6.2 Other investment types: Partnerships

Partnerships

Partnerships

• A business that is owned by two or more people as an unincorporated association

• a type of business organization in which the partners manage the business and pay taxes on the business' profits (if any)

Partnerships are tax-reporting entities but not

tax-paying entities

• The partnership reports profits and how much went to which partner to the IRS.

• The partners reflect the income on their tax returns and pay income taxes on the amount they receive.

two types of business partnerships:

1. General partnership

2. Limited partnership

interest in a Limited Partnership is a type of security

true

general partnerships:

• All the partners are general partners (GPs).

• All the partners have some level of management authority

• Ownership may be unequal.

  • Ownership interests may be found in the partnership agreement.

  • The business results (profits or losses) are distributed in proportion to the partner's ownership interest.

• General partners have no liability protection.

  • Partners may be sued personally for actions taken by the partnership.

General partners have the following responsability

Making day-to-day business decisions

Limited partnership

• A LP has one or more general partners and one or more limited partners.

• General partners manage the business and have no liability protection.

• Limited partners have no management responsibilities and are protected from the liabilities of the partnership.

• If a limited partner participates in the management of the business, they may lose their liability protection.

• Income received from the LP by limited partners is called passive income.

• The most common industries are real estate, energy (oil and gas programs), and equipment leasing.

Limited partners (LPs) have a number of rights

• to vote on business objectives

• to inspect all books and records

• if the GPs are not acting in their best interest, to sue them.

Another term for a limited partnership

direct participation program (DPP).

limited partnership vs partners

sales rules of limited partnerships.

• LPs may be sold through private placements or public offerings.

• If sold privately, investors receive a private placement memorandum for disclosure.

• Private placements involve a small group of limited partners, each contributing a large sum of money.

• In a public offering, LPs are sold by a prospectus.

• In a public offering distribution, a larger number of limited partners each making a relatively small capital contribution is more likely.

liquidation rules of limited partnerships.

When dissolution occurs, the GP must settle accounts in the following order:

1. Secured lenders

2. Other creditors

3. Limited partners—first for their claims to shares of profits and then for their claims to a return of contributed capital

4. GPs

points to remember about limited partnerships.

• The most common industries are real estate, energy (oil and gas programs), and equipment leasing.

• These programs often experience losses in the early part of the program.

• These losses pass through to the investors and may be used to offset sources of passive income from other programs.

• DPPs use depreciation and depletion to reduce taxable income. These deductions are not actual cash costs. They reduce taxable income without affecting cash flow.

Benefits of Limited Partnerships

• An investment managed by others (the GP)

• Limited liability (a partner can only lose the amount invested)

• Flow through of income and certain expenses

tax advantages relating to a DPP investment

• accelerated depreciation.

• depletion

• intangible drilling costs.

Intangible drilling costs

those that are associated with items that have no resale or recoverable value when the program ends.

ex: wages and insurance premiums.

Tangible or recoverable costs

are those associated with items like equipment that can be sold when the program ends.

Depletion allowances can only be associated with

programs where natural resources might be depleted such as oil, gas, or even timber.

Depreciation

is common with buildings and equipment. Raw land does not cost much to run, doesn't depreciate, nor does it deplete.

For real estate DPPs, both income and capital growth are possible.

Income comes from the property rents received, and capital growth would come from the appreciation of the properties.

facts about income and loss for LPs

• Income produced by LPs is called passive income

• losses are called passive losses

• Passive income is part of a customer's ordinary income

• Passive losses may be used to reduce a taxpayer's passive income but are not applied to ordinary income

Risks of Limited Partnerships

• Liquidity

• Audit/Recapture of Tax Benefit

What is the greatest disadvantage of limited partnerships?

Lack of liquidity

Liquidity risk

LPs are highly illiquid (meaning very hard to sell

Audit/Recapture of Tax Benefit

• If the IRS disallows a prior tax benefit, the consequences flow through to the limited partners.

• The IRS would likely impose taxes and penalties for the underreporting of income plus interest on the unpaid taxes.

• The limited partners would have to pay for the problem

n oil and gas DPP that invests in wells that are already producing is known as

income program.

Exploratory programs are

drilling new wells in search of new deposits.