Direct Participation Programs (DPPs) — Limited Partnerships; Certificate Of Limited Partnership

Most direct participation programs are based on a business entity called a limited partnership, which is formed for a specific business venture for a predetermined length of time. They are long-term, illiquid investments, and have significant tax advantages. There are many different businesses that are suitable as DPPs, and generally do not correlate with stocks and bonds; thus, they are a good way to diversify a portfolio. Most DPPs have terms of 5 years or longer. In the earlier years, most DPPs generate tax losses which the limited partners can use to offset other income, with most of the profits coming in later years, until the final termination of the partnership, which, if successful, will generate long-term capital gains, which are taxed at a lower rate than ordinary income.

A limited partnership is a partnership which consists of a general partner, who contributes the management and expertise in running the business, and limited partners who contribute only money—they are not involved in the day-to-day operation of the business. By satisfying certain tax requirements, a limited partnership also enjoys certain tax advantages.

The general partner is the person who actually sets up and manages the business, and assumes all liabilities of the business. The IRS requires that the general partner have at least a 1% financial investment in the partnership, but, in most cases, the general partner does not contribute a significant amount of money. The general partner is remunerated by assessed fees and a percentage of the profit. Upon liquidation, the general partner frequently gets 50% or 60% of the profits, with the limited partners getting the rest as a capital gain.

The limited partners invest only their money by buying limited partnership units, and their liability is limited to what they invest. Limited partners receive income, tax deductions, and capital gains directly from the business. In fact, limited partnerships are called direct participation programs (DPPs) because the limited partners participate directly in the profits and losses of the business. Although the limited partners are not involved in running the business, they do have the right to vote on important issues.

The limited partnership is created by contract—the Agreement of Limited Partnership—between the general partner and the limited partners, which delineates the rights and duties of all partners. This contract stipulates that the limited partners have the right:

The agreement also restricts the resale of limited partnerships. Any new partners must satisfy the requirements of the Agreement of Limited Partnership, and the general partner usually has the right to accept or reject any new partners. In any case, limited partnerships are illiquid investments because they are not listed on any exchange, and because it would be difficult to value the partnership.

The Certificate of Limited Partnership is a document that must be filed with the state, and includes the name of the business, business purpose, its proposed lifespan, the name of the general partner, the names and capital contributions from the limited partners, and how the partnership will be terminated.

In certain cases, the Certificate of Limited Partnership must be amended, and any action that requires an amendment of the certificate also requires a majority vote of approval from the limited partners. Some of these actions include changing the name of the business; changing either general or limited partners, changing the business purpose; a change to the stipulated lifetime of the partnership; or changing any event that would cause a termination of the partnership.

Because the Agreement of Limited Partnership is considered to be an investment contract, the SEC considers the limited partnership units to be securities. If the partnership is sold to the public, then they must be registered under the Securities Act of 1933. However, most partnerships are sold as private placements under Regulation D of the Securities Act.

The main tax advantage of limited partnerships is that they are flow-through instruments—all profits and losses flow directly to the limited partners. The business itself pays no tax on its business income. However, the income is considered to be passive income and losses are can only be used to offset other passive income until the investor’s interest in the partnership is terminated; then losses can offset any kind of income.

Prior to the Taxpayer Relief Act of 1986, DPPs were true tax shelters, which allowed wealthy people to write off losses that were larger than their investment, especially in the early years of the DPP. Nowadays, they still have tax advantages, but the write-offs have been limited. To obtain the tax benefits, the structure and operation of DPPs is partly governed by tax rules.

The types of businesses that benefit from the structure of a limited partnership include:

Information is provided 'as is' and solely for education, not for trading purposes or professional advice.