Direct participation programs

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 (a.k.a. “flow 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 effectively the issuer, as they set up and actually run and manage 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.

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.

There are two specific types of limited partnership programs that you’ll need to be aware of: real estate limited partnerships (RELPs) and oil and gas programs. RELPs are similar to REITs, but with a different business structure. Oil and gas programs are business ventures that focus on drilling for natural resources.

RELPs are limited partnership investments that aim to make market returns based on their real estate holdings. There are many ways RELPs accomplish this task. Some RELPs invest in real estate for capital appreciation, which occurs when property values rise. Others collect income from mortgages or tenants paying rent.

RELPs also pursue unique tax credits and deductions. Tax credits can be achieved when supporting government-subsidized projects like low-income housing or rehabilitation of historic properties. Tax deductions are achieved through mortgage interest payments and the depreciation of properties.

Investors often weigh the pros and cons of RELPs vs. REITs. Both invest in real estate projects but are structured differently. RELPs are limited partnerships that come with liquidity concerns and the added benefit of passing through losses. REITs are trust units that generally avoid liquidity risk (except for non-listed and private REITs), but do not allow losses to be passed through (only income and gains).

Oil and gas limited partnerships come in various forms with different benefits and risks. Regardless of form, many oil and gas programs seek the same goals. Intangible drilling costs (IDCs) are tax-deductible expenses that are not associated with actual drilling. These costs include fuel, relocation costs of the drilling equipment, and employee wages related to discovering oil. Many of these costs relate to moving drilling equipment while trying to find natural resources. In the first year of operation, limited partnerships can fully write off these costs and pass them through to the limited partners (passing through losses).

Depletion allowances also provide a tax benefit. The IRS provides tax deductions for every barrel of oil pulled from the ground, which are used to counter losses of income when an oil well begins to run dry.

There are three general types of oil and gas limited partnerships. We’ll discuss income wells, developmental wells, and exploratory wells. Each comes with unique risks and benefits.

Income wells, also known as stripper wells, are investments in proven oil wells. If the general partner purchased an oil well that has been producing, there isn’t much risk involved. While the oil well may be inching closer to being exhausted, it’s a less risky venture than drilling for oil in unproven areas and not finding it. Because the landowner knows there is oil in the ground, the mineral rights (fees charged by the owner of the land) are fairly high. These costs can be offset by the value of the oil pulled out of the ground. Income wells are generally low risk, and have the potential for low returns, with little-to-no IDCs. As the well already exists, there is no need to spend money on IDCs.

Developmental wells, also known as step-out wells, invest in drilling projects that are near proven oil wells. For example, if oil is found in a remote area in Wyoming, the general partner may pay for oil drilling rights a mile or two down the road in hopes that oil can be found near the proven well. IDCs need to be spent, but they are fairly low as the general partner is staying close to a proven well. Mineral rights (fees charged by the owner of the land) are less than income wells as oil hasn’t been proven in the drilling area. Developmental wells are intermediate risk, have the potential for mid-level returns, and some IDCs.

Exploratory wells, also known as wildcat wells, invest in drilling projects in unproven areas (sometimes in the middle of nowhere). This type of well is known for drilling in unproven areas in hopes of striking oil. IDCs are high as equipment typically needs to be moved multiple times in attempting to find oil. Mineral rights (fees charged by the owner of the land) are low as oil has never been found in the drilling area. In most cases, oil isn’t found, but exploratory wells are very profitable if they do. Wildcat wells are high risk, have the potential for high returns, and can have significant IDCs.

In conclusion, DPPs provide a different way of investing in a business. Investors are more closely aligned with their DPP investments, especially from a tax perspective. With the tax benefits and low liquidity of these securities, they are only suitable for wealthy individuals seeking tax benefits that can withstand the inability of selling their investments for long periods of time.