The basics

Direct participation programs (DPPs) are investments in businesses that allow the investor to “directly” participate in the profits and losses of the business. A DPP investment could be connected to anything from a grocery store to an oil drilling operation. Just like any other investment, investors make money if the business venture is profitable.

What makes a DPP unique is its business structure and that it provides a way for investors to become directly connected to their investment. Unlike a normal stock investment, which provides limited ownership to their stockholders, investors in DPPs share in all of the finances of their issuer. The defining feature of a DPP is its ability to pass-through losses to its owners.

Passing through losses doesn’t sound great. Who would want a loss? When DPPs pass through losses to their investors, they’re actually providing a tax deduction. The more tax-reportable losses an investor has, the fewer taxes they pay. When a DPP spends substantial amounts of money or has a business loss, it passes through the loss to its investors, providing them with a tax deduction.

Normal investments, like a mutual fund, can only pass through income and gains to their investors. DPPs pass-through income, gains, and losses in the form of tax deductions to their investors. Although they are more tax-beneficial, DPPs are not suitable for every investor. To better understand this, we’ll need to talk through DPP structures.

Limited partnerships are a common type of DPP. A limited partnership is a business form that includes one or more general partners, plus one or more limited partners. The general partners are responsible for actually running and managing the business. Limited partners are the investors; they have no management capabilities, but have rights similar to stockholders. When investing in this type of DPP, investors take on the role of the limited partner.

The term ‘limited’ refers to liability for investors. As a limited partner, the risk is limited to their investment. If a limited partner contributes $100,000 to a partnership investment, their maximum potential loss is $100,000. General partners assume unlimited liability as the managers of the business venture. It’s a risky position; a general partner’s personal assets are fair game in legal proceedings.

While a limited partner’s losses are limited to their contributions, it’s not uncommon for limited partnerships to institute capital calls. These are requests for the limited partners to deposit more funds into the limited partnership. This could occur because of business losses or new opportunities for the business. Additionally, limited partners may be asked to sign recourse notes, which are loans made to the partnership for which the limited partnership is personally liable for. All in all, limited partners can be subject to considerable amounts of risk even with limited liability.

In general, limited partnership investments come with a considerable amount of liquidity risk. Typically, there is no secondary market that trades limited partnership units, therefore liquidating them can be difficult. Investors should not consider investing in DPPs if they need quick access to their funds.