secured lenders ■ Other creditors ■ Limited partners —— First, for their claims to shares of profits —— Second, for their claims to a return of contributed capital ■ General partners —— First, for fees and other claims not involving profits —— Second, for a share of profits —— Third, for capital return
An LP's basis consists of:
■ cash contributions to the partnership; ■ property contributions to the partnership; ■ recourse debt of the partnership; and ■ nonrecourse debt for real estate partnerships only. Partners must adjust their basis at year end. Any distributions of cash or property and repayments of recourse debt (also nonrecourse debt for real estate only) are reductions to a partner's basis. Partners are allowed deductions up to the amount of their adjusted cost basis.
Rights of the GP as defined in the partnership agreement include the:
■ right to charge a management fee for making business decisions for the partnership; ■ authority to bind the partnership into contracts; ■ right to determine which partners should be included in the partnership; and ■ right to determine whether cash distributions will be made.
Along with the subscriber's money, the subscription agreement must include:
■ the investor's net worth; ■ the investor's annual income; ■ a statement attesting that the investor understands the risk involved; and ■ a power of attorney appointing the GP as the agent of the partnership.
