Limited Partnerships (DPPs)

A C-corporation is taxed as a business entity, with the owners then getting taxed on any dividend income they distribute to themselves from the business's profits. C-corporations, in other words, lead to the double taxation of dividends for the owners.
On the other hand, in a direct participation program (DPP) the owners of the business take a share of the business entity's net income or net loss on their own personal income taxes. The partnership itself is not taxed. Rather, the partners are taxed on their share of the net income or net loss that flows through the business directly to them. Partnerships like LLCs and S-corporations are associated with flow through of net income/net loss to the owners.
Types of Programs
There are partnerships organized to perform all kinds of business, from movie making to sports teams, from construction projects to law firms. Broker-dealers often raise capital for their investment banking customers looking to form natural resource or real estate ventures through DPP offerings.
Oil & gas programs could involve exploring for natural resources, developing proven reserves, or buying an income/production program. Exploratory programs for oil and gas are the riskiest programs with the highest return potential as well. The act of exploring for oil is sometimes called "wildcatting," which provides a hint of the risk/reward nature.
Exploration generates intangible drilling costs or IDCs. As opposed to capitalized costs sunk into the oil rig and other equipment, intangible drilling costs are the costs/expenses that leave nothing to be recovered. IDCs include labor costs and the expense of the geological survey indicating there is or should be oil or natural gas down below The IDCs in these programs are so high in the first few years that this type of program typically provides the most tax shelter to the investor, especially in the early years. Beyond IDCs, drilling programs take depreciation expenses on any equipment owned, which also may provide tax shelter to the LPs.
Sometimes DPPs drill for oil or gas in an area where these natural resources are already being extracted, with engineering studies confirming the existence of oil or natural gas below the ground. Such programs are called developmental programs. They're less risky than exploratory programs, but with a lower return potential. Some call these "step-out" programs, as if someone is starting at the existing well and stepping out so many paces before constructing another one. These programs also provide tax shelter through the intangible drilling costs we just looked at. And, there is depreciation on the expensive equipment if the partnership owns that equipment as opposed to leasing it.
The safest natural resources programs buy existing production and are called income programs. These investments provide immediate cash flow and are, there¬fore, the safest programs with the lowest potential reward. The main tax advantage offered from these programs comes in the form of depletion. When oil or natural gas is sold, the partnership takes a charge against their revenue. If the business entity owns the drilling equipment, depreciation may also provide tax shelter to the LPs.
In real estate, which is riskier, buying raw land or buying an apartment complex al¬ready filled with renters? Raw land is purely speculative and is, therefore, the riskiest type of real estate DPE You buy parcels of land betting an airport or industrial park will be built in the next few years. If you're right, the land appreciates in value. If not, it doesn't. And, you receive no income or tax benefits on raw land as you sit waiting for its value to go up. There is nothing to deplete, and land does not depreciate the way apartment buildings and oil rigs do.
New construction programs are aggressive programs, but once the projects are completed the townhouses or condominiums can be sold for capital gains. So, they're safer than raw land and probably provide a lower reward potential. They also involve more costs, of course, as someone has to finance all that construction. For a construction program lasting several years, the LPs are likely to receive a share of net loss at the beginning, as the partnership sinks capital into building a townhouse community on the front end, hoping to sell enough units on the back end to turn a profit.
Existing properties DPPs are similar to income programs for oil. Here, the busi¬ness is already up and running, with immediate cash flow Investors can examine the financial statements and know what they're getting into, as opposed to an investment in raw land. Therefore, existing property DPPs offer lower risk and lower reward to investors. The tax shelter comes through depreciation of the buildings themselves as well as any maintenance equipment owned by the partnership.
Another common type of limited partnership is the equipment leasing program. These partnerships typically lease equipment that other companies do not want to own. For example, computers, transportation equipment, oil drilling and construction equipment, etc., might not be cost-effective for the users to own; therefore, it makes more sense to lease such equipment from an equipment leasing program. Tax benefits for equipment leasing would come largely through depreciation of the equipment.
