Partnerships, in love and in business, are complicated.
And anyone who is preparing to get into the financial industry will quickly realize that a surprising amount of time is spent on the legal, practical, and structural aspects of getting a partnership right.
Partnerships have two major issues that they are built around: liability and tax consequences. Direct participation partnerships (DPPs) are a crucial part of the financial sector in America, with these projects often designed for the development of real estate, for energy projects such as oil drilling, and for leasing of equipment that directly supports both real estate development and energy projects. However, there are many other kinds of DPPs such as private equity funds, production companies for movies, and hedge funds.
DPPs have some key features: they are typically not centrally managed, they provide limited liability to limited partners (hence the name), and they exist for a fixed term—that is, they aren’t supposed to exist in perpetuity like a normal corporation.
DPPs have general and limited partners, and they exist to pass through income, gains, losses, and tax benefits to the partners. DPPs will have a general partner in addition to the limited partner, with the GP being personally liable for business losses and debts of the DPP. Additionally, they are responsible for manning the entire project and have a fiduciary responsibility to act in the best interest of investors, the limited partners. LPs, on the other hand, can lose only what they’ve put into the partnership.
LPs not only get income from the partnership but also get tax advantages from the project, as some expenses in some partnerships will pass through to the LPs, while depreciation and depletion will reduce taxable income produced by the DPP. Some costs, known as intangible expenses, are things like costs for employees, fuel, repairs, transportation—these are the opposite of tangible costs, of which depreciation is the most common form. For the IRS, intangible costs related to drilling for oil/gas is fully deductible in the year realized, while tangible costs are deductible over several years.
These limited partnerships can be resold—however, that is not terribly common, and DPPs are typically an illiquid form of investment. That also means they’re not suitable for the vast majority of investors, but the tax advantages and the exposure to uncorrelated assets (the value of a DPP won’t necessarily be tied to interest rates, the stock market, or other things that influence other kinds of assets) typically make them compelling for very wealthy investors.
The tax benefits of DPPs are complicated and come with their own risks. DPPs provide passive income and passive losses for tax purposes, which means that the losses from a DPP can only be written against passive income from other DPP investments. On the flip side, though, DPPs also provide capital growth potential beyond the passive income stream if the assets in the DPP appreciate. Imagine for instance a DPP that develop apartments in the center of a small city that, in fifty years, becomes a big city. Los Angeles, for instance, was built on many DPPs that created a lot of generational wealth.
There are other less formal kinds of partnerships such as an unincorporated association (or voluntary association), when two or more individuals form an organization for a specific purpose. These run the risk of being taxed at a corporate tax rate if they look too much like a corporation, however, which is one reason why these aren’t something you will see very often.
Like issues discussed in the last couple of weeks, DPPs are a hot topic for SIE/Series 7 exams and for the financial industry as a whole, because establishing liability and tax burdens is a crucial first step in making sure a relationship like a business partnership will work to everyone’s satisfaction. Like in personal relationships, communicating is absolutely key, which is why bankers need to know DPPs deeply and be able to explain them to their clients.