Unit 11 - Packaged Products

A working interest in an oil and gas partnership entitles the holder to I a portion of the revenue. II responsibility for part of the expense of extraction. III royalty interest in the revenue. IV royalty interest in revenue after deducting certain expenses. A) III and IV B) I and II C) I and III D) II and IV

The best answer B. I and II A working interest is a right to revenues from production, but it also carries the responsibility for extraction costs. A royalty interest carries no responsibility for extraction costs.

A high-net-worth investor with substantial annual income likes real estate as a potential investment. The investor notes that any investment potentially offering tax credits would be most interesting to consider first. Which of the following would be suitable investments to discuss? A) Historic rehabilitation and government-assisted housing direct participation programs (DPPs) B) Real estate investment equity trusts (REITs) and new-construction direct participation programs (DPPs) C) Real estate investment trusts (REITs) D) Raw land and existing property direct participation programs (DPPs)

The best answer is A. Historic rehabilitation and government-assisted housing direct participation programs (DPPs) REITs, either equity or mortgage, should be eliminated, as they offer no tax credits. Given the customer's high net worth and income, a discussion of DPPs is suitable. Of those DPPs shown here, only historic rehabilitation and government-assisted housing offer tax credits, and either should be suitable for discussion. LO 11.e

FINRA Rule 2310 defines a direct participation program as "a program which provides for flow-through tax consequences regardless of the structure of the legal entity or vehicle for distribution including, but not limited to, oil and gas programs, real estate programs, agricultural programs, cattle programs, condominium securities, Subchapter S corporate offerings and all other programs of a similar nature, regardless of the industry represented by the program, or any combination thereof." The rule places limits on the amount of broker-dealer sales compensation considered fair and reasonable. That limit is A )10% of the gross proceeds. B) 2% of the gross proceeds. C) 15% of the gross proceeds. D) 5% of the gross proceeds.

The best answer is A. 10% of the gross proceeds FINRA limits the amount of the sales compensation to 10% of the gross proceeds of the offering. If the organization and offering expenses exceed 15% of the gross proceeds, FINRA considers that too high. The 2% is the maximum charge in a DPP rollup if the firm wishes to solicit votes from the limited partners. The 5% is the FINRA markup policy and that does not apply to DPPs

A customer with a moderate income from a secure job is in the 28% tax bracket. She has a small diversified portfolio and has $10,000 she would like to invest in a limited partnership. If she is willing to accept only a moderate amount of risk, which of the following limited partnerships would be the most appropriate recommendation? A) An oil and gas income program B) An exploratory oil and gas drilling program C) A raw land real estate limited partnership D) A new-construction real estate limited partnership

The best answer is A. An oil and gas income program The customer is not in a high tax bracket and would not be able to take full advantage of the tax benefits produced by an exploratory oil and gas program or by new-construction real estate limited partnerships. A raw land real estate partnership is usually speculative. Of the answers listed, the income and moderate risk from an oil and gas income program would be of greatest benefit to this investor. LO 11.e

A direct participation program (DPP), organized as a limited partnership, must avoid at least two characteristics of a corporation. Which two characteristics are easiest to avoid? A) Continuity of life and freely transferable interests B) Continuity of life and centralized management C) Centralized management and continuity of life D) Freely transferable interests and centralized management

The best answer is A. Continuity of life and freely transferable interest Continuity of life and freely transferable interests are the easiest to avoid. The limited partnership is formed to exist for a limited time, and general partner (GP) must approve any transfer of interests. Centralized management is the hardest characteristics to avoid because management of the program is the responsibility of the general partner (GP), so management is centralized. LO 11.c

All of the following are oil and gas program sharing arrangements except A) reversionary working interest. B) all-or-none underwriting arrangement. C) disproportionate sharing. D) functional allocation.

The best answer is B. Functional allocation, disproportionate sharing, and reversionary working interest are all types of oil and gas sharing arrangements. All or none is a type of best efforts underwriting agreement.

If a customer holds certificates of beneficial interest in a real estate investment trust (REIT), all of the following statements regarding this investment are true except A) the certificates are publicly traded. B) the issuer must redeem certificates on shareholder request. C) a mortgage REIT represents pooled capital for real estate financing. D) investors receive dividends periodically.

The best answer is B. REITs are not redeemed by the issuer. REITS are publicly traded units that represent either an interest in pooled capital for real estate financing or an interest in real property that pass through income and capital gains distributions to investors. Investors who wish to liquidate their interests must sell them in the secondary market.

