Chapter 11
IN THIS CHAPTER
Understanding the specifics of DPPs
Distinguishing a limited partner from a general partner
Getting a handle on the paperwork and taxes involved
Looking at the different types of DPPs
Direct participation programs (DPPs) can raise money to invest in real estate, oil and gas, equipment leasing, and so on. More commonly known as limited partnerships, these businesses are somewhat similar to corporations (stockholder-owned companies). However, limited partnerships have some specific tax advantages (and disadvantages) that a lot of other investments don’t have. According to tax laws, limited partnerships are not taxed directly; the income or losses are passed directly through to the investors.
DPPs were once known as tax shelters because of the tax benefits to investors; however, tax law changes have taken away a lot of these advantages. As a result, DPPs have somewhat fallen out of favor for investors (though not entirely for the Series 7 designers).
In this chapter, I explain the differences between limited and general partners as well as the types of partnerships, their particular risks, and potential rewards. The info here can help you examine those risks and rewards and determine the suitability of DPPs for investors. I also explain two inevitable facts of life as they apply to partnerships: the filing of paperwork and the payment of taxes. As with just about every chapter, you will see some overlap between the information covered on the Securities Industry Essentials exam and the Series 7. As always, I give you some practice questions to go along with the rest of the questions in this book.
Just as stockholders are owners of a corporation, limited (and general) partners are owners of a direct participation program (DPP). The key difference for people investing in DPPs is that they’re required to tie up their investment dollars for a long period of time, though they receive tax advantages for doing so. Most DPPs are set up for real-estate projects, oil and gas projects, or equipment leasing.
By law, limited partnerships require at least one limited partner and one general partner. Limited partners are the investors, and general partners are the managers. When you’re looking at general and limited partners, you want to focus on who can and can’t do what.
General partners are responsible for the day-to-day decision making (overseeing operations, deciding when to buy or sell, choosing what to invest in, and so on) for the partnership. Limited partners (the investors) provide the bulk of the money for the partnership but, unlike general partners, can’t make any of the partnership’s investment decisions. Table 11-1 lays out the key things to remember about general and limited partners for the Series 7.
TABLE 11-1 Comparing General and Limited Partners
Category |
General Partners |
Limited Partners |
Decision making |
Are legally bound to make decisions in the best interest of the partnership; make all the partnership’s day-to-day decisions |
Have voting rights but can’t make decisions for the partnership |
Tasks |
Buy and sell property for the partnership; manage the partnership’s assets |
Provide capital; vote; can keep general partners in check by reviewing books |
Liability and litigation |
Have unlimited liability (can be sued and held personally liable for all partnership debts and losses) |
Have limited liability (limited to the amount invested and a proportionate share of any recourse loans taken by the partnership); can inspect all the partnership books; can sue the general partner or can sue to dissolve the partnership |
Financial involvement |
Maintain a financial interest in the partnership |
Provide money contributed to the partnership, recourse debt of the partnership, and nonrecourse debt for real-estate DPPs |
Financial rewards |
Receive compensation for managing the partnership |
Receive their proportion of profits and losses |
Conflicts of interest |
Can’t borrow money from the partnership; can’t compete against the partnership (for example, they can’t manage two buildings for two different partnerships in close proximity to each other) |
None; can invest in competing partnerships |
For the Series 7, you need to know about certain paperwork that’s specific to limited partnerships. In the following sections, I discuss the three required documents necessary for a limited partnership to exist.
The partnership agreement is a document that includes the rights and responsibilities of the limited and general partners. Included in the agreement are basics that you would probably guess such as the name of the partnership, the location of the partnership, the name of the general partner, and so on. In addition, the partnership agreement addresses the general partner’s rights to
The certificate of limited partnership is the legal agreement between the general and limited partners, which is filed with the Secretary of State in the home state of the partnership. The certificate of limited partnership includes basic information such as the name of the partnership and its primary place of business, the names and addresses of the limited and general partner(s), and the following items:
If any significant changes are made to the partnership, such as adding new limited partners, the certificate of limited partnership must be amended accordingly.
The subscription agreement is an application form that potential limited partners have to complete. The general partner uses this agreement to determine whether an investor is suitable to become a limited partner. The general partner has to sign the subscription agreement to officially accept an investor into the DPP.
One of your jobs as a registered rep is to prescreen the potential limited partner to make sure that the partnership is a good fit for the individual. Also, you need to review the agreement to ensure (to the best of your ability) that the information the investor provides is complete and accurate. Besides the investor’s payment, the subscription agreement has to include items such as the investor’s net worth and annual income, a statement explaining the risks of investing in the partnership, and a power of attorney that allows the general partner to make partnership investment decisions for the limited partner.
