Direct Participation Programs - General Characteristics
Now that you understand how REITs pool capital for real estate, let's look at a broader category of flow-through investments: Direct Participation Programs (DPPs).
What Is a DPP?
A Direct Participation Program (DPP) is any program that provides for flow-through of tax consequences regardless of the legal entity structure.
- DPPs pass income, gains, losses, deductions, and tax credits directly to investors without entity-level taxation
- Primary appeal: combination of potential income, capital appreciation, and tax benefits (depreciation, depletion, deductions)
- Unlike REITs, DPPs are typically illiquid with no secondary market
Think of it this way: In a regular corporation, the company pays tax on profits, and then shareholders pay tax again on dividends. A DPP skips the company-level tax entirely. Profits and losses "flow through" straight to each investor's personal tax return, as if they earned or lost that money themselves.
DPP Structures
| Structure | Characteristics |
|---|---|
| Limited partnership (LP) | Most common DPP structure; has general partner(s) and limited partner(s) |
| Limited liability company (LLC) | Members have limited liability; managed by members or designated managers |
| S corporation | Corporation with tax pass-through election from the IRS; limited to 100 shareholders |
The limited partnership is the structure you'll encounter most on the exam.
Limited Partnership Roles and Duties
The limited partnership has two distinct roles with very different rights and responsibilities:
| Feature | General Partner (GP) | Limited Partner (LP) |
|---|---|---|
| Management | Manages day-to-day operations; makes all business decisions | No involvement in management; passive investor |
| Liability | Unlimited personal liability for all partnership debts and obligations | Liability limited to amount invested (plus any recourse notes signed) |
| Fiduciary duty | Owes fiduciary duty to limited partners | No fiduciary duty to partnership |
| Non-compete | Cannot compete with the partnership | May invest in competing businesses |
| Voting | Controls operations without LP approval (except fundamental changes) | May vote on fundamental matters only (admission of new GP, dissolution, sale of all assets) |
| Tax reporting | Files partnership return (Form 1065); issues Schedule K-1 to each partner | Reports share of income/loss on personal tax return via Schedule K-1 |
Key LP Rules
- A limited partner who participates in management risks losing limited liability protection
- The certificate of limited partnership must be filed with the state to legally form the LP
- The partnership agreement (also called the agreement of limited partnership) governs rights, duties, profit/loss sharing, and distributions
Exam Tip: Gotchas
A limited partner's maximum loss is the amount invested plus any recourse debt for which the LP is personally liable. If a limited partner contributes $50,000 cash and signs a $20,000 recourse note, their total at-risk amount is $70,000, not $50,000. The exam loves scenarios where a recourse note increases loss exposure beyond the cash contribution.
General Partner Responsibilities
The general partner (GP) carries the heaviest obligations in the partnership:
- Unlimited liability: Personal assets are at risk if partnership debts exceed partnership assets
- Fiduciary duty: Must act in the best interest of the limited partners
- Cannot compete: Prohibited from running a business that competes with the partnership
- Full management authority: Does not need limited partner (LP) approval for routine business decisions
- Tax compliance: Files Form 1065 (informational partnership return) and issues Schedule K-1 to each partner
Exam Tip: Gotchas
- The partnership itself pays no income tax. Form 1065 is purely informational. Each partner reports their share of income or loss on their own personal return via Schedule K-1.
- A GP's unlimited liability means creditors can pursue the GP's personal assets (home, savings) if the partnership cannot pay its debts.
What Limited Partners CAN and CANNOT Do
Limited partners (LPs) CAN:
- Vote on fundamental matters (new general partner (GP), dissolution, sale of substantially all assets)
- Inspect partnership books and records
- Invest in competing businesses
- Sue the general partner for breach of fiduciary duty
Limited partners CANNOT:
- Participate in day-to-day management (risk losing limited liability)
- Bind the partnership in transactions
- Act as an agent of the partnership
Exam Tip: Gotchas
- An LP who binds the partnership or acts as its agent may be treated as a general partner, taking on unlimited personal liability.
- The GP's non-compete obligation applies only to the partnership's line of business. LPs face no such restriction.