A customer invests $20,000 in a direct participation program and signs a recourse note for $50,000. During the first year of operation, the customer receives a cash distribution of $15,000 from the partnership. At year's end, the customer receives a K-1 statement reporting his share of partnership losses of $75,000. How much of the loss may the customer deduct from passive income? A) $75,000 B) $55,000 C) $0 D) $35,000

The best answer is B. $55,000 A limited partner can only deduct partnership losses to the extent of his basis. To determine basis, add the original investment ($20,000) to any recourse debt assumed by the investor ($50,000). Recourse debt adds to basis as the partner is liable for this amount. Cash distributions received reduce basis ($15,000). At year's end, the investor's basis and the amount he can deduct from passive income is $55,000. Investment + recourse debt - cash distributions = year-end basis => $20,000 + $50,000 - $15,000 = $55,000 Thus, Year-end basis = $55,000

As a requirement of investing in a particular business investment, your customer has just signed a statement attesting to her annual income, net worth, and affirming that the risks associated with the investment are understood. The signed statement, once submitted with the intended investment amount, will either be approved or disapproved. Approval allows the investor to subscribe to the investment. Which of the following investments would have such a requirement? A) A special situation fund B) A direct participation program C) A collateralized mortgage obligation D) A variable annuity

The best answer is B. A direct participation program Investors purchasing limited partnership participations or direct participation programs are required to sign a subscription agreement. In part, the investor would be attesting to annual income, net worth and that they understand the risks associated with the type of program they are investing in. While suitability would be a factor for each of the investments listed, they do not require that this type of statement is signed by the customer. LO 11.c

A customer wanting to invest in an oil and gas limited partnership wants to know what her cost basis would be for tax purposes. While there can be a number of variables, cost basis for a limited partner (LP) is best defined as A) noncash contribution plus nonrecourse debt minus recourse debt. B) cash investment made plus recourse debt minus distributions. C) cash investment made minus distributions. D) recourse debt minus cash contributions.

The best answer is B. cash investment made plus recourse debt minus distributions Cost basis for a limited partner is defined as investment made (cash contributions) plus recourse debt (debt the LP is responsible for) minus distributions. Nonrecourse debt would only be included for real estate programs. Real estate programs are the only types where LPs can be responsible for both recourse and nonrecourse debt. LO 11.f

The term wildcatting refers to A) buying new-construction real estate for speculative appreciation value. B) drilling for oil or gas where none has occurred previously. C) limiting your investment portfolio to initial public offerings. D) small-cap mutual fund diversification

The best answer is B. drilling for oil or gas where none has occurred previously. In an oil and gas drilling program, the term wildcatting is used to describe the most speculative type of program, which is drilling where none has occurred before (i.e., in an unproven location). This is the riskiest of the oil and gas programs.

Losses from direct participation programs can be used to offset A) none of these. B) income from limited partnerships. C) portfolio income. D) earned income from salary or commissions.

The best answer is B. income from limited partnerships Passive losses can be used only to offset passive income, which is earned from direct participation programs and rental real estate

Real estate investment trusts (REITs) offer investors an opportunity to pool their money with others to receive professional management of real estate. Generally available types of REITs include all of the following except A) equity REITs. B) preferred REITs. C) hybrid REITs. D) mortgage REITs.

The best answer is B. preferred REITs While some corporations may issue preferred stock, there is no such term as a preferred REIT. Equity REITs take ownership positions in real estate properties. Mortgage REITs make loans to real estate properties. Hybrid REITs do both. LO 11.a

An investment banking firm has been hired to roll up various partnerships into one master limited partnership. What is the compensation limit for this activity? A) 5% B) 8.5% C) 2% D) 10%

The best answer is C. 2% Maximum compensation in a limited partnership roll-up is limited to 2%. That amount must be paid to the brokerage firm, whether the partners vote for or against the proposed roll-up

An investor in a limited partnership generating passive losses can offset these against I. passive income from other partnerships. II. rental income from direct investments in real estate. III. dividends received from listed securities. IV. capital gains from the sale of unlisted securities. A) I and III B) III and IV C) I and II D) II and III

The best answer is C. I and II Passive losses can be deducted from passive income and income from certain real estate investments; it cannot be deducted from active or portfolio (investment) income. LO 11.f

Which of the following choices would generate the largest first-year deductions in an oil and gas exploratory drilling program? A) Depreciation B) Recapture C) Intangible drilling costs D) Depletion allowance

