Direct Participation Programs

Unique investment opportunities that permit the economic consequences of a business to flow through to investors

Offer investors a share in income, gains, losses, deductions, and tax credits of the business entity

• Limited Partners in DPPs enjoy several advantages:
• 1)An investment managed by others
• 2)Limited Liability
• 3)Flow-through of income and certain expenses

• Disadvantages:
• 1)Lack of liquidity - secondary market for limited partnerships is extemely limited, so investors who wish to sell their interests frequently cannot locate a buyer

DPPs are generally structured as limited partnerships, or subchapter S corporations - which are not tax-paying entities like corporations, and instead only report income and losses to the IRS and then the partners (limited partnership) or shareholders (subchapter S corporation) have the responsibility to report income and losses individually and pay the taxes due

Since the DPP is not taxed first at the level of the business, double taxation is avoided

Flow-Through (or Pass-Through): all the income and losses and corresponding tax responsibilities go directly to the investors with no taation to the business entity

• 1)Tax-Reporting Entity (entity does not pay taxes)
• 2)Investors receive a share of all income and losses of the business reported on Form K-1
• 3)No Double Taxation on Distributions

*DPPs (limited partnerships) are the only investment opp that you will study that offer a pass-through of losses to the investor. Also, DPP passive losses shelter passive income, not ordinary income

• A DPP established without a profit motive or with the intention of only generating tax losses for investors may be determined abusive. Investors in abusive DPPs may be subject to:
• 1)Back Taxes
• 2)Recapture of tax credits
• 3)Interest penalties
• 4)Prosecution for fraud

• A Partnership must avoid corporate characteristics - the easiest of corporate characteristics to avoid is continuity of life. Typically partnerships have a predetermined date of dissolution when they are established.
• *Most Difficult to avoid: Centralized management, no business can function without it
• *Most likely to be avoided by a DPP: continuity of life and freely transferable interests - interests cannot be freely transferred; general partner approval is required to transfer shares

An unincorporated organization with 2 or more members is generally classified as a partnership for federal tax purposes if its members engage in a trade, business, financial operation, or venture and divide its profits

A joint undertaking merely to share expenses is not a partnership (example: co-ownership of property maintained and rented or leased is nota partnership unless the co-owners provide services to the tenants)

• 1)Organization formed under a federal or state law that refers to it as incorporated or as a corporation, body corporate, or body politic
• 2)An organization formed under a state law that refers to it as a joint-stock company or a joint-stock association
• 3)An Insurance company
• 4)Certain banks
• 5)Organization wholly owned by a state or local government
• 6)An organization specifically required to be taxed as a corporation by the Internal Revenue Code
• 7)Certain foreign organizations
• 8)A tax-exempt organization
• 9)A REIT
• 10)Organization classifed as a trust or ortherwise subject to special treatment under the Internal Revenue Code
• 11)Any other orgaization that elects to be classifed as a corporation by filing Form 8832

• 1)DPPs were formerly known as tax shelters bc investors used losses to reduce or shelter ordinary income (by writing off passive losses against ordinary income)
• 2)Tax law revisions now classify income and loss from these investments as passive income and loss. current law allows passive losses to shelter only passive income, not all ordinary income as before. many programs lost their appeal because of this critical change in tax law.
• 3)Investors should not purchase DPPs primarily for tax shelter; they should be economically viable and offer investors teh potential of cash distributions and capital gains

LPs may be sold through private placements or public offerings

• If sold Privately:
• *Investors receive a private placement memorandum for disclosure
• *Genrally involve a small group of limited partners, each contributing a large sum of money
• *These investors must be accredited investors

• If sold Publicly:
• *Sold with prospectus to a larger number of limited partners, each making a relatively small capital contribution, such as $1,000 or $5,000

Syndicator oversees the selling and promotion of the partnership and is responsible for preparation of any paperwork necessary for registration of the partnership. Synidication or "finders" fees are limited to 10% of the gross dollar amount of securities sold.

