Series 7

By Investopedia AAA

Equities - Direct Participation Programs (DPPs)

There is another class of equity ownership that does not involve exchange-traded stock at all. This is the form of ownership known generally, but imprecisely, as partnerships.

Direct participation programs (DPPs) enable investors to have an immediate claim on an enterprise's cash flow and tax benefits, typically as a passive investment.

  • The most well-known form of DPP is the limited partnership.
  • "Limited" refers to liability: it means a partner cannot be held legally responsible for the company's debts.
  • The word "partnership" is a bit misleading, if you take it to mean ownership by two or more individuals.
  • State laws vary, but it is perfectly legal from Washington's vantage point for a limited partnership to be owned solely by one person. Therefore, it is more accurate to refer to such an entity as a limited liability company (LLC).

While the number of partners is not important, it is crucial that all procedures and requirements are followed when forming the LLC. The founding partner(s) must submit the following material to the state in which the entity is formed:

  • Articles of organization
  • Filing fees
  • Initial franchise taxes
  • Other initial fees which vary by state

Other LLC Details

  • The name of an LLC must not be deceptively similar to that of any existing company.
  • An LLC is owned by its members - the more correct term for partners - and members are analogous to shareholders in a corporation.
  • Current members have discretion over who may purchase membership, which is very different from the exchange-traded shares available to the general pool of investors that typify the public corporation.
  • However, members of an LLC need not exercise that discretion, and some DPP offerings have been publicly issued.
  • Members generally manage the company as well. In the special cases where the LLC hires professional management, the members more closely resemble shareholders.

Typically, LLCs and other DPPs are organized to support the following kinds of risky and capital-intensive enterprises:

  • Real estate development
  • Oil and gas exploration
  • Equipment leasing

The Three Main Benefits of LLCs:

  1. Pass-through taxation: The earnings of an LLC are taxed only once, as income to the members as individuals. LLCs are not subject to the tax on earnings faced by corporations.
  2. Limited liability: A member's liability is generally limited to the amount of money he or she has invested in the LLC. This is similar to the legal protection guaranteed to corporate shareholders.
  3. Flexible management structure and ownership: LLCs can establish any organizational structure agreed on by their members. An LLC's managing partner is free to spread profits to equity holders in proportion to the investments they made in the enterprise while concentrating voting rights to those partners most closely connected to the business.

Drawbacks of LLCs:
LLCs also have drawbacks which offset these benefits.

  1. First, they often require more paperwork than corporations.
  2. Second, their organizational structure is not as familiar to the public - that is, the pool of potential investors - as the structure of the traditional, publicly traded corporation.
  3. Furthermore, some states require that a dissolution date be listed in the articles of organization for an LLC, and such events as the death or disassociation of a member can automatically trigger dissolution. A corporation, on the other hand, has the legal status of a perpetually living entity.

DPPs and Corporate Taxes
Finally, here are some points to keep in mind regarding corporate taxes.

  • The main purpose of structuring an enterprise as a DPP rather than as a corporation is to tax revenue at the individual investor level and not at the corporate level.
  • The reason for this is that most publicly held corporations are double-taxed.
  • In other words, the income of a corporation is taxed when it is realized as income before taxes, and the income after taxes is taxed again when it lands in the hands of the shareholders as dividends.

RR Responsibility
As with any investment you might recommend as a registered representative, it is your responsibility to ensure that your client clearly understands the benefits and risks of a DPP and that these are appropriate for the client's financial goals.

Criteria to consider include:

  • The economic soundness of the DPP and the expertise of the general partner, whose ongoing participation is generally the foundation of the entire enterprise.
  • The enterprise's basic objectives, start-up costs, certainty of revenue and upside potential are other considerations.
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