The best answer is C. Intangible drilling costs Intangible drilling costs (IDCs) would be the largest deduction in an oil and gas exploratory drilling program. These are also known as a wildcat program. This type of program attempts to discover oil or gas in an area where proven reserves have yet to be discovered. IDCs are deductible in the year incurred. The unpredictability and huge costs associated with drilling for oil and gas make this the largest deduction in an oil and gas wildcat program. The allowance for depletion comes into play only when the well begins producing and product is sold. Depreciation of the equipment can be taken in the early years, but it is not as significant as the full deduction for the IDCs. Recapture is not a deduction; it is reporting as income something previously deducted. LO 11.f

A married couple both hoping to retire within the next five to seven years have expressed having a low-risk tolerance regarding the stock market. They have a combined income of $350,000. Given this information, which of the following portfolio mixes would be most suitable? A) Treasury bills, corporate bonds, preferred stock B) Direct participation programs, real estate investment trusts, preferred stock C) Treasury notes, municipal bonds, GNMAs D) Treasury bills, common stock, options

The best answer is C. T-notes, muni bonds, GNMAs In light of their low risk tolerance, U.S. government securities would certainly be suitable, and the time frame noted for retirement allows for middle term T-notes to be useful. Given their higher income level, tax-free municipal bonds could also have a place in the portfolio. Longer term GNMAs would accommodate monthly income, should that be desirable upon retirement. The remaining product suggestions are either illiquid (DPPs) or do not align with their risk aversion (common, preferred, options, and REITs).

Under FINRA rules, members are prohibited from soliciting votes from limited partners in connection with a proposed rollup unless any compensation to be received by the member A) does not exceed 15% of the value of the securities to be received in the exchange. B) does not exceed 5% of the value of the securities to be received in the exchange. C) does not exceed 2% of the value of the securities to be received in the exchange. D) does not exceed 10% of the value of the securities to be received in the exchange.

The best answer is C. does not exceed 2% of the value of the securities to be received in the exchange. In connection with a DPP rollup, member firms may not solicit votes from limited partners unless the compensation is 2% or less. The 10% limitation is the maximum compensation in the sale of a DPP. The 15% limitation is the maximum percentage of the gross proceeds of a DPP that may be used for the organization and offering expenses. The 5% is likely an attempt to make you think about the FINRA 5% markup policy. That does not apply to DPPs.

One of the key requirements in offering a DPP to a customer is that the program must be suitable. FINRA has some specific suitability requirements for DPPs. Among those is the investor A) does not own a DPP that will compete with the program being offered. B) has sufficient net worth to be deemed an accredited investor. C) has a net worth sufficient to sustain the risks of the DPP, including loss of investment. D) has sufficient experience in the type of business the program is undertaking.

The best answer is C. has a net worth sufficient to sustain the risks of the DPP, including loss of investment FINRA's Rule 2310 lists a few suitability standards necessary for recommending DPPs. Among those is the need for the investor to have a net worth sufficient to sustain the risks of the DPP, including loss of the investment. Although many DPPs, but not all, are limited to accredited investors, that is not a FINRA suitability standard; that is an SEC requirement. It is the general partner who cannot be in a business that competes with the DPP

When investing in a RELP (real estate limited partnership), it is generally agreed that the highest risk is a RELP consisting of A) existing residential apartments. B) new construction. C) raw land. D) historic structures.

The best answer is C. raw land Because there is no income and the potential of a long wait, most consider raw land to be the riskiest of the real estate limited partnership programs

If a limited partnership interest is sold, the gain or loss in the sale is the difference between the sales proceeds and A) the original basis. B) the total of the deductible losses taken by the investor. C) the adjusted basis. D) the total of tax preference items allocated to the investor.

The best answer is C. the adjusted basis The adjusted basis is a limited partner's cost basis at any point in time. Gain or loss on the sale of the partnership is determined by comparing the sales proceeds to the adjusted basis. LO 11.f

An investor in an equipment-leasing direct participation program (DPP) using straight-line depreciation would probably not be concerned about A) liquidity risk. B) legislative risk. C) the likelihood of recapture. D) the quality of the management.

The best answer is C. the likelihood of recapture. Recapture of deductions is a concern when accelerated, but not when straight-line depreciation is used. In any business, there is always concern about the quality of the management. By and large, DPPs are not liquid investments, so an investor needing a quick sale may have problems. The nature of DPPs tends to make them more sensitive to legislative risk than most other securities.

