Chapter 13- Direct Participation Programs 5-12 Questions Flashcards
Definition of a Direct Participation Program
Illiquid investment that pass income, gains, losses and tax benefits directly to limited partners
Limited partnerships are one of the most common
Only pass through entity for losses
Limited partnerships
Allow economic consequences of an investment to flow through to investors
Offer share of income, losses, gains, deductions and tax credits
Enjoy limited liability, investment management and flow through income and expenses
Greatest disadvantage is lack of liquidity
Master limited partnerships (MLPs) are traded on exchange/otc
Tax reporting
Limited partnerships flow income and losses to partners
SCorps flow through to shareholders
Double taxation is avoided through this process
Both still report their income to IRS but DPPs send K-1s to participants
Only receive passive losses (only be used on passive income)
Abusive DPPs
Investors can be subject to: Back taxes Recapture of tax credits Interest penalties or Prosecution of fraud
Established without a profit motive
Partnership classification
Must provide a service or product to be classified as partnership
Must avoid corporation characteristic like:
Continuity of life (most partnerships have a set end date at beginning), easiest to avoid
Transfer of shares is second easiest to avoid
Centralized management is the hardest characteristic to avoid for a DPP
Purchasing an LP
Either sold through private placement or public offering
Limited partners must be accredited investors, and usually make large contributions in a private placement
Public offering however has many LPs and most positions are 1-5 thousand
Sold by a syndicator (fee limit of 10% of gross amount sold)
Main purpose of purchasing should be to make a profit
Required documentation for an LP
Certificate of limited partnership- Provides creditors with info regarding an LPs term and member contributions
Must be filed in home state of partnership
Material changes must be noted in 30 days-
General Partners role as defined by partnership agreement
Has right to change management fee
Authority to bind partners to contract
Right to determine who should be included in partnership
Right to determine cash distributions
Recourse vs non recourse loan
Recourse- investor can be forced to repay partial amount of a loan
Nonrecourse- GPs are in charge of repayment, except for in real estate partnerships where LP may have partial liability
Dissolving of a partnership
LPs usually liquidate themselves or dissolve upon the partner group selling off assets or disposing them
GP must cancel certificate of LP and settle accounts in order:
Secured loans
Other creditors
LPs: first for claim to profits and second for claims to return of contributed capital
Gps: first for fees and claims not providing profit
Second for profits
Third for capital return
Limited partnerships become effective when
The certificate of limited partnership is filed
General partners
Unlimited liability, personal liability for business debts
Responsibility of management
Fiduciary responsibility
Can make legally binding decisions
Buy and sell property for partnership
Maintain financial interest (1% minimum)
Cannot: Borrow from partnership Compete against Commingle funds with personal fund Continue partnership after loss of a GP
Limited partners
Limited liability; can lose only investment and portion of recourse debt
May not participate in management
May sue the GP
Vote on new GPs
Vote on sale or refinancing of partnership
Receive income
Cannot:
Act on behalf of partnership or participate in management
Knowingly sign a false certificate
Have name appear in partner name
Real Estate Partnerships
Provide investors with benefit of:
Capital growth potential
Cash flow
Tax deductions from interest expense and depreciation
Tax credits for government assisted housing
5 types of Real Estate partnerships
- Raw Land- Bought for appreciation of a lot, has no income distributions or tax deductions, not considered a tax shelter, speculative
- New Construction- Minimal maitenance costs, purchase for appreciation of property. Could run into cost overruns in construction. Riskier than existing property. Depreciation and deductions after income is generated
- Existing property- immediate cash flow, greater maintenance expense, low risk, deductions for mortgage interest and depreciation
- Gov assisted housing- low income and retirement housing, get tax credits and rent subsidies, but low appreciation potential, tax credits and losses are benefit
- Historic Rehab- tax credits for preserving structure, possible cost overruns and inability to deduct current expenses during construction
Oil and Gas Partnerships unique tax breaks
- Intangible Drilling Costs (IDCs)- First year of drilling intangible costs can be 100% deducted, any cost that has no salvage value
- Tangible Drilling Costs (TDCs)- Deducted over a series of years, have a salvage value
- Depletion Allowance- tax deduction for sale of oil or gas based on loss of asset, only allowed after product is actually sold
3 types of oil and gas programs
- Exploratory- Locating undiscovered reserves of oil and gas, high risk, high IDCs for immediate tax shelter
- Developmental- Drilling near existing fields to discover new, medium IDCs
- Income- existing, income shelter from depletion allowances
- Combination- split between exploratory and income
Oil and Gas sharing arrangements
Overriding Royalty Interest- Receive interest from rights but no partnership risk
Re visionary working interest- GP bears no cost and receives no income until LPs recover capital
Net operating profit interest- LP bears all deductible and non deduct costs, only available in private placement
Disproportionate share- GP bears small expense but high rev
Carried interest- LPs receive share of Drilling Costs but no IDCs
Functional Allocation- shared revenues, LP receives the IDCs which immediately deduct
Equipment Leasing Program
Purchase leased equipment to get lease pay income
Also get share of write offs for op expenses, interest deductions and depreciation
No longer receive tax credits
Economic Viability of an investment
Measured by IRR and cash flow analysis
Deductions from an LP
Include the following expenses: Salaries Interest payments Management fees Depreciation write offs Depletion allowance
Principal payments on property are not deductible
Depreciation and depletion can only be claimed when there is income and when the product can be no longer used at end of life usually
Credits related to LPs
Most are attributed to gov assisted housing programs and historical restoration
Crossover point
When a program begins to generate taxable income instead of losses
Generally occurs after a few years
Cost basis of an LP
LP Cost Basis consists of: Cash contributions Property contributions Recourse debt And non recourse for real estate
Allowed to make deduction up to cost basis
Cost basis is the full investment regardless of the commission
Unused losses can be subtracted from a sale of an LP
Blind pool
Less than 75% of assets have been specified for use
Cash flow
Net income or loss plus added back non cash changes
Depreciation is just added back to the Net gain or loss
The partnership agreement-
Outlines roles of general partner and LPs
Right of GP include:
Right to charge a management fee
Authority to bind partnerships into contract
Right to determine which partners should be included
Right to determine cash distribution
The subscription agreement (Passive investors only)-
Passive investors only
Appoints one or more GPs who act on behalf of LPs
Only effective once GP signs it
tells net worth of investor
acknowledgment of risk
power of attorney for the GP as the agent of the partnership
Agreement (certificate) of limited partnership-
Provides creditors with information regarding an LPs term and member contributions
Must be filed in home state of the partnership
Establishes basic identification of company
Includes:
Partnership name
Partnership business
Amount of time partnership expects to be in business
Size of LP investments
Share of compensation
Whether death of GP destroys partnership or not
Any material change require 30 day update
LP becomes effective once Certificate is filed
Partnership Democracy
Allows LPs to vote on major decisions, but not on day to say operations
Basis
Share of company that can be lost by a specific shareholder
Investment in partnership + share of recourse debt - cash distributions
Basis is unaffected by commission
Would still have 50,000 basis if had to pay a commission
Depreciation Recapture
Depreciation deductions must be taken back if overdone
