Partnership agreement

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

• Charge a management fee for making decisions for the partnership
• Enter the partnership into contracts
• Decide whether cash distributions will be made to the limited partners
• Accept or decline limited partners

Certificate of limited partnership

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:

• The objectives (goals) of the partnership and how long the partnership is expected to last
• The amount contributed by each partner, plus future expected investments
• How the profits are to be distributed
• The roles of the participants
• How the partnership can be dissolved
• Whether a limited partner can sell or assign his interest in the partnership

If any significant changes are made to the partnership, such as adding new limited partners, the certificate of limited partnership must be amended accordingly.

Subscription agreement

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:

All of the following statements are TRUE regarding the subscription agreement EXCEPT

(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.

Private placements

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.

Public offerings

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.

Checking Out Types of Partnerships

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.

Because of the risks associated with some of the different types of DPPs, investors should have the ability to tie up their money for a long period of time and be able to recover from a loss of all the money invested in case the partnership never becomes profitable.

Building on real-estate partnership info

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:

• Public housing (government-assisted housing programs): This type of real-estate DPP develops low-income and retirement housing. The focus of this type of DPP is to earn consistent income and receive tax credits. The U.S. government (through U.S. government subsidies), via the department of Housing and Urban Development (HUD), makes up any deficient rent payments. Appreciation potential is low and maintenance costs can be high, but the DPP does benefit from a little government security. Public housing DPPs are backed by the U.S. government and, therefore, are considered the safest real-estate DPP. One of the major benefits of public housing DPPs is that they qualify for tax credits (LIHTC, or Low-Income Housing Tax Credits). These tax credits or tax incentives are built into the IRS code to encourage developers to create affordable housing. The biggest risks for public housing DPPs is their lack of appreciation potential and the risk of having to foreclose on non-payers.
• Existing properties: This type of DPP purchases existing commercial properties and apartments, and the intent is to generate a regular stream of rental income. Because the properties already exist, this DPP generates immediate cash flow. The risk with this type of DPP is that the maintenance or repair expenses will eat into the profit or that tenants won’t renew their leases. The properties already exist and are producing income, so the risk for this type of DPP is relatively low.
• New construction: This type of DPP purchases property for the purpose of building. After completing the construction, the partnership’s goal is to sell the property and structure at a profit after all expenses. Building costs may be more than expected, and the partnership doesn’t receive income until the property is sold, but the DPP can benefit from appreciation on both the land and the structure. Although this investment is speculative due to potential increases in building costs, economic downturns, changes in tax laws, competing projects, and so on, it’s not as risky as a raw land DPP.

• 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.

• Blind Pool: This type of DPP gives the general partner wide discretion as to the types of investments that the DPP makes. A blind-pool DPP may have a stated goal of growth, income, and so on, but the investment choices are left to the general partner.

One of the advantages for real estate DPPs that invest in existing properties, such as public housing DPPs and existing property DPPs, is real estate depreciation, which means you can write off the value of an asset (in this case homes or buildings) over its useful life. I know it sounds strange, but investors can actually write off the value of a house or building (land is not depreciable) over a set number of years (such as 10, 20, 25, and so on). At the end of that period, you've written off enough so that, according to the IRS, your home or building is worth nothing (even though it's most likely appreciated in value), and you can't take additional depreciation write-offs. Although things like equipment can be depreciated on an accelerated basis, real estate DPPs can only depreciate on a straight-line basis (writing off an equal amount each year).

The following question tests your understanding of real-estate DPPs.

Gearing up with equipment leasing

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:

• Operating lease: This type of equipment leasing program purchases equipment and leases it out for a short period of time. The DPP doesn’t receive the full value of the equipment during the first lease. This type of arrangement allows the DPP to lease out the equipment several times during the life of the machinery.
• Full payout lease: This type of equipment leasing program purchases the equipment and leases it out for a long period of time. The DPP receives enough income from the first lease to cover the cost of the equipment and any financing costs. Usually, the initial lease lasts for the useful life of the equipment.

The main thing to remember about equipment leasing is that the operating lease is riskier because the equipment becomes less valuable or outdated over time and, therefore, less rentable — in other words, no appreciation potential. However, equipment leasing programs, unlike real estate programs, may qualify for accelerated depreciation (being able to write off more in the early years and less in the later years).

Strengthening your grasp on oil and gas

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:

• Intangible drilling costs (IDCs): IDCs are write-offs for drilling expenses. The word intangible is your clue that you’re not talking about actual equipment. These costs include wages for employees, fuel, repairs, hauling of equipment, insurance, and so on. IDCs are usually completely deductible in the tax year in which the intangible costs occur. IDC deductions are only for the drilling and preparing of a well for the production of oil and gas. Therefore, when a well is producing, IDC write-offs are not allowed. IDCs provide a tax advantage to exploratory programs.

• 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.

The following question concerns different DPP investments.