Which of the following statements describes an oil and gas blind pool offering? A) An unknown number of representatives participate in the sale of known partnership units. B) The oil exploration occurs in an area that is not adjacent to any known oil reserves. C) The income from producing wells is purchased at a discount from the present value of the projected future flows. D) Money is raised without a specific property being stated, and the general partner selects the investments.

The best answer is D. Money is raised without a specific property being stated, and the general partner selects the investments. A blind pool offering, also known as a non-specified program, involves an investment in a program without specific prospects or properties being identified. LO 11.g

Which of the following is not generally associated with an existing real estate direct participation program? A) Lower risk than other types of real estate programs B) Immediate income stream C) Known history of income and expenses D) Appreciation potential

The best answer is D. Appreciation potential Appreciation potential is generally not associated with existing real estate programs because most appreciation occurs in the earliest years for real estate assets.

A company set up to invest in real estate, mortgages, construction, and development loans that must distribute at least 90% of its net income to avoid paying taxes on the income distributed is called A) a trust indenture. B) a unit investment trust. C) an open-end investment company. D) a real estate investment trust.

The best answer is D. REIT A real estate investment trust, to avoid tax on its income, must distribute 90% of its net investment income to investors.

Programs allowing for the direct pass-through of losses and income to investors include all of the following except A) new-construction real estate direct participation programs. B) oil and gas drilling direct participation programs. C) S corporations. D) real estate investment trusts (REITs)

The best answer is D. REITS REITs allow for the direct pass-through of income, but not losses. The other choices are forms of business that allow for pass-through of income and losses.

Which of the following is not a correct statement in respect to the at-risk provisions when investing in a direct participation program (DPP)? A) Losses disallowed by the at-risk provisions in any one year may be carried over to following taxable years. B) Qualified nonrecourse financing is excluded from tax basis except in the real estate programs. C) Deductions or losses are limited to the investors' invested capital plus their percentage of partnership liabilities for which they are personally liable. D) The at-risk provisions do not apply to oil and gas exploration programs.

The best answer is D. The at-risk provisions do not apply to oil and gas exploration programs. The at-risk provisions (you can only deduct what you can lose) apply to all DPPs. Real estate has one unique feature in that nonrecourse financing is part of the investor's tax basis. LO 11.f

There are various direct participation program offerings giving investors a range of choices of different types of oil and gas drilling opportunities. All of the following are types of oil and gas direct participation programs except A) income B) developmental. C) exploratory D) functional allocation

The best answer is D. functional allocation Functional allocation is the most common form of revenue sharing. It is not a type of program. There are three basic types of programs. The exploratory, sometime called wildcat, which is drilling in an unproven area. The next is development where an existing field is continued to be developed by additional drilling. Finally, there is the income, sometimes called production, programs. This is a program that purchases producing wells. There are some program sponsors who split the proceeds from the offering into two or three of these types making it a combination program. LO 11.e

All of the following are objectives in a direct participation program (DPP) except A) deductions against passive income. B) deferment of taxes. C) long-term capital gains. D) short-term capital gains.

The best answer is D. short-term capital gains DPPs are used to defer present income into the future and take advantage of time. In doing so, any gains will be taxed at favorable long-term rates. The expected losses in the early years may be taken as deductions against passive income from other sources.

A FINRA member firm wishes to encourage its registered representatives to sell more limited partnership DPPs. As an incentive, the firm offers an all-expenses-paid trip to a popular vacation resort for those reaching certain sales targets. FINRA rules provide that A) sales incentives are limited to gifts that do not exceed $100 in value. B) the member can weight the credits differently for different investment companies. C) the target must be based on the total production of associated persons with respect to specific investment company securities distributed by the member. D) the target must be based on the total production of associated persons with respect to all direct participation programs offered by the member.

The best answer is D. the target must be based on the total production of associated persons with respect to all direct participation programs offered by the member FINRA made a slight modification to its rules on noncash compensation because of the SEC's Regulation BI (best interest). Specifically, if there is to be any kind of sales contest or other method of incentivizing registered representatives, sales of the particular product type must give equal weighting to all of those investments sold by the firm. This applies largely, but not exclusively, to sales of investment companies, variable products of life insurance companies, and direct participation programs. Previously, firms could give higher weighting to sales of proprietary products, but that ended on June 30, 2020. **This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback.