Chapter 18- Direct Participation Programs Flashcards
Direct Participation Programs
AKA as limited partnerships
Allows investors certain tax advantages
Composed of General and Limited Partners
General Partners
AKA- the manager and the Sponsor
Has unlimited liability
Limited Partner
Liability is limited to the amount that they have invested
Adjusted Basis
investors basis can change based on certain activities. This new basis is referred to as an adjusted basis
Adjusted basis can be increased by
additional contributions by the partner
Partnership Income
Adjusted basis can be decreased by
Distribution of property (including cash) to the partner by the partnership
Partnership loses
Non-deductible partnership expenses
depletion deduction for oil and gas partnerships
A limited partner can never write off more than
Their adjusted basis
At risk investments is
any money they invest along with any recourse loans
Recourse loans
Loans for which they are personally responsible
Advantages of DPP
single tax status- flow through tax
Limited Liability
Depreciation
Flexibility
diversification of financial risks
Limited Partnership and tax returns
Must file a tax return but does not pay taxes itself
Form K-1 are issued to limited partners for tax purposes
Disadvantages of DPP
Lack of liquidity
Lack of control over Managment
Tax code changes possibility
Losses of investment
Possibly assessment of additional funds
Additional IRS scrutiny
Potential ATM consequences
Considerations when investing in a DPP
Possible loss of principal
General Partners ability in the limited partnership
Possible federal tax code changes
The projected Rate of Return
You wouldn’t be concerned with the financial status of the other limited partners
Characteristics of Partnerships
Agreement must be in writing
The intent must be to carry on business for profit
profits and losses can be shared in any percentage that is agreed upon
A certificate of limited partnership must be filed with the secretary of state in the state where the partnership is formed to protect the limited partner
Certificate of partnership must include
Information of future contributions by the limited partner
The manner in which new partners will be added
The agreement for sharing profits and losses
An explanation of the General partners roll in the venture
Certificate must be amended if
there is an increase in contributions from the partners
There is a change in the profit sharing agreement
An error was discovered in the original certificate
A DPP offered to the public must be
registered with the SEC
The responsibility for exercising due diligence relating to statements made in the prospectus is borne by
The managing underwriter
Maximum Spread for a DPP is
10%
Factors used to determine suitability for DPP
Income and net worth
investment objectives
intention to hold long term
investment experience and tax bracket
Risk Tolerance
Understanding the risk and benefits
the Need for tax advantaged accounts
The economic viability of the DPP is a major concern in establishing suitability
Subscription agreement must contain
A statement saying the investor has read the prospectus and knows the risks
A statement that the general agent will act as an agent of the limited partnership
The investors social security number and tax id number
A statement that the investor has sufficient annual income and net worth for this money to be tied up
does not require a statement of where the investor source of funding came from
Subscription agreement
This is a signed application for the investor to become a limited partner
Must be approved and accepted by the general partner
Only becomes final when the general partner signs the agreement
Rights of the limited partner includes
Inspect the books and records
Receive a complete accounting of the operation
to demand dissolution by court decree
To sue general manager for good cause
To remove general manager for good cause
To share in profits as stated in participation agreement
Return of capital contribution
To receive agreed upon disposition of proceeds upon death of limited partner if partnership agreement includes a death clause. If none then the estate acquires the interest in the partnership
Limited partner can not
Sell partnership assets
Take place in the management of the partnership. (if they do they get reclassified as a general partner and become liable for debts and actions
Limited partner making a loan causes
The limited partner to also become a general creditor
But their interest in the partnership does not change
A general partner cannot (without the approval of the limited partners
Admit another general partner
Confess a judgement on the partnership
Violate the partnership agreement
Prevent the ordinary business of the partnership
Assign of posses partnership property for other than partnership purposes
Admit another limited partner
Continue the business of the limited partnership on the death, retirement or insanity of a general partner
Compete with the limited partnership
Limited Partnerships can be dissolved by
The loss of the general partner
Actions by limited partners such as a class action suit for damages
Winding up of the business of the partnership on the agreement of the partners
Bankruptcy of a partner
any event that makes it unlawful to continue the partnership
Cancelation of the Certificate of Limited Partnership by the Secretary of State
Claims upon a limited partnership dissolution
Creditors - secured then unsecured
Limited partner - profit claims, then capital claims
General partner - Profit claims, then capital claims
Characteristics of a corporation
If a business contains 3 of these 4 items then it is considered a corporation (and can not be a limited partnership)
1. Continuity of Life (length of life)
2. Centralization of management
3. Limited Liability
4. Free transferability of beneficial interests
Ways to avoid corporation status
Have a termination date
Make them illiquid investments, requiring general partners approval to sell the asset
Can not avoid centralization of management and limited liability
Tax Reform act of 1986
individuals would no longer be allowed to deduct losses on passive activities
If the IRS determines that a tax shelter is abusive then
The deduction is disallowed
the taxpayer is charged interest on back taxes
the taxpayer is charged penalties on back taxes
the taxpayer may be charged with intent to defraud
Types of Real Estate DPP
Residential Property
Commerical Property
Industrial Property
Government Assisted housing - either low income or subsidized housing
Condominium securities - time shares
Raw land
Deductions available to investors in real estate are
Depreciation (except for raw land)
And interest on mortgage payments
Advantages of Real Estate DPP
Capital appreciation
Tax deductions
Flow through of income and expenses
Limited Liability
Factors to consider when considering Real Estate DPP
Forecast for regional economic conditions
Changes in interest rates
Changes in tax law
Qualifications of general partner
Sale and Leaseback
When the owner of a real estate property sells a property and then leases that property from the new owner.