• 3 Important Documents Required:
• 1)Certificate of Limited Partnership
• 2)Partnership Agreement
• 3)Subscription Agreement

• Must be filed in the home state of the partnership and includes:
• 1)Partnerships name
• 2)Partnership business
• 3)Principal place of business
• 4)Amount of time the partnership expects to be in business
• 5)Size of each LP's current and future expected investments
• 6)Contribution return date, if set
• 7)Share of profits or other compensation of each LP
• 8)Conditions for LP assignment of ownership interest
• 9)Whether LPs may admit other LPs
• 10)Whether business can be continued by remaining general partners (GPs) at death or incapacity of a GP

*If any material info on the certicate has changed, an update must be made within 30 days of the event

Each partner receives a copy of this agreement

Describes the roles of the general and limited partners and guidelines for the partnership's operations

• Rights of the GP as defined in the partnership agreement include:
• 1)Right to charge a management fee for making business decisions for the partnership
• 2)Authority to bind the partnership into contracts
• 3)Right to determine which partners should be included in the partnership
• 4)Right to determine whether cash distributions will be made

All investors interested in becoming limited partners must complete a subscription agreement

Agreement appoints one or more GPs to act on behalf of the limited partners and is only effective when the GPs sign it

• Along with the subscribers money, the subscription agreement must include:
• 1)Investor's net worth
• 2)Investor's annual income
• 3)Statement attesting that the investor understands the risk involved
• 4)Power of attorney appointing the GP as the agent of the partnership

Generally liquidated on the date specified in the partnership agreement, but early shutdown may occur if the partnership sells or disposes of its assets or if a decision is made to dissolve the partnership by the LPs holding a majority interest

• When dissolution occurs, GP must cancel the certificate of Limited Partnership and settle accounts in the following order:
• 1)Secured Lenders
• 2)Other Creditors
• 3)Limited Partners
• *First, for their claims to shares of profits
• *Second, for their claims to a return of contributed capital
• 4)General Partners
• *First, for fees and other claims not involving profits
• *Second, for a share of profits
• *Third, for capital return

• 1)Unlimited Liability: Personal liability for all partnership business losses and debts
• 2)Managemetn Responsibility: Assumes responsibility for all aspects of the partnership's operation
• 3)Fiduciary Responsibility: Morally and legally bound to use invested capital in the best interest of the investors

• 1)Limited Liability: Can lose no more than their investment and proportionate interest in recourse notes
• 2)No Management Responsibility: Provides Capital for the business but may not participate in its managment; known as a passive investor. Attempted to take part in a management role jeopardizes limited liability status
• 3)May sue the GP: lawsuits may recover damages if teh GP does not act in the best interest of the investors or uses assets improperly

• 1)Make decisions that legally bind the partnership
• 2)Buy & Sell property for the partnership
• 3)Maintain a financial interest in the partnership (must be a minimum of 1%)
• 4)Receive compensation as specified in the partnership agreement

• 1)Vote on changes to partnership investment objectives or the admission of a new GP
• 2)Vote on sale or refinancing of partnership property
• 3)Receive cash distributions, capital gains, and tax deductions from partnership activities
• 4)Inspect books and records of the partnership
• 5)Exercise the partnership democracy (vote under special circumstances, such as permitting the GP to act contrary to the agreement, to contest a judgment against the partnership, or admit a new GP)

• 1)Compete against the partnership for person gain
• 2)Borrow from the partnership
• 3)Commingle partnership funds with person assets or assets of other partnerships
• 4)Admit new GPs or LPs or continue the partnership after the loss of a GP unless specified in the partnership agreement

• 1)Act on behalf of the partnership
• 2)Knowingly sign a certificate containing false information
• 3)Have their names appear as part of the partnership's name

• Benefits:
• 1)Capital Growth Potential - appreciation of property
• 2)Cash Flow (income) - collected from rents
• 3)Tax Deductions - mortagage interest expense & depreciation allowances for "wearing out the building" & capital improvements
• 4)Tax Credits - for govt assisted housing and historic rehabilitation

• 1)Raw Land
• 2)New Construction
• 3)Existing Property
• 4)Government-Assisted Housing
• 5)Historic Rehabilitation