The following question tests your ability to answer questions about DPP paperwork:
(A) A general partner must sign the agreement to officially accept a limited partner.
(B) A registered rep must first examine the subscription agreement to make sure that the investor has provided accurate information.
(C) After the general partner has signed the subscription agreement, it gives the limited partner power of attorney to conduct business on behalf of the partnership.
(D) The subscription agreement is usually sent to the general partner with some form of payment.
The answer is Choice (C). The test designers want to know that you understand what this document is and that you have a grasp of who does what. The subscription agreement is a form that the potential limited partner fills out; then the registered rep reviews the document before sending it (with the investor’s payment) to the general partner, who signs to accept the terms. Choice (B) shows where the registered rep (that’s you!) comes in. Here, you assume that the “investor” is the potential limited partner, so Choice (B) checks out.
Because this is an except question, the correct answer is Choice (C); the subscription agreement gives the general partner, not the limited partner, power of attorney to make decisions for the partnership. If you remember that limited partners don’t really do much in the way of decision making (as I explain earlier in “The DPP Characters: General and Limited Partners”), you can spot the false answer right away.
As with many other securities, DPPs can be sold privately through private placements or through public offerings. It's up to the syndicator (underwriter) to help determine which type of offering makes the most sense.
If a DPP is to be sold privately, the syndicator helps to find a several accredited investors, who will become limited partners, to contribute large sums of money. These accredited investors are persons who can afford to take the financial risk and typically have a lot of investment experience. A private placement of DPPs is made through an offering memorandum (private placement memorandum). Private placements of DPPs are exempt from SEC registration under Regulation D of the Securities Act of 1933. For more on private placements, please refer to Chapter 5.
Unless the transaction is exempt, as in private placements, all non-exempt securities transactions must be registered with the SEC. Public offerings of DPPs are no exception. So in a public offering, not only do investors need to be prescreened, but they also must receive a prospectus. When there's a public offering of a DPP, there will be a lot more investors, and the initial capital contribution will generally be much smaller than in a private placement. In some cases, investors may become a limited partner with an initial contribution as low as $1,000.
DPPs used to be called tax shelters because DPPs flow through (or pass through) not only income but also losses to investors (corporations only flow through income). Prior to 1986, investors could write off these losses against income from other investments. Then the IRS stepped in because it felt that this write-off was too much of an advantage for investors (or the IRS wasn’t making enough money) and decided to give DPPs their own tax category. Now, because investors are not actively involved in earning the income, taxes on DPPs are classified as passive income and passive losses. (See Chapter 15 for more info on taxes and types of income.) So basically, DPPs are like corporations that have a tax pass-through exemption from the IRS. However, unlike corporations that are taxed on the corporate level, prior to distributing dividends to investors, DPPs pass through untaxed income to investors.
Direct participation programs can be offered publicly or privately. Public offerings of DPPs must be registered with the Securities and Exchange Commission (SEC) whereas private offerings (offerings to mostly wealthy investors) are not. Typically, publicly offered DPPs have a lower unit (buy-in) cost than that of privately offered DPPs.
Certainly direct participation programs do provide some advantages, but they also have additional risks that investors don’t face with other types of investments, such as having to loan additional money to the partnership if needed. Therefore, when evaluating whether an investment in a DPP may be right for one of your clients, not only do you need to determine whether investing in a partnership is wise for that client, but you also need to consider the following items:
Certainly partnerships can be formed to run any sort of business that you can imagine, including business development companies (BDCs), small-cap debt and equity, and so on. However, the Series 7 exam focuses on the big three: real estate, equipment leasing, and oil and gas. You need to be able to identify the risks and potential rewards for each of the following types of partnerships.
Real-estate partnerships include programs that invest in raw land, new construction, existing properties, or government-assisted housing. You need to know the differences among the types of programs, along with their risks and potential rewards. Here are the types of real-estate DPPs, from safest to riskiest:
Raw land: This type of DPP invests in undeveloped land in anticipation of long-term capital appreciation; raw land DPPs don’t build on or rent out the property. The partnership hopes the property purchased will appreciate in value so that the DPP can sell the property for more than the purchase price plus all expenses. Until that hopefully happens, investors have the cost of principal and interest of borrowed money plus carrying costs (taxes). In the event that the land held by the DPP isn't sold in a reasonable amount of time, investors may have to provide additional funds to cover expenses.
