Chapter 8: Direct Participation Programs

Question 1

Direct Participation Programs (DPPs)

Answer 1

Entities that pass all income and expenses directly to the owners. Consequently, the DPP itself is not taxed. This tax advantage makes DPPs very attractive, but less so since 1986. Since the Tax Reform Act of that year, passive losses generated by DPPs can only be offset against passive income. Passive losses may NOT offset earned income.

No more than 15% of the money raised can be used for start-up costs, such as, distribution, attorney fees, accounting fees, and filing fees.

Four types:
1. General partnership
2. Limited partnership
3. Subchapter S corporation
4. LLC - Limited liability corporation

Direct participation programs themselves do not pay taxes. All gains and losses pass through to the individual investors. Therefore, all taxes are paid by the investors. However, the direct participation program does have to file a tax information form. Also, DPP investors are at higher risk for IRS audit because the IRS regularly verifies the authenticity of DPPs as pass through vehicles.

The IRS has a test to ensure that DPPs meet the criteria for pass through advantages. DPPs must be different than corporations.

Question 2

General partnership

Answer 2

In a general partnership, all partners are general partners, and are fully liable for all activities and obligations of the partnership.

Question 3

Limited partnership

Answer 3

A limited partnership has at least one general partner (GP) who is fully liable and at least one limited partner (LP) who has limited liability. The GP is chosen based on their expertise in the field in which they are investing. LPs are only liable to the amount they’ve invested and to the extent of any recourse financing to which they have agreed.

LPs are silent partners and can make no management decisions. If the LP has any management input, the LP has changed status, and becomes a general partner with full liability.

To summarize, a limited partnership gives the LPs two important advantages: limited liability and avoidance of double taxation on distributions from the limited partnership.

Limited partnerships offer several attractive features to investors, such as limited liability, direct flow through of income and expenses, and central record keeping. However, the most important objective of a limited partnership must be economic viability, or profit motive. If the IRS concludes that a limited partnership’s primary goal is tax advantages, the IRS will deem the limited partnership to be abusive. The IRS will consequently assess back taxes and penalties, and might even prosecute for fraud.

Question 4

Subchapter S corporation

Answer 4

A small company, usually family-owned and operated. A Sub S is a closely held corporation and all income and expenses pass through to the individual shareholders. Because it is a corporation, it has some limited liability characteristics for the investors. The maximum permissible number of shareholders in a Sub S is 100.

Question 5

LLCs

Answer 5

• LLCs also function as conduits; the entity avoids taxation by passing income and expenses through to the owners. Like other DPPs, an LLC exposes the owners to limited liability.
• Business Development Companies (BDCs) provide venture capital to small companies and allow investment from a larger pool of investors. Normally these types of investments are reserved for wealthy or institutional investors. BDCs allow anyone to participate in small start-up businesses.

Question 6

REIT

Answer 6

REITs are not considered a DPP, or pass-through vehicle. Though REITs must pass through 90% of their investment income, they do not pass through losses. A REIT must have 75% of its assets invested in real estate-related activities. A REIT owner’s liability is limited to the amount invested in the REIT.

Question 7

DPP must avoid at least two of the six corporate characteristics

Answer 7

DPPs are carefully structured so that they avoid at least two of the characteristics below. By doing so, they qualify as pass through conduits for preferential tax treatment.

1. A group of associates: People must be involved whether it’s a corporation or partnership, so this is a difficult corporate characteristic to avoid.
2. Gathered to achieve a profit: The entity’s primary purpose must be economic viability. This characteristic cannot be bypassed.
3. Centralized management: A corporation has a management team, typically led by the CEO and board of directors. In a limited partnership, the general partner is this centralized management. This necessity for centralized management cannot be avoided.
4. Freely transferable interest: Unlike a corporation’s stock, which freely trades in the secondary market, limited partnership interests are difficult, if not impossible, to transfer. There is a very limited secondary market for limited partnership interests. Also, the general partner must approve the new LP if a partnership interest is sold. Therefore, this characteristic is easy to avoid.
5. Limited liability: In a corporation, all shareholders have limited liability. In a partnership, this characteristic is easily avoided. The GP has unlimited liability for all partnership activities and debt. The GP is said to be jointly and severally liable.
6. Continuity of life: Corporations are ongoing concerns. They can run in perpetuity, generation after generation. However, a limited partnership easily avoids this by setting a future liquidation date. On this date, operations cease, all assets are sold, and each owner is given their share. Also, the partnership frequently has a policy of automatic liquidation upon the GP’s death, illness or removal.

Question 8

Passive income

Answer 8

-Passive income is income earned from rents, royalties, and stakes in limited partnerships.