Objective: Purchase undeveloped land for its appreciation potential

Advantages: Appreciation potential of property

Disadvantages: Offers no income distributions or tax deductions

Tax Features: No Income or depreciation deductions, not considered a tax shelter

Degree of Risk: Most speculative Real Estate Partnership

Objective: Build new property for potential appreciation

Advantages: Appreciation potential of the property and structure; minimal maintenance costs in the early years

Disadvantages: Potential cost overruns; no established track record; difficulty of finding permanent financing; inability to deduct current expenses during construction period

Tax Features: Depreciation and expense deductions after construction is completed and income is generated

Degree of Risk: Less risky than new land; more risky than existing property

Objective: Generate and income stream from existing structures

Advantages: Immediate cash flow, known history of income and expenses

Disadvantages: Greater maintenance or repair expenses than for new construction; expiring leases that may not be renewed; less than favorable rental arrangements

Tax Features: Deductions for mortgage interest and depreciation

Degree of Risk: Relatively low risk

Partnership Objective: Develop low-income and retirement housing

Advantages: Tax credits and rent subsidies

Disadvantages: Low appreication potential; risk of changing government programs; high maintenance costs

Tax Features: Tax credits & Losses

Degree of Risk: Relatively Low Risk

Objective: Develop historic sites for commercial use

Advantages: Tax credits for preserving historic structure

Disadvantages: Potential cost overruns; no established track record; difficulty of finding permanent financingl; inability to deduct current expenses during construction period

Tax Features: Tax credit and deductions for expenses and depreciation

Degree of Risk: Similar to risk of new construction

1)Intangible Drilling Costs (IDCs) - Write offs for the expenses of drilling are usually 100% deductible in the first year of operation (includes wages, supplies, fuel costs, and insurance) - basically any cost that once incurred, has no salvage value

2)Tangible Drilling Costs (TDCs) - Costs incurred that have a salvage value; not immediately deductible, rather they are deducted (depreciated) over several years

3)Depletion Allowances - tax deductions to compensate the partnership for the decreasing supply of oil or gas (or other resource) and may only be taken once the oil or gas is sold

Objective: Locate undiscovered reserves of oil & gas

Advantages: High rewards for discovery of new reserves

Disadvantage: Few new wells actually produce

Tax Features: High IDCs for immediate tax sheltering

Risk: High - most risky oil & gas program

Objective: Drill near existing fields to discover new reserves (step out wells)

Advantages: Less risk of discovery than exploratory

Disadvantages: Few new wells actually produce

Tax Features: Medium IDCs, immediate tax sheltering

Risk: Medium to high risk

Objective: Provide immediate income from sale of existing oil

Advantages: Immediate cash flow

Disadvantages: Oil prices; well stops producing

Tax Features: Income sheltering from depletion allowances

Risk: Low

Partnership allocates dollars between income and exploratory drilling

• Overriding Royalty Interest
• Holder of the interest receives royalties but has no partnership risk (ie. landowner that sells mineral rights to a partnership)

• Revisionary Working Interest
• The GP bears no costs of the program and receives no revenue until LPs have recovered their capital. LPs bear all deductible and non deductible costs

• Net Operating Profits Interest
• GP bears non of the program's costs but is entitled to a % of net profits. The LP bears all deductible and non deductible dosts. This arrangement is only available to private placements

• Disproportionate Sharing
• The GP bears a relatively small percentage of expenses but receives a relatively large % of the revenues

• Carried Interest
• GP shares tangible drilling costs with the LPs but receives no IDCs. The LP receives the immediate deductions, whereas the GP receives write-offs from depreciation over the life of the property

• Functional Allocation
• Under this most common sharing arrangement, the LP receives the IDCs, which allow immediate deductions. The GP receives the tangible drilling costs, which are depreciated over several years. Revenues are shared.

Created when DPPs purchase equipment leased to other businesses

Investors receive income from lease payments and also a proporational share of write-offs from operating expenses, interest expense, and depreciation.

Primary objective is tax-sheltered income

Offered to govt-assisted housing programs and historic rehabilitation programs