Surprisingly, there is no requirement a "DPP" must be formed as a limited partnership. Here is how FINRA defines the term "direct participation program":
a program which provides fir flow-through tax consequences regardless of the structure of the legal entity or vehicle for distribution programs, agricultural programs, cattle programs, condominium securities, Subchapter S corporate offerings and all other programs of a similar nature, regardless of the industry represented by the program, or any combination thereof
GPs and LPs
The owners who provide most of the capital to the business are the limited partners (LPs). They are called "limited partners" because their liability is limited to their investment. If they invest $100,000, then $100,000 is all they can lose as pas¬sive investors in the partnership. Creditors can't come after the LPs for their personal assets if the business goes bankrupt. Lawsuits of all types could be filed against the partnership, but, again, the LPs would not have their personal assets at risk in such cases.
To maintain their limited liability status the limited partners need to stay out of day- to-day management of the business. Day-to-day management is left solely to the general partner (GP). As manager, the GP can also be compensated for these managerial efforts through a salary. While the LPs provide most of the capital, the GP (general partner) must have at least a 10/0 financial interest in the partnership as well. The GP is granted the authority to acquire and sell property on behalf of the business and sign any documents on behalf of the business required to carry out Its management. The GP must keep accurate books and records and must provide annual financial statements to the LPs. Typically, the GP can also admit new limited partners at his discretion.
Unlike an LP, the general partner has unlimited liability. That is why the GP is often a corporation, providing the individual controlling the business protection for his or her personal assets. The general partner is also a fiduciary to the limited partners. That means the GP must maintain a duty of loyalty and good faith to the investors trusting him to manage the business using their invested capital.
The GP's fiduciary responsibility to the limited partners means he must put the inter¬ests of the partnership ahead of his own interests or the interests of other businesses in which he is involved. The GP can't compete with the partnership through some other business venture and, therefore, can't charge some bogus "no compete" payment since they can't compete in the first place. When the GP sells a building, piece of equipment, or the business itself, he/they must refrain from receiving economic gain at the expense of the limited partners. As with an investment adviser, if there are any conflicts of interest involved, these must be fully disclosed to the LPs.
On the other hand, the LPs have no such duty to refrain from owning businesses that compete with the partnership.
The GP could provide a loan to the business, but as a fiduciary to the LPs, he would have to disclose any conflicts of interest he might have. For example, if he's lending money to the partnership through a savings & loan institution that he controls or owns shares in, this potential conflict of interest that could end up clouding his judgment must be disclosed. On the one hand, he wants to help the business. On the other hand, he likes to help his own lending institution. That is an example of a conflict of interest an honest GP will consider and disclose to the LPs rather than waiting for them to sue for breach of fiduciary duty.
Limited partners stay out of day-to-day management decisions, but because of partnership democracy they do get to vote on major issues like suing the GP or dissolving the partnership.
Why would they sue the GP?
Maybe the oil & gas program turns out to be a scam in which the sponsor is using partners' money to fund other businesses or a high-rolling lifestyle.
If the exam asks if LPs can make loans to the partnership, the answer is yes. In other words, some of the capital LPs provide to the partnership can be through debt securities paying a reasonable rate of interest. If you're in business for yourself, you may have fronted some cash to your business and then had the business pay you a rate of interest on the "promissory note." Same idea here. Some partnerships might have investors providing capital in exchange for debt securities that later to convert to equity in the business. There are many ways to structure the financing of a DPP.
Documents
The General Partner is responsible for filing the certificate of limited partner¬ship with the state where the entity is organized. This is a public document that provides only the most basic information, including the name and address of the partnership, the name and addresses of all the general partners as well as the registered agent who would accept any "service of process" should a lawsuit arise against the business. The GP signs and files this document with the state where the business is organized.
The partnership agreement is signed by all partners and is the foundation for the partnership. In this agreement, we would find the following information:
•    business purpose of the partnership
•    effective date and term of operation (if termination date or event is stated)
•    required capital commitments now and in future for GP and LP
•    name and address of GP
•    principal place of business for the partnership
•    powers and limitations of the GP's authority
•    allocation of profits and losses
•    distributions of cash
•    transfer of interests
•    withdrawal, removal of a partner
Corporations are presumed to go on for perpetuity. A partnership is also assumed to live on indefinitely unless the partnership agreement establishes a date or triggering event for dissolution of the entity. For example, a new construction program may dissolve when the last townhouse has been sold. Or, if the GP dies, the business may dissolve according to the stipulations in the agreement.