• Passive income includes regular earnings from a source other than an employer or contractor. The Internal Revenue Service (IRS) says passive income can come from two sources: rental property or a business in which one does not actively participate, such as being paid book royalties or stock dividends.

Question 9

Earned income

Answer 9

• Earned income consists of income you earn while you are working a full-time job or running a business. Note that “running a business” does not include a rental real estate business in most cases.
• This is money you work for. It includes salary, hourly wages, tips, and sales commissions.

Question 10

General partner characteristics

Answer 10

-As manager of the partnership, the GP has a fiduciary responsibility to act in the best interest of the LPs. Therefore, the GP must avoid activities which present a conflict of interest. These include borrowing from the partnership and competing with the partnership (though the GP may be paid not to compete). Also, the GP may not sell personally owned assets to the partnership.

Frequently, the GP is the sponsor of numerous programs at the same time, creating potential conflicts of interest.

Question 11

Limited partner characteristics

Answer 11

As owners of the partnership, the LPs have the right to regularly inspect the books. The LPs may also sue the GP if the GP willfully mismanages partnership assets or breaches the partnership agreement.

There are many risks associated with investing in a limited partnership, in addition to higher IRS audit risk. Such audit risk might result in the IRS revoking limited partnership status, such that the LPs lose tax advantages and limited liability. There are no guarantees that the partnership will meet its objectives. Limited partnership interests are very illiquid, and the investor might lose the entire investment.

Question 12

Cost Recovery Systems (CRSs)

Answer 12

Cost recovery systems are accounting methods whereby enterprises recognize the cost of capital assets against their revenues. The enterprise first purchases a major asset, such as computer equipment or machinery, and then recognizes a portion of that purchase price in each year of the asset’s life. It is important to realize that depreciation is not a cash flow item; the corporation does not write a check for depreciation each year. Depreciation is simply an accounting system to systematically spread an asset’s purchase price over its lifespan.

Question 13

Accelerated Cost Recovery Systems/ Depreciation

Answer 13

Accelerated cost recovery methods (or systems, ACRSs) allow the enterprise to write off large portions of the asset’s cost during early years of the asset’s life. This is advantageous to the entity due to the time value of money. In addition, these ACRS methods typically allow the owner to depreciate the full cost of the asset, leaving no residual value. Certain ACRS methods even allow for the write off of more than the cost of the asset

When an enterprise is using these generous accelerated cost recovery methods, it can experience significant cash flows, but simultaneously report operating losses due to large depreciation charges. If this enterprise is a limited partnership, these large expenses flow through to the LP’s personal tax returns.

However, this advantage carries a risk. Suppose the partnership sells a piece of equipment on which it has used an ACRS. Through using the ACRS, the asset’s book value (or cost basis) to the partnership may be quite low (below its market value). When this asset is sold for fair market value, the partnership consequently experiences a capital gain. This capital gain flows through directly to the LP’s tax return, and the LP is taxed on the gain.

This process is called recapture. In other words, a portion of the large depreciation taken by the LP is “recaptured” by the IRS. The prior tax advantage experienced by the LP is canceled by this current capital gain tax. Recapture is a risk that an LP assumes when investing in a limited partnership.

Limited partnerships also depreciate improvements to land, such as buildings. These buildings might be office towers, apartment complexes, or shopping centers. Though these improvements are depreciated, it is important to remember that the land itself is not. Depreciation for real property improvements is usually done on a straight line basis. Under straight line depreciation, an equal amount of the asset’s cost is expensed during each year of the asset’s life. Straight line depreciation differs from ACRSs, where larger expenses are taken during the early years of the asset’s life. Remember that depreciation reduces the investors’ cost basis.

Question 14

Depletion

Answer 14

Depletion is taken on irreplaceable natural resources. For example, oil, natural gas and coal reserves are depleted. There are two types of resource depletion: percentage depletion and cost depletion. Percentage depletion benefits small oil and gas producers.

IMPORTANT: depletion lowers cost basis

Question 15

Cost basis in a limited partnership

Answer 15

The LP’s cost basis is first established by the LP’s initial investment.

Next, any recourse debt which the LP has assumed is added to the LP’s cost basis.

Finally, depreciation and depletion reduce the LP’s cost basis.

Note: can never be less than zero.

Question 16

Recourse debt

Answer 16

Recourse debt, or recourse financing, is potential debt for which the LP is liable upon partnership liquidation. In other words, if the partnership is liquidated and liquidation proceeds do not extinguish all debts, the LP is liable for the LP’s share of the remaining debt. A limited partnership assumes recourse debt when it needs financing, and lenders will only provide financing with recourse to the LPs. The LPs must consent before the GP may obligate them with this recourse debt. Because each LPs is responsible for a share of this debt, it is added to each LP’s cost basis.

