Direct participation programs

Direct participation programs (DPPs) are investments in businesses that let you participate “directly” in the profits and losses of the business. A DPP investment could be tied to almost any type of venture, from a grocery store to an oil drilling operation. Like any investment, investors make money when the underlying 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 report the business’s losses on their own tax returns. In a DPP, investors share in the issuer’s financial results more directly. 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 (also called “flow-through”) loss can create a tax deduction for the investor. The more tax-reportable losses an investor has, the lower their taxable income may be, which can reduce taxes owed. When a DPP has substantial expenses or an operating loss, it can pass that loss through to investors, giving them a tax deduction.

Most traditional investments, such as mutual funds, can pass through income and gains to investors, but not business losses. DPPs can pass through income, gains, and losses (as tax deductions). Even with these potential tax benefits, DPPs aren’t appropriate for every investor. To see why, it helps to understand how DPPs are commonly structured.

Limited partnerships are a common type of DPP. A limited partnership includes one or more general partners and one or more limited partners. The general partners organize the partnership and run the business day to day. 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 invest as a limited partner.

The word “limited” refers to the investor’s liability. A limited partner’s risk is generally limited to the amount invested. For example, if a limited partner contributes $100,000, the 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 active secondary market for limited partnership units, so selling them can be difficult. If you need quick access to your funds, a DPP is usually not a good fit.

Two limited partnership programs you’ll want to recognize are real estate limited partnerships (RELPs) and oil and gas programs. RELPs resemble REITs in that both invest in real estate, but they use different business structures. Oil and gas programs focus on drilling and producing natural resources.

RELPs are limited partnership investments that seek returns from real estate holdings. They may pursue:

• Capital appreciation, when property values rise
• Income, such as mortgage interest or rent from tenants

RELPs may also offer specific tax benefits through tax credits and deductions. Tax credits may be available when the partnership supports government-subsidized projects such as low-income housing or rehabilitation of historic properties. Tax deductions may result from mortgage interest and depreciation of properties.

Investors often compare RELPs and REITs. Both invest in real estate, but the structure affects liquidity and taxes:

• RELPs are limited partnerships, often illiquid, and may pass through losses.
• REITs are trust units that generally have less liquidity risk (except for non-listed and private REITs), but they don’t pass through losses - only income and gains.

Oil and gas limited partnerships also come in different forms, each with its own risk/return profile. Many oil and gas programs pursue tax benefits through two key concepts.

Intangible drilling costs (IDCs) are tax-deductible expenses that aren’t tied to the physical drilling equipment itself. Examples include fuel, relocation costs for drilling equipment, and wages related to locating oil. Many of these costs arise while moving equipment and searching for natural resources. In the first year of operation, limited partnerships can fully write off these costs and pass them through to limited partners (as losses).

Depletion allowances provide another tax benefit. The IRS allows a tax deduction for each barrel of oil removed from the ground, intended to offset the declining production and income as a well begins to run dry.

There are three general types of oil and gas limited partnerships: income wells, developmental wells, and exploratory wells. Each has a different mix of risk, potential return, and IDCs.

Income wells, also called stripper wells, invest in proven oil wells. If the general partner buys a well that has already been producing, the risk is relatively low compared with drilling in unproven areas. Because the landowner knows oil exists, mineral rights (fees charged by the landowner) tend to be high. Those costs may be offset by the value of the oil produced. Income wells are generally low risk with the potential for low returns, and they typically have little-to-no IDCs because the well already exists.

Developmental wells, also called step-out wells, fund drilling near proven oil wells. For example, if oil is found in a remote area in Wyoming, the general partner might lease drilling rights a mile or two away, expecting the oil field may extend into nearby land. IDCs are incurred, but they’re usually lower than in exploratory drilling because the project stays close to a proven area. Mineral rights are typically lower than for income wells because oil hasn’t been proven at the new drilling site. Developmental wells are intermediate risk, with the potential for mid-level returns, and some IDCs.

Exploratory wells, also called wildcat wells, fund drilling in unproven areas. The goal is to strike oil where it hasn’t been found before. IDCs are often high because equipment may need to be moved and repositioned multiple times during the search. Mineral rights are usually low because oil hasn’t been proven in the area. In many cases, no oil is found, but if oil is discovered, the venture can be very profitable. Wildcat wells are high risk, with the potential for high returns, and can involve significant IDCs.

In summary, DPPs offer a way to invest in a business where investors share more directly in the venture’s financial results, especially for tax purposes. Because these investments can offer tax benefits but often have low liquidity, they’re generally suitable only for investors who can tolerate holding the investment for long periods and who are specifically seeking tax advantages.