New owner can depreciate the property and old owner can deduct the lease payments
Triple net lease
tenant is responsible for:
property taxes
insurance
operating and maintenance expenses related to the property
Debt service is paid by the owner, not the tenant
Condominiums sold to investors with the purpose of renting them out is considered
condominium securities
To qualify as an investment the condominium must
Not be able to be considered a residence and have a unit deed that specifies areas which the owner will have exclusive rights and shared rights
Finding a limited partners loss in real estate
revenue - all deductions = loss
Finding a limited partners cash flow from real estate
Revenue - all deductions except depreciation = cash flow
An investor in oil and gas partnerships will general bear
more risk than those in a real estate program
An investor in oil and gas can generally write off
more in the early years then someone investing in a real estate program
Advantages of Oil and Gas DPP
Intangible drilling costs
Depletion allowances - based on oil sold (not drilled or mined)
Tax deductions
flow through tax benefits
Deprecation deductions on equipment
Intangible Drilling
Costs that can not be recaptured or have salvage value
Such as fuel, labor, supplies, and repairs
deductible as they are incurred and paid and represent a large portion of first years deductions
Equipment costs
Equipment costs are considered capital expenditures and must be depreciated over time
Drilling costs on a well that does not produce oil are considered
dry hole costs and are listed as intangible costs
4 main types of drilling programs
Exploratory drilling (wildcatting)
Developmental drilling
Balanced Drilling program
oil and gas income program (not a tax shelter)
Exploratory Drilling
Drilling for oil in areas without proven reserves, higher return potential
Developmental Drilling
Drilling in areas with proven reserve
Probability of finding oil is higher
Leasing costs in these areas are higher
Returns are lower
Balanced Drilling program
Drills both Exploratory and developmental wells
Oil and Gas income program
Buy properties with proven oil and gas reserves that are already producing
no or few intangible drilling costs
Lowest capital risk
Program assessments
provide assessment of investors for additional capital contributions
demand to investors for additional cash contributions for additional drilling or completion costs
If investor does not meet demand their share in revenue plus expenses and ownership will be automatically reduced
Sharing arrangement
Over riding royalty sharing arraignment - GP (sponsor) does not pay any costs for the well but shares in the profits as soon as they begin. (may be the property owner)
Disproportionate - GP (sponsor) receives a higher percentage then their financial contribution (contributed 10% of the investment but receives 20% of the income)
Subordinate working interest- GP doesn’t contribute anything financially but does not receive income until investors have recouped their investment
Functional allocation - most common
Functional Allocation sharing arrangiment
GP (sponsor) bears the capital or tangible costs that will be depreciated over time
Limited partners bear the intangible costs that will be immediately deductible as they are incurred
Equipment leasing partnerships
formed to buy equipment such as computers, railroad cars and airplanes, and then lease them to businesses
Advantages of Equipment leasing partnerships
Depreciation deduction
interest deduction
Limited Liability for limited partner
NEVER depend of appreciation in value of the leased equipment
Blind pool
the investor does not know the identity of the asset until after the partnership is formed.
Typically they know the plan but the partnership hasn’t finished all the paper work on the property
Return on investment analysis
payback - how long it will take to have the after tax income to equal the after tax expenditure
Internal rate of return - discounts future returns on an investment to see how much you should invest today
Present value - measures future returns in relation to todays dollars
Cash on cash - annual return/amount invested. effects of taxes are disregarded
IRR and present value consider the time value of money
S Corporations
treated like a partnership
flow through of income and expenses
Requirements for an S Corp
100 or fewer shareholders
Issues only 1 class of stock
Other corporations can not be shareholders
Non-resident aliens are prohibited from being share holders
LLCs
Companies treated like partnership for tax purposes
no limit to the number of member/owners to an LLC
