Ch. 13 Direct Participation Programs

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.

...

LPs are liable for a proportionate share of recourse loans assumed by partner- ships. LPs have no liability for nonrecourse loans, except in real estate partnerships.

...

Oil and gas programs include speculative drilling programs and income programs that invest in producing wells. Unique tax advantages associ- ated with these programs include intangible drilling costs and depletion allowances.

...

If a customer has an adjusted cost basis of $22,000 and unused losses of $10,000 and sells his partnership interest for $20,000, his loss on the sale would be

12,000

If a partner's basis is $25,000 at year end and the investor has losses of $35,000, only _____of the losses may be used to deduct against passive income.

25,000 the remaining 10,000 may be carried forward

Which of the following would NOT be a valid use of the partnership democracy? A. Decidingwhichpartnershipassetsshouldbe liquidated to pay creditors B. Removing the general partner C. Consenting to an action of a general partner that is contrary to the agreement of limited partnership D. Consenting to a legal judgment against the partnership

A Deciding which partnership assets should be liquidated to pay creditors involves limited partners in the active management of partnership affairs. This would result in their being treated as general partners with respect to liability and possible loss of limited partner status.

All of the following would be considered tax advantages relating to a DPP investment EXCEPT A. depreciation recapture B. depletion C. intangible drilling costs D. accelerated depreciation

A Depreciation recapture can occur when an investor sells his interest in a real estate program. If, at the time of the sale, the amount of accelerated deprecation taken exceeds the straight line depreciation amount, the difference (called recapture) must be reported by the investor as ordinary income.

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 sale of unlisted securities A. I and II B. I and III C. II and III D. III and IV

A Passive losses can be deducted against passive income and income from certain real estate investments. It cannot be deducted against active or portfolio (investment) income.

A limited partnership becomes effective when A. the certificate is filed with the proper authorities B. all limited partnership interests are sold C. all LPs are notified that all units are sold D. the limited partnership registration is filed

A The certificate creates the partnership's limited nature; until the document is properly filed, the partnership is a general partnership.

A customer has an annual income of $38,000 from a fairly secure job and is in the 28% bracket. She has a balanced portfolio of stocks and fixed- income securities and has $10,000 to invest in a limited partnership. She is willing to accept only a moderate amount of risk. Which of the following types of limited partnerships would be the most appropriate recommendation? A. Oil and gas income program B. Exploratory oil and gas drilling program C. New construction real estate limited partnership D. Blind pool raw land real estate limited partnership

A 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 probably be of greatest benefit to this investor.

The person who organizes and registers a partnership is known as A. a syndicator B. a property manager C. a program manager D. an underwriter

A The individual who organizes and registers the partnership is the syndicator.

A client invests $100,000 in a tax shelter as a limited partner, giving him a 10% interest in the program. The general partners cannot meet the expenses of the program. There is a mortgage balance remaining of $3 million. The property of the program is then liquidated for $1 million. how much does the investor get back from his original investment? A. $0 B. $10,000 C. $33,000 D. $100,000

A The limited partner will not receive any return on his investment. In a program that has failed, the creditors of the partnership will be paid first out of any sale proceeds before the limited partners receive any money. Because the limited partners had not signed a recourse agreement, even though the partnership still owes $2 million on the mortgage, the limited partners are not liable for any money beyond their original investments.

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

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.

Limited partners in DPPs enjoy several advantages: (3)

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

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

Answer: 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. Developmental oil and gas programs offer high IDCs, not ITCs (investment tax credits).

1. 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 con- siderations but should not be the primary motive to invest. Short-term trading op- portunities do not exist. The investor should expect to hold the interest until the partnership is dissolved or liquidated.

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

Answer: 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.

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 partner- ship 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, computed as follows: Investment (10,000) + Recourse debt (40,000) =50,000 - Cash distributions (5,000) Year-end basis= 45,000 Therefore, the customer can deduct $45,000 on his tax return. The remaining $15,000 is carried forward.

Which of the following corporate characteristics do most limited partnerships avoid? I. Continuity of life II. Limited liability III. Centralized management IV. Free transferability of interest A. I and II B. I and IV C. II and III D. II and IV

B The 2 corporate characteristics that most limited partnerships avoid are continuity of life and free transferability of interest.

In considering a direct participation program, rank the following in order of priority. I. Tax write-offs II. Liquidity and marketability III. Potential for economic gain A. I,II,III B. II, III, I C. III, I, II D. III, II, I

C A program's economic viability is the first priority in the assessment of DPPs. The IRS considers programs designed solely to generate tax benefits abusive. Because there is a very limited secondary market for DPPs, liquidity and marketability should be a low priority.

