Direct participation programs (DPPs) are investments in businesses that let you participate directly in the business’s profits and losses. A DPP can be tied to many kinds of ventures, from a grocery store to an oil drilling operation. Like any investment, you make money if the venture is profitable.
What makes a DPP different is its business structure. Unlike a typical stock investment, where shareholders have limited involvement in the issuer’s finances, DPP investors share in the issuer’s financial results. The defining feature of a DPP is its ability to pass through losses to its owners.
Passing through losses may sound undesirable at first, but in a DPP, those losses can create a tax benefit. When a DPP “passes through” (or “flows through”) losses to investors, it can provide a tax deduction. In general, the more tax-reportable losses an investor has, the less tax they may owe.
When a DPP spends substantial amounts of money or experiences a business loss, it can allocate that loss to investors, who may be able to claim it as a deduction. By contrast, typical investments like a mutual fund can pass through income and gains, but not losses. DPPs can pass through income, gains, and losses (as tax deductions) to investors.
In a future chapter, you’ll learn about several different forms of DPPs, including general partnerships, limited liability companies (LLCs), and S corporations. This chapter focuses on limited partnerships.
Limited partnerships are a common type of DPP. This business entity includes one or more general partners and one or more limited partners.
You can think of general partners as the managers and limited partners as the investors. When you invest in a limited partnership, you typically do so as a limited partner.
The word limited refers to the investor’s liability. As a limited partner, your risk is limited to the amount you invest. For example, if you contribute $100,000, your maximum potential loss is $100,000.
General partners, as the managers of the venture, assume unlimited liability. That means a general partner’s personal assets may be at risk in legal proceedings.
In general, limited partnership investments involve significant liquidity risk. Typically, there’s no active secondary market for limited partnership units, so selling (liquidating) the investment can be difficult. Because of this, DPPs generally aren’t appropriate for investors who need quick access to their funds.
To form a limited partnership, the partnership must file documents with the state where it will primarily operate. These filings typically include the business name, address, and information about the general and limited partners. After the filing is accepted, the state issues a certificate of limited partnership. Once the partnership has this certificate, it’s legally formed.
Each state has its own requirements for forming limited partnerships. For a real-world example of what a state may require, here are the protocols from the state of Colorado (my home state).
The general and limited partners must also put their arrangement in writing. This document is the agreement of limited partnership. It describes the rights, duties, and restrictions of each type of partner, and it explains how revenues and losses will be allocated. If you’d like to see an example, here’s a boilerplate agreement of limited partnership provided by a law firm in California.
It’s important to understand how the roles differ:
Unlike traditional equity and debt offerings, investors usually must complete additional steps to become limited partners. A subscription agreement (essentially an application to invest) is used to evaluate the investor’s suitability for the partnership. General partners often prefer investors who are financially able to commit capital without needing liquidity.
In addition to suitability, the subscription agreement typically requires the investor to acknowledge the risks involved. Registered representatives (like you) often help clients understand the investment well enough to evaluate it. If a registered representative recommends a limited partnership, they should perform a thorough suitability determination. This typically includes gathering the client’s investment objectives, risk tolerance, tax status, net worth, annual income, personal liabilities, and investment goals. Some subscription agreements also require the registered representative to certify that the client understands the relevant facts and is suitable for the investment.
To reach potential investors, limited partnerships often use investment banking services. If offered privately, limited partnerships are commonly sold through Regulation D private placements, where unlimited numbers of accredited investors can participate. Limited partnerships can also be sold through public offerings. In that case, registration with the SEC and/or the state administrator is required (depending on whether the offering is intrastate or interstate), and a prospectus must be provided to investors.
A defining characteristic of limited partnerships is their limited lifespan. Unlike corporations, which can exist in perpetuity, limited partnerships are dissolved at some point. Dissolution may be voluntary or required (often due to bankruptcy). When a limited partnership is liquidated, debts are paid, remaining assets are sold, and cash is distributed in this order:
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