Question 17

Internal rate of return (IRR)

Answer 17

Internal rate of return (IRR) is the most commonly used measure when determining the value of a limited partnership. IRR considers current value or net present value, tax deductions, and cash flow from the investment.

Question 18

Cash Flow vs. Taxable Income

Answer 18

Cash flow is actual money left over after all expenses are paid. To calculate cash flow, only money that was actually paid out is deducted from revenues.

Conversely, taxable income is income reportable to the IRS. Taxable income is calculated using IRS-permitted depreciation and depletion methods. Remember that these cost recovery methods are non-cash items. They do not reduce cash flow. Therefore, taxable income is typically lower than cash flow during the early years of a limited partnership, due to these depreciation and depletion deductions.

The LP often has positive cash flow and yet reports a loss to the IRS because of these accelerated cost recovery systems. However, after several years, the limited partnership often experiences the crossover point. Crossover is the point at which taxable income exceeds cash flow. In other words, the investor is taxed on greater reportable income than the cash flow actually received. This is called phantom income. Phantom income is income that the investor is taxed on, but that was not received in cash flow.

Question 19

Cash Flow vs. Taxable Income - Example

Answer 19

Cash Flow:

Revenue $100,000
Debt service (principal & interest) ($55,000)
Operating expenses ($40,000)
Depreciation $0
=CASH FLOW $5,000

Taxable Income (Loss):
Revenue $100,000
Interest paid on debt ($10,000)
Operating expenses ($40,000)
Depreciation ($60,000)
=TAXABLE INCOME (Loss) ($10,000)

An LP who owns 10% of this partnership receives $500 in cash flow. But because of the partnership’s taxable loss, the LP reports a $1,000 loss on the LP’s personal tax return to the IRS.

Question 20

Cash flow vs. taxable income - Crossover point

Answer 20

Cash Flow (stayed the same):
Revenue $100,000
Debt service (principal & interest) ($55,000)
Operating expenses ($40,000)
Depreciation $0
=CASH FLOW $5,000

Taxable Income:
Revenue $100,000
Interest paid on debt ($10,000)
Operating expenses ($40,000)
Depreciation ($20,000)
TAXABLE INCOME $30,000

The 10% LP receives $500 in cash flow but reports $3,000 taxable income to the IRS. This LP has $2,500 in phantom income.

for tax purposes, losses can only be written to the extent of the cost basis

Question 21

Distribution

Answer 21

The maximum permissible sales charge on limited partnership interests is 10% plus ½% for due diligence expenses. The broker/dealer that forms the selling syndicate is sometimes called the syndicator and is responsible for securities registration. A general partner may also act as a syndicator when organizing and establishing a partnership. The syndicate may be separately reimbursed for expenses such as printing costs and regulatory filing fees. However, if the syndicate is reimbursed for any solicitation expenses, this is considered part of its 10% compensation.

A limited partnership might change its status through an offering called a roll up. In a roll up, the limited partnership changes its status to a master limited partnership (MLP) or possibly a corporation. Frequently, this roll up benefits the GP. If so, this conflict of interest must be disclosed to the LPs. Also, the roll up requires a vote of the LPs. An MLP is a limited partnership that is freely transferable, either on an exchange or OTC. The broker/dealer’s fee for structuring a roll up is limited to 2%.

Limited partnerships are complex, illiquid investments designed for sophisticated, affluent investors. They are not suitable for investors without substantial net worth or those who are not in high-tax brackets. Therefore, registered representatives must carefully assess customer suitability when selling limited partnerships. The “trade ticket” for a limited partnership purchase is called the subscription agreement. This document contains a detailed financial questionnaire which the investor must complete and sign. Written verification of net worth is required. This document is carefully reviewed, approved, and signed by the GP before the investor is accepted as an LP.

Question 22

Required documents – limited partnership

Answer 22

A certificate of limited partnership was filed with the Secretary of State when the partnership was started. This is an important document because this is what creates limited liability for the limited partners and unlimited liability for the GP.

A subscription agreement is signed by the general partner and the limited partner when the LP enters the partnership. It is important to remember that the limited partner is not accepted into the partnership until the general partner signs this subscription agreement. Both the GP and the LP are required to sign the subscription.

Memory trick! “S” for subscription and “S” for signature.

Question 23

Public offerings and private placements

Answer 23

Limited partnership interests are distributed through both public and private offerings. In a public offering, the disclosure document is called a prospectus. However, in a private placement or private offering, the disclosure document is called an offering memorandum.

Most DPPs are sold through Reg D private placements. DPPs may also be sold through public offerings.