A subscription for a limited partnership is accepted when A. the proposed LP signs the partnership agreement B. the LP's check is cashed C. the GP signs the subscription agreement D. the certificate of limited partnership is filed

C Acceptance of an investor as an LP occurs when the GP signs the subscription agreement. The LP receives confirmation of acceptance when the subscription agreement is returned.

Which of the following sequences reflects the priority, from first to last, of payments made when a limited partnership is liquidated? I. General partners II. Limited partners III. General creditors IV. Secured creditors A. I,II,III,IV B. I, IV, III, II C. IV, III, II, I D. IV, III, I, II

C Creditors are paid first in a liquidation, with priority given to the secured lenders. General partners are the last to get paid.

DPP stands for A. direct placement program B. directed profits program C. direct participation program D. directors' and principals' program

C DPP stands for direct participation program.

If an investor expects to have a large amount of passive income over the next 2 years, which of the following programs will most likely lead to the largest amount of shelter? A. Equipment leasing B. Undeveloped land purchasing C. Oil and gas drilling D. Real estate income

C Oil and gas drilling programs allocate the majority of investment dollars to drilling. These costs are intangible drilling costs (IDCs), which are 100% deductible when drilling occurs. In equipment-leasing programs, the investment dollars are recovered through depreciation over the lives of the leased assets.

When a certificate of limited partnership must be rerecorded, it must be filed A. before the change B. within 5 business days of the change C. within 30 days of the change D. within 60 days of the change

C Refiling must occur within 30 days.

The rights and liabilities of general and limited partners are listed in A. the certificate of partnership B. the Uniform Limited Partnership Act C. the agreement of limited partnership D. the partnership title

C The agreement is the contract between the partners and contains each entity's rights and duties.

The rights and liabilities of general and limited partners are listed in A. the certificate of partnership B. the Uniform Limited Partnership Act C. the agreement of limited partnership D. the partnership title

C The agreement is the contract between the partners and contains each entity's rights and duties.

Carried Interest.

Carried Interest. 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.

Which of these characteristics is the most difficult to avoid?

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 of these characteristics is the easiest to avoid?

Continuity of life—there is a predetermined time at which the partnership interest is dissolved.

A. Provides creditors with information regarding an LP's term and member contributions B. Allows LPs to vote on major decisions, but not on day-to-day operations C. Passive investors only D. Outlines roles of both general and limited partners 1) Partnership agreement 2)Subscription agreement 3) Certificate of limited partnership 4)Partnership democracy

D C A B

All of the following statements are true with respect to a limited partnership subscription agreement EXCEPT A. the investor's registered representative must verify that the investor has pro- vided accurate information B. the general partner endorses the subscription agreement, signifying that a limited partner is suitable C. the investor's signature indicates that he has read the prospectus D. the general partner's signature grants the limited partners power of attorney to conduct the partnership's affairs

D The limited partner's signature on the subscription agreement grants the general partner power of attorney to conduct the partnership's affairs. The subscription agreement for a limited partnership is deemed accepted when the general partner signs the subscription agreement.

Which of the following statements regarding limited partnerships are TRUE? I. Maximum commission in selling partnership offerings is 5%. II. Maximum commission in selling partnership offerings is 10%. III. Commissions taken are deducted from the original investment to determine beginning basis. IV. Commissions taken are not deducted from the original investment to determine beginning basis. A. I and III B. I and IV C. II and III D. II and IV

D Under the rules, the maximum compensation that may be taken by sponsors selling DPPs is 10%. Up- front costs, such as commissions taken, accounting costs, and so forth, do not affect the beginning basis.

Equipment leasing programs are 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, inter- est 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.

Disproportionate Sharing.

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

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.

Limited partners are able to apply certain deductions and/or tax credits to income as described here.

Expenses of the partnership, such as salaries, interest payments, and man- agement fees, result in deductions in the current year to the LPs. Principal payments on property are not deductible expenses.

Functional Allocation

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.

Basis is computed using the following formula:

Investment in partnership + share of recourse debt - cash distribution

Net Operating Profits Interest

Net Operating Profits Interest. 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.

The costs and revenues associated with oil and gas programs are shared in a variety of ways. A description of these arrangements follows.

