Series 22 Exam Lesson 5 Kinds of Limited Partnerships

Lesson 5 Kinds of Limited Partnerships:

People are allowed to create a limited partnership in order to attempt anything that is legally allowed. Most limited partnerships fall into one of three categories: investing in real estate of some kind, investing in fossil fuel production, or engaging in equipment leasing.

If a limited partnership is investing in real estate, they have many different options for this as well, such as investing in existing property, new construction, unimproved land, government-assisted housing, or in restoring historic sites.

Buying up existing property offers low risk and can provide you with a steady cash flow, but you need to be willing to maintain the properties. You can also write off mortgage interest and depreciation on your taxes.

Investing in building new properties has a much higher risk, but can also bring you much higher rewards. It does not come with that guaranteed, sustained cash flow like existing property. You do not have a guarantee that what you build will sell, and if it does not, you can be out your investment.

Building up raw land has the highest risk of any real estate investment.

There are different kinds of fossil fuel programs, such as income programs (buying existing wells), developmental programs (drilling near established reserves), and exploratory drilling programs (drilling to find new materials).

They provide tax advantages, because you can deduct intangible drilling costs (IDC) in the year that they happen. These costs can include geological surveys, wages, supplies, insurance, well casings, etc.

You can also deduct some expenses as a depletion allowance. (Not depreciation). Income programs provide immediate income and less risk, but they can be subject to depletion or changing prices. Developmental and exploratory programs are more risky, but can potentially have large payouts. For example, if you discover a new reserve, the profits can be huge over time.

When an oil or gas partnership has been formed, both the limited partners and the general partner will share in the income and the tax benefits enjoyed by the partnership. There are different ways that profits can be shared:

Functional allocation: (most often used) The limited partners receive the deductions for IDC and general partners get any property write-offs. The total revenue is shared between both kinds of partners.

Reversionary working interest: The limited partners accept all of the costs of running the partnership. The general partner does not get anything until the limited partners recoup their initial investment.

Disproportionate working interest: The general partner takes a large share of the revenue, but only has to pay a small portion of the operating expenses.

Net operating profits: The limited partners take on all of the expenses of the operation. The general partner does not have to pay any of the expenses, but gets a percentage of the net profits. This only works with limited partnerships created with private placements.

Carried interest: The limited partners get the IDC write-offs. The general partner shares in the other drilling costs and gets property depreciation write-offs.

Overriding royalty interest: If a person has this, they do not bear any of the partnership risks, but they do get a royalty from the partnership.

For equipment leasing partnerships, the partnership buys up various pieces of equipment in hopes of leasing it at a profit to various corporations. These partnerships also get tax benefits from operating expenses, the depreciation of their equipment, and the interest that is paid by those who lease the equipment.

DPPs are either limited partnerships or as a subchapter S corporation, which allows for the flow through of income and losses. The DPP reports the results to the IRS, and the partners or shareholders are responsible for taxes. DPPs cannot be created only to reap the tax benefits. They have to be created to earn income. If any DPP is found to have been formed just for taxes, the investors can be penalized for fraud.

Things for Investors to Consider Before Investing
How viable the economics of the program are.
How the program affects their taxes.
The liquidity of the project.
The time horizon.
Whether or not it is a blind pool or a special program.
The internal rate of return (IRR). This will allow you to measure how DPPs rate against each other. It is equal to the discounted present value of the future projected cash flow.

A blind pool is where a partnership where less than 75% of the assets they are planning to acquire have not yet been identified. The opposite is a specified program, where 75% of more of assets have been identified.

Tax deductions lower a partnership’s taxable income.
Tax credits create dollar-for-dollar reductions in the amount of taxes due.

The crossover point is the time when a partnership begins to earn taxable income for its partners.

Partnerships can take out two kinds of loans: non recourse loans and recourse loans. A non-recourse loan, if the partnership defaults on the the loan, the lender cannot go to the limited partners. With a recourse loan, in the case of a default, the lender can go after the limited partners.

A partnership ends on the termination date in the partner agreement, unless it is terminated earlier. This can only happen if a majority of the limited partners vote for this course of action. If this happens, the general partner has to cancel the certificate of limited partnership and liquidate the assets of the partnership. First, the secured lenders get paid, then the general creditors, then the limited partners, and then the general partner.