Question 24

Types of limited partnerships

Answer 24

Limited partnerships are organized by syndicating general partners, and are typically sold on a best efforts basis using an escrow account. The majority invest in real estate, oil and gas, or equipment leasing ventures:

• Real estate partnerships emphasize either depreciation deductions, income from existing rental properties, or growth from new development.
• Oil and gas ventures vary from risky wildcat or exploratory deals, to less profitable but more reliable developmental programs, to more conservative income programs.
• Equipment leasing programs are structured to provide income because there is little or no capital appreciation potential.

Question 25

Real estate limited partnerships

Answer 25

There are several different types of real estate limited partnerships. The type with the highest risk and greatest potential return is a raw land partnership. This vacant land partnership has a long investment time horizon, meaning it has a long-term holding period. This partnership provides no expenses because land doesn’t depreciate, and there is no resource depletion. However, if the land is purchased at the right price and is held for a long time, it can appreciate substantially.

The next riskiest real estate program is new construction. Its objective is capital appreciation. The general partner purchases land, develops it, and hopefully sells at a profit. Commercial property’s value is largely determined by rental income, which is produced by quality tenants. Because there are no tenants at the beginning of this partnership, the ultimate market value of the property is uncertain. Therefore, the probability of a profitable sale is also uncertain.

A safer real estate partnership seeks rental income. This partnership buys and manages existing property for its rental income. This partnership is the safest type because it invests in an established real asset with an existing rental income stream historical occupancy rate, and known tenant base.

Real estate partnerships may take advantage of tax credits, including the historical rehabilitation credit and the low-income housing credit. Like other income and expenses, these tax credits flow through to the LP’s tax return. Tax credits provide a powerful benefit to the LP because the credit offsets the LP’s calculated tax liability dollar for dollar. For example, if the investor owes $1,000 in taxes and also has a $1,000 tax credit, the investor pays no taxes.

A partnership uses the historical rehab credit by purchasing and restoring an old property. This property must be listed on a national registry, and at least 75% of the original structure must exist before the partnership starts restoration.

The second type of credit (and possibly the best) is the low-income housing credit. Low-income housing projects offer very limited capital appreciation because there is no potential to improve the rental income stream; the rents are fixed at a low rate. Remember that rental property value is largely determined by its rental income stream. Consequently, the low-income housing credit is designed to attract investor capital to this otherwise unattractive market sector.

Low-income housing rents are modest but tend to be steady because the Department of Housing and Urban Development (HUD) typically subsidizes these rents. The low-income housing credit tends to provide the best credit. Therefore, when asked for the investment that provides the BEST tax relief, the low-income tax credit is usually the correct answer.

Debt in limited partnerships consists of recourse (at risk) and nonrecourse (mortgages). Recourse debt increases the LP’s cost basis in the partnership. Nonrecourse debt does not typically get added to an LP’s cost basis; however, the exception is with real estate programs. Nonrecourse debt through a qualified lender increases investor basis in a real estate program, without the investor being legally at risk. Both a cash distribution and any repayment of principal on the debt decreases the limited partner’s basis.

Question 26

Oil and gas limited partnerships

Answer 26

The first type of oil and gas program is a drilling program. If the drilling is in an unproven area, this is called a wildcat program. The wildcat program is the riskiest of all oil and gas programs because of the high percentage of dry wells. However, wildcat programs also offer the greatest potential return if successful.

The next type is a developmental program. In a developmental program, drilling is done in an area with proven reserves. Developing these proven reserves is less risky than exploratory drilling.

Exploratory wells are in unproven areas and are primary sites. Developmental wells are in proven areas. Secondary sites use supplemental means of surfacing the oil, secondary drilling is water and steam, and tertiary is chemicals and gas.

A combination program combines exploratory and developmental drilling. These combination programs are less risky than pure exploratory drilling and also offer better potential returns than pure developmental.

An income program purchases and manages producing wells. This is the safest type of program because it invests in established, measurable production.

Energy programs have high depletion write-offs. Remember that depletion is the cost recovery system for wasting natural resources.

Energy programs also incur intangible drilling costs (IDCs). IDCs are expenses for consumables such as labor and equipment rental. Consequently, IDCs are immediate expenses of drilling programs and provide high early write-offs for the LPs. IDCs are more closely associated with exploratory wells because of the relatively higher upfront labor costs. If a test question describes an investor looking for high first- and second-year write-offs, a drilling program is the best answer, due to high initial IDCs.

Question 27

Equipment leasing limited partnerships

Answer 27

Equipment leasing programs are specifically designed to provide income to the investors. An example is a partnership that owns and leases planes to an airline. Airlines frequently lease, rather than own, their planes. The objective of this partnership is to generate rental income for the partners.

Equipment leasing partnerships typically use accelerated depreciation methods, which create larger expense write-offs in the early years of the partnership. While these ACRSs provide great advantages, they also increase the risk of crossover/phantom income, and possible future recapture. Another risk is equipment obsolescence, which happens when the equipment is no longer useful.