Overriding Royalty Interest Reversionary Working Interest. Net Operating Profits Interest

Overriding Royalty Interest

Overriding Royalty Interest. 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.

Reversionary Working Interest.

Reversionary 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.

Tangible drilling cos

Tangible drilling costs are those costs incurred that have salvage value (e.g., storage tanks and wellhead equipment). These costs are not immedi- ately deductible; rather, they are deducted (depreciated) over several years.

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.

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. 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

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.

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.

An LP can lose no more than his

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.

Depreciation write-offs

apply to cost recovery of expendi- tures for equipment and real estate (land cannot be depreciated).

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 lim- ited 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 dis- continued this credit.

Direct Participation Programs

are illiquid investments that pass income, gains, losses, and tax benefits (such as deprecia- tion, depletion, and tax credits) directly to the limited partners. There are some unique tax concepts and suitability issues involving DPPs, also known as limited partnerships (LPs).

Limited partnerships (LPs)

are 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, deduc- tions, and tax credits of the business entity.

An unincorporated organization with two or more members is generally classified as a

artnership for federal tax purposes if its members engage in a trade, business, financial operation, or venture and divide its profits. however, a joint undertaking merely to share expenses is not a partnership. For example, co-ownership of property maintained and rented or leased is not a partnership unless the co-owners provide services to the tenants.

Investors in abusive DPPs may be subject to:

back taxes; recapture of tax credits; interest penalties; or prosecution for fraud.

There is a fourth type of oil and gas partner:

combination. In this program, the partnership allocates dollars between income and exploratory drilling.

A partnership must avoid 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.

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, depre- ciation recapture is not a tax advantage.

Since an investment in a DPP is not taxed first at the level of the busi- ness, ______ is avoided

double taxation is avoided.

Investors should not purchase DPPs primarily for tax shelter; they should be

economically viable and offer investors the potential of cash distribu- tions and capital gains.

Three types of oil and gas programs are

exploratory, developmental, and income.

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

Cash flow

is defined as net income or loss plus noncash changes (such as depreciation).

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.

Accelerated depreciation,

known as modified accelerated cost recovery system (MACRS), increases deductions during the early years and decreases them during the later years.

In a limited partnership, the term basis defines the

liability assumed by the LP.

DPPs are generally structured as

limited partnerships or subchapter S corporations.

In selecting a limited partnership interest, an investor should first consider whether the partnership

matches his investment objectives and has economic viability.

Economic viability

means that there is potential for returns from cash distributions and capital gains. Although tax benefits may be attractive, they should not be the first consideration in the purchase of an LP interest.

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.

Frequently, partnerships borrow money through

nonrecourse loans; the GPs have responsibility for repayment of nonrecourse loans (not the LPs).

The syndicator does what?

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 lim- ited to 10% of the gross dollar amount of securities sold.

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.

If sold privately, investors receive a

private placement memorandum for disclosure.

LPs may be sold through

private placements or public offerings.

In a public offering, limited partnerships are sold with

prospectus to a larger number of limited partners, each making a relatively small capital con- tribution, such as $1,000 to $5,000.

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

real estate, oil and gas, and equipment-leasing businesses.

If a partnership interest is sold, the gain or loss is the difference between

sales proceeds and adjusted basis at the time of sale. If, at the time of sale, the customer has unused losses, these losses may be added to the cost basis.

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.

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).

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.

The limited partnership form of DPP involves two types of partners:

the GP(s) and the LP(s). A limited partnership must have at least one of each.

Depreciation and depletion allowances may be claimed only when income is being produced by

the partnership

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 distri- butions and additional investments.

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).

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.

Depletion allowances apply

to the using up of natural resources, such as oil and gas.

recourse loan.

ubscribers may assume responsibil- ity for the repayment of a portion of a loan made to the partnership. This type of loan is called a

Any DPP established without a ______may be determined abusive.

without a profit motive or with the intention of only generating tax losses for investors may be determined abusive

Partners must adjust their basis at

year end. Any distributions of cash or prop- erty 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.

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 treat- ment under the Internal Revenue Code ■ Any other organization that elects to be classified as a corporation by filing Form 8832

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 rehabilita- tion (reduce tax liability dollar for dollar but are subject to recapture)

how is economic viability measured? Two methods applied to the analy- sis 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 esti- mated future revenues and sales proceeds to allow comparison to other programs.

Three important documents are required for a limited partnership to exist:

■ The certificate of limited partnership ■ The partnership agreement ■ The subscription agreement

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.

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.

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.