Chapter 13: Direct Participation Programs

Certificate of Limited Partnership

*must be filled out in home state* - 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 - Whether business can be continued by remaining general partners (GPs) at death or incapacity of a GP

Subscription agreement

- Agreement appoints one or more GPs to act on behalf of the limited partners and is only effective when the GPs sign it - Subscription must also include: investors net worth, investors 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

Name three advantages Limited Partners in DPPs enjoy several advantages:

- An investment managed by others - Limited liability - Flow through of income and certain expenses

What are exemptions to being a partnership?

- 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 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

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 - Prosecution for fraud

Real estate limited partnerships provide investors with the following benefits:

- Capital growth potential (achieved through appreciation of property) - Cash flow (collected from rents) - Tax deduction (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)

How is economic viability measured?

- 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

"Basis" in terms of a limited partnership

- Defines the liability assumed by the LP - An LP can lose no more than his basis - His basis puts a limit on how much he may deduct on his tax return

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 that 57% of the assets are specified 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

The important documents that are required for a limited partnership to exist

- The certificate of limited partnership - The partnership agreement - The subscription agreement

Depletion allowances

- may be taken only once the gas or oil has been sold - tax deductions that compensate the partnership for the decreasing supply of oil or gas (or any other resource or mineral)

When *dissolution* occurs, the GP must cancel the certificate of limited partnership and settle accounts in the following order:

1. Secured lenderse 2. Other creditors 3. Limited partners 4. General partners

Master Limited Partnerships (MLPs)

A small number of limited partnership interests are negotiable and trade on the OTC and exchanges

Which of the following limited partnership programs provide potential tax credits to partners? I. Rehabilitation of historic properties II. Equipment leasing III. Developmental oil and gas programs IV. Government assisted housing programs A. I and II B. I and IV C. II and III D. III and IV

B; Historic rehabilitation and government assisted housing are the programs discussed that offer potential tax credits. Tax credits were formerly available through equipment leasing, but Congress changed the rules. Development oil and gas programs offer high IDCs, not ITCs (Investment tax credits)

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

C; Economic viability

Which of the following sharing arrangements is the most common? A. Net operating profits B. Carried interest C. Functional allocation D. Overriding royalty interest

C; Functional allocation is most commonly used because it gives the best benefits to both parties. The LPs receive the immediate tax write offs from the IDCs, whereas the GPs receive continued write offs from the tangible costs over the course of several years. Both share equally in the revenues.

Intangible drilling costs (IDCs)

Can be defined as any cost that, after being incurred, has no salvage value

From list of corporate characteristics, which is most difficult to avoid?

Centralized management - as no business can function without it

From list of corporate characteristics, which is easiest to avoid?

Continuity of life - there is a predetermined time at which the partnership is dissolved

Which two corporate characteristics are most likely to be avoided by a DPP?

Continuity of life and freely transferable interest - interest cannot be freely transferred; general partner approval is required to transfer shares

Cash flow

Defined as net income or less plus non cash changes (such as depreciation)

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 operations

Recourse loan

In addition to a cash contribution, subscribers may assume responsibility for the repayment of a portion of a loan made it to the partnership

Nonrecourse loans

In this type of loan, GPs have responsibility for repayment of nonrecourse loans (not the LPs)

"Basis" formula

Investment in partnership + share of recourse debt - cash distribution

What is the greatest disadvantage of limited partners is their lack of liquidity

Lack of liquidity

DPPs are generally structured as __________ or __________

Limited partnerships; subchapter s corporations

Economic viability

Means that there is potential for returns from cash distributions and capital gains

An unincorporated organization with two or more members is generally classified as a __________ for federal tax purposes if its members engage in trade, business, financial operation, or venture and divide its profits

Partnership

LPs may be sold through private placement or public offerings. What occurs in each case?

Private placement: - 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 - Investors are accredited investors aka they have substantial investment experience - General public does not meet this decision Public offering: - sold with prospectus to a larger number of limited partners, each making a relatively small capital contributions (such as $1,000 or $5,000) - Syndicator oversees the selling and promotion of this partnership

Disproportionate sharing

The GP bears a relatively small percentage of expenses but receives a relatively large percentage of the revenues

net operating profits interest

The GP bears none of the programs 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.

Equipment leasing programs

These are created when DPPs purchase equipment leased to other businesses.

Oil and gas partnerships

These programs include speculative drilling programs and income programs that invest in producing wells

How does tax reporting work with DPPs?

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

Tangible drilling costs (TDCs)

Those costs incurred that have salvage value (e.g. storage tanks and wellhead equipment); these costs are not immediately deductible - rather they are depreciated over several years

T/F ... double taxation is avoided with DPPs

True; investment in a DPP is not taxed first at the level of business

Functional allocation

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.

Limited Partnerships (LPs)

Unique investment opportunities that permit the economic consequences of a business to flow through to investors and these programs offer investors a share in the income, gains, losses, deductions, and tax credits of the business entity

Depreciation recapture

When a partnership unit is sold, recapture may apply if the partnership has been depreciating its fixed assets using accelerated depreciation NOT A TAX ADVANTAGE

What are the three types of oil and gas programs

exploratory, developmental, and income

Tax law revisions now classify income and loss from these investments as __________ income and loss

passive

Limited partnerships can be formed to run any type of business. The most common types are:

real estate, oil and gas, and equipment leasing business

DPPs were formally known as __________ because investors used losses to reduce or shelter ordinary income (by writing off passive losses against ordinary income)

tax shelters

Revisionary working interest

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

Carried interest

the GP shares tangible drilling costs with the LPs buy receives no IDCs. The LP receives the immediate deductions, whereas the GP receives write offs from depreciation over the life of the property

Overriding royalty interests

the holder of this interest receives royalties but has no partnership risk ex) landowner that sells mineral rights to a partnership