Raw land DPPs are considered the riskiest real-estate DPP because the partnership doesn’t have any cash flow (no rental or sales income), and the value of the land may not increase — it may actually decrease. In addition, investors cannot claim depreciation deductions because land cannot be depreciated.
The following question tests your understanding of real-estate DPPs.
Which of the following types of real-estate DPPs has the fewest write-offs?
(A) Raw land
(B) New construction
(C) Existing properties
(D) Public housing
The correct answer is Choice (A). DPPs that invest in raw land are buying property and sitting on it with the hope that it’ll be worth more in the future. Because the DPP isn’t spending money on improving the property and land can’t be depreciated, raw land DPPs have the fewest write-offs.
Although you will be tested on equipment leasing programs on the Series 7 exam, it’s the least-tested type of DPP. Equipment leasing programs purchase equipment (trucks, heavy machinery, airplanes, railroad cars, computers … you name it) and lease it out to other businesses. The objective is to obtain a steady cash flow and depreciation write-offs. The two types of leasing arrangements you need to be aware of are the operating lease and the full payout lease:
Oil and gas partnerships include programs that produce income, are speculative in nature, or are a combination of the two. You need to know how the types of programs differ, along with their risks and potential rewards. Oil and gas partnerships also have certain tax advantages that are unique:
Tangible drilling costs (TDCs): TDCs are write-offs on items purchased that have salvage value (items that can be resold). All oil and gas DPPs have TDCs, which include costs for purchasing items such as storage tanks, well equipment, and so on. These costs are not immediately written off but are depreciated (deducted) over seven years. Depreciation may be claimed on either a straight-line basis (writing off an equal amount each year) or an accelerated basis (writing off more in the early years and less in the later years).
IDCs are fully deductible in the current year; TDCs are depreciated (deductible) over several years.
Depletion: Depletion is a tax deduction that allows partnerships that deal with natural resources (such as oil and gas) to take a deduction for the decreasing supply of the resource. Partnerships can claim depletion deductions only on the amount of natural resources sold (not extracted and put in storage for future sale).
Depletion deductions are only for DPPs that deal with natural resources. On the Series 7 exam, the only DPP with depletion deductions that you need to be concerned with is oil and gas.
When investing in oil, partnerships can pioneer new territory, drill near existing wells, buy producing wells, or try a combination of those methods. For Series 7 exam purposes, exploratory programs are the riskiest oil and gas DPPs because oil may never be found, and income programs are the safest oil and gas DPPs. To make your life easier (hopefully), I’ve composed a DPP comparison chart (see Table 11-2) to help you focus on the main points of each type of oil and gas DPP.
TABLE 11-2 Advantages and Risks of Various Oil and Gas DPPs
Type |
Objective |
Advantages |
Risks |
Exploratory (wildcatting) programs |
To locate and drill for oil in unproven, undiscovered areas |
Long-term capital appreciation potential; high returns for discovery of new oil or gas reserves |
Riskiest oil and gas DPP because new oil reserves may never be found; high IDCs because the DPP isn’t working with producing wells |
Developmental programs |
To drill near producing wells (in proven areas) with the hope of finding new reserves |
Long-term capital appreciation potential (not as much as an exploratory program) with less risk than exploratory programs; oil will likely be found |
The property’s expensive; the drilling costs may be higher than expected; the risk of dry holes (non-producing wells) is still somewhat high; medium level of IDCs |
Income programs |
To provide immediate income by purchasing producing wells |
The partnership generates immediate cash flow; the least risky of the oil and gas DPPs; no IDCs |
High initial costs; the well could dry up; gas prices could go down |
Combination (balanced) programs |
To provide income to help pay for the cost of finding new oil reserves |
The ability to offset the costs of drilling new wells by using income generated by existing wells |
Carries the risks of all the programs combined |
The following question concerns different DPP investments.
Mr. Smith has money invested in a limited partnership that’s expecting to have a significant amount of income over the next one to two years. Which of the following programs would BEST help Mr. Smith shelter the MOST of that income?
(A) Oil and gas exploratory
(B) Raw land purchasing
(C) Equipment leasing
(D) Existing real-estate property
The answer you want is Choice (A). Oil and gas exploratory programs spend a lot of money attempting to find and drill for oil. These programs have high IDCs (intangible drilling costs), which are fully tax-deductible when the drilling occurs. Therefore, the oil and gas exploratory programs have the largest write-offs in the early years, which could help Mr. Smith offset some or all of his passive income from the other limited partnership.