Direct participation programs (DPPs) are investments in businesses that let you participate directly in the business’s profits and losses. A DPP could be tied to almost any type of venture, 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 exposure to the company’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 it often creates a tax benefit. When a DPP reports losses, those losses can be passed through to investors as tax deductions. In other words, more tax-reportable losses can reduce an investor’s taxable income and, therefore, their taxes.
When a DPP spends substantial amounts of money or experiences a business loss, it can pass that loss through to investors. Typical investments, like a mutual fund, can generally 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. We’ll specifically focus on limited partnerships (another type of DPP) in this chapter.
Limited partnerships are a common type of DPP. This business entity includes one or more general partners and one or more limited partners.
A helpful way to think about it is that general partners act as the managers, while limited partners are the investors. When you invest in this type of DPP, you take the role of the 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 a limited partner contributes $100,000, their 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 can be at risk in legal proceedings.
In general, limited partnership investments involve significant liquidity risk. Typically, there’s no secondary market for limited partnership units, so selling (liquidating) the investment can be difficult. Investors generally shouldn’t consider DPPs if they need quick access to their funds.
To form a limited partnership, paperwork must be filed with the state where the partnership will primarily operate. This filing typically includes the business name, address, and information about the partners (general and limited). After the filing is accepted, the state issues a certificate of limited partnership. Once the partnership has this certificate, it’s recognized as a legitimate business entity.
Each state has unique requirements and protocols for establishing limited partnerships. For a real-world look into the information requested by a state to legally form a limited partnership, here are the protocols from the state of Colorado (my home state).
The relationship between the general and limited partners must also be documented in writing. This written contract is the agreement of limited partnership. It describes the rights, duties, and restrictions for each type of partner, and it explains how revenues and losses will be allocated. If you’re interested, here’s a boilerplate version of an agreement of limited partnership provided by a law firm in California.
It’s also 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 wealthy and not concerned with liquidity, since that can provide substantial capital without pressure for quick payouts.
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 complete a thorough suitability determination by gathering information such as the client’s:
Some subscription agreements also require registered representatives to certify that the client understands the relevant facts and is suitable for the investment.
To solicit interest from potential investors, limited partnerships often use investment banking services. If offered privately, limited partnerships are typically 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 must occur (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 always dissolved at some point. Dissolution may be voluntary or required (often due to bankruptcy). When a limited partnership is dissolved, it’s liquidated in a standard order: debts are paid, remaining assets are sold, and cash is distributed in this priority:
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