The basics

Direct participation programs (DPPs) are investments in businesses that let you participate directly in the profits and losses of the business. A DPP can be tied to many types of ventures, from a grocery store to an oil drilling operation. Like any investment, you make money if the business is profitable.

What makes a DPP different is its business structure and how it connects investors to the issuer’s financial results. With a typical stock investment, stockholders have limited ownership and don’t share directly in the issuer’s tax-reportable results. In a DPP, investors share in the issuer’s financial outcomes. The defining feature of a DPP is its ability to pass-through losses to its owners.

At first, passing through losses sounds undesirable. Why would you want a loss? In a DPP, a passed-through loss can create a tax deduction. In general, the more tax-reportable losses an investor has, the lower their taxable income may be, which can reduce taxes owed. When a DPP has significant expenses or a business loss, it can pass that loss through to investors, and investors may be able to claim it as a deduction.

Most traditional investments, such as mutual funds, can pass through income and gains to investors. DPPs can pass through income, gains, and losses (as tax deductions). Even though this can be tax-beneficial, DPPs aren’t appropriate for every investor. To see why, it helps to understand how DPPs are structured.

Limited partnerships are a common type of DPP. A limited partnership includes one or more general partners and one or more limited partners. General partners run and manage the business. Limited partners are the investors; they don’t manage the business, but they have rights similar to stockholders. When you invest in this type of DPP, you take the role of a limited partner.

The word “limited” refers to the investor’s liability. As a limited partner, your risk is generally limited to the amount you invest. For example, if a limited partner contributes $100,000, their maximum potential loss is typically $100,000. General partners, as the managers of the venture, assume unlimited liability. That can be a significant risk because a general partner’s personal assets may be exposed in legal proceedings.

While a limited partner’s losses are generally limited to their contributions, limited partnerships may still impose additional financial obligations. It’s not uncommon for limited partnerships to institute capital calls, which are requests for limited partners to contribute additional funds. This can happen due to business losses or because the partnership wants to pursue new opportunities. Limited partners may also be asked to sign recourse notes, which are loans made to the partnership that the limited partner is personally liable for. As a result, limited partners can still face substantial risk even though their liability is described as “limited.”

In general, limited partnership investments come with a considerable amount of liquidity risk. Typically, there is no secondary market for limited partnership units, so selling them can be difficult. Investors shouldn’t consider investing in DPPs if they need quick access to their funds.