Direct participation programs and limited partnerships are entities that allow income, expenses, gains, losses, and tax benefits to be passed through to the investors. There is generally no active secondary market for these investments, so, it’s important that investors understand the risks and can afford the risks associated with direct participation programs and limited partnerships. Series 7 candidates can expect to see several questions on this material on their exam.
A limited partnership is an entity that allows all of the economic events of the partnership to flow through to the partners. These economic events are:
- Tax credits
There are two types of partners in a limited partnership. They are the limited partners and the general partner. The limited partners:
- Put up the investment capital
- Losses are limited to their investment
- Receive the benefits from the operation
- May not exercise management over the operation
- May vote to change the objective of the partnership
- May vote to switch or remove the general partner
- May sue the general partner, if the general partner does not act in the best interest of the partnership
A limited partner may never exercise any management or control over the limited partnership. Doing so would jeopardize their limited liability status and they may be considered a general partner.
The general partner is the person or corporation that manages the business and has unlimited liability for the obligations of the partnership business. The general partner may also:
- Buy and sell property for the partnership
- Receive compensation for managing the partnership
- Enter into legally binding contracts for the partnership
- The general partner also must maintain a financial interest in the partnership of at least 1%. The general partner may not:
- Commingle funds of the general partner with the funds of the partnership
- Compete against the partnership
- Borrow from the partnership
It is important to note that there are no tax consequences at the partnership level. In order to qualify for the preferential tax treatment, a DPP or LP must avoid at least two of the
six characteristics of a corporation. These characteristics are:
- Continuity of life
- Profit motive
- Central management
- Limited liability
- Freely transferable interest
Several of the characteristics cannot be avoided, such as associates and a profit motive. The easiest two characteristics of a corporation to avoid are continuity of life and freely transferable interest. The LP can put a termination date on the partnership and substitute limited partners may not be accepted or may only be accepted once the general partner has agreed.
Structuring and Offering Limited Partnerships
The foundation of every limited partnership is the partnership agreement. All limited partners must be given a copy of the partnership agreement. The partnership agreement will spell out all of the terms and conditions, as well as the business purpose for the partnership. The powers and limitations of the general partner’s authority will be one of the main points detailed in the partnership agreement. Prior to forming a limited partnership, the general partner will have to file a certificate of limited partnership in the state in which the partnership is formed. The certificate will include:
Name and address of the partnership
- A description of the partnership’s business
- The life of the partnership
- Size of limited partner’s investments (if any)
- Conditions for assignment of interest by limited partners
- Conditions for dissolving the partnership
- Conditions for admitting new limited partners
- The projected date for the return of capital if one is set
A material change to any of these conditions must be updated on the certificate within 30 days.
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