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Chapter 27 Limited partnerships.

WHAT IS IT?

A limited partnership is a specialized form of business organization. It is an association or combination of one or more "general" partners with at least one or more "limited" partners. In many cases, there is a single general partner and a substantial number of limited partners.

In a typical limited partnership, one general partner manages and operates the business, while the limited partners contribute capital and share in the profits. The general partner's major contribution is frequently in the form of management expertise, not capital. Also, general partners are personally liable for the debts of the partnership.

Limited partners, on the other hand, have no liability beyond their contributions of capital to the partnership. Indeed, limited partners cannot participate in the management of the enterprise or they risk losing their limited-liability protection. The limited partnership form of business encourages individuals to invest without risking more than the capital they have contributed.

Since a general partner in a limited partnership has such a unique role and set of personal responsibilities, his participation in the organization and running of the business is critical. The death, disability, or withdrawal of a general partner normally dissolves the partnership, unless the partnership agreement provides otherwise, or all partners agree, in writing, to substitute a new general partner. Unlike the case with a general partner, the death or incapacity of a limited partner has no effect on the partnership.

There are a variety of different forms of limited partnerships. These include:

* Private Limited Partnerships--limited partnerships having no more than 35 limited partners, which allows them to avoid registration with the U. S. Securities and Exchange Commission.

* Master Limited Partnerships--an investment that combines the tax benefits of a limited partnership with the liquidity of publicly traded securities.

* Public Limited Partnerships--a limited partnership that is registered with the SEC and which is offered to the general public through broker/dealers.

* Venture Capital Limited Partnerships--limited partnerships that are formed to invest in small startup businesses.

In the case of larger enterprises, a corporation may be formed to serve as the general partner. This has the advantage of spreading the risk among the shareholders of the corporation acting as the general partner rather than concentrating the risk in a single individual.

WHEN IS THE USE OF THIS TOOL INDICATED?

1. When an investor wants to participate in an enterprise but does not want the responsibility and legal liability of a general partner.

2. When an individual wants to invest in a business but lacks the knowledge or experience to take an active role in the management of the business.

3. When an investor has limited capital and desires the investment diversification that a limited partnership can provide.

ADVANTAGES

1. Limited Liability--Similar to the purchase of stock in a publicly-traded corporation, the limited partners in an limited partnership are at risk only for the amount of money they have invested in the business. It is the general partner who has unlimited liability.

2. Pooling of Resources--Limited partnerships offer a means by which investors can combine their resources and achieve a level of diversification and risk reduction that they would not be able to enjoy individually. For example, the partnership may be able to invest in several parcels of real estate in various areas where an individual might be limited to a single investment.

3. Professional Management--Investing in real estate, energy resources (oil and gas properties), equipment leasing, and other specialized assets requires a degree of professional knowledge and experience that most investors do not have. Thus, a limited partnership, employing a qualified general partner, permits individuals to take advantage of a wider range of investment opportunities than they might be willing to consider on a personal basis.

4. Investment Income--Limited partnership investors normally receive periodic payments from the cash flows of their investment. The amount of these payments is proportionate to their share of the partnership, and the payments are taxable to the limited partners as ordinary income. Also, while the general partner's management fee is normally paid prior to these distributions, the general partner will frequently earn a reduced fee until the limited partners have recovered their initial investment.

5. Capital Gain Potential--An additional source of return for limited partnership investors is the possibility of capital gain, or appreciation of the partnership's assets. Capital gains are typically shared with the general partner according to a clearly defined formula in the partnership agreement.

6. Leverage--The use of borrowed funds to finance a significant part of the limited partnership's investments can add significantly to the returns earned by the limited partners. The partnership may be able to borrow more money than any single individual. However, this is a two-edged sword that can increase the risk of the investment as well (see "Disadvantages," below).

DISADVANTAGES

1. Lack of Control--This is the trade-off that investors make when they engage a general partner to operate and manage the enterprise. Limited partners must rely on the management abilities, experience, and ethics of the general partner. While collectively the limited partners generally have the ability to terminate the general manager and/or sell their interests in the partnership, doing so may require lengthy and expensive legal procedures.

2. Lack of Ready Marketability--Unlike publicly traded stocks, bonds, or mutual funds, an interest in a limited partnership may be difficult to sell or liquidate. Some partnerships have arrangements whereby investors can offer their interest for sale to other partners (or the general partner), but there is no guarantee that others will be interested in buying it. Also, in some states, a limited partnership interest may not be salable prior to the dissolution of the partnership.

The lack of liquidity in a limited partnership can be overcome to some extent through the use of a master limited partnership (MLP), which is a limited partnership that is publicly traded on a major stock exchange. Another vehicle to improve liquidity is the emerging secondary market in these programs. There are a number of well-known public limited partnerships where secondary market quotes are available.

3. Leverage--As noted earlier, the use of borrowed funds to finance the limited partnership's activities can magnify both potential gains and potential losses for the limited partners. More importantly, limited partners may be liable for their proportionate share of any loans taken out in the name of the partnership. Before taking part in such an investment, the investor should clearly understand whether or not the partnership has the authority and intends to use borrowed funds and what legal liability the investor may have as a limited partner to repay such loans.

4. Investment Suitability--In general, limited partnerships tend to be relatively risky investments, and as noted above, can be highly illiquid. Those two features make them unsuitable for the average investor, especially those who lack expertise in the area where investments are to be made. For these reasons, limited partnerships often restrict potential investors to persons with a certain level of income, wealth, or both, or to those subject to a certain federal income tax bracket. These criteria are intended to filter out those individuals who may not be capable of understanding or accepting the risks involved with this type of investment.

TAX IMPLICATIONS

Limited partnerships may be taxed either as corporations or partnerships. If the limited partnership is a publicly-traded partnership it will be taxed as a corporation, and the owners of the limited partnership interests will be taxed as if they were holding stock in a corporation (see Chapter 10, "Common Stock"). A publicly-traded partnership is generally a partnership that is traded on an established securities market or is readily tradable on a secondary market or a substantial equivalent. (1)

A limited partnership that is not treated as a corporation for tax purposes is treated as a "pass-through" entity. The limited partnership itself does not pay taxes on its income. (2) Instead, the income (or loss) of the limited partnership "passes-through" to the general and limited partners. Generally, the partnership agreement determines how the income (or loss) is allocated among the general and limited partners. However, if the allocations specified in the partnership agreement do not have "substantial economic effect," the partners' income (or loss) will be based on the partners' interests, based on all the facts and circumstances. (3) In many cases, the partnership agreement will provide for allocations to the limited partners until their contribution to the limited partnership is recovered. For example, the agreement might allocate 90% to the limited partners and 10% to the general partner; after the limited partners have recovered their investment, the allocation might change so that the new allocation will be 50% to the limited partners and 50% to the general partner.

The amount of loss that a limited partner is able to take may be limited. The limitation could come in one of three ways: due to the partner's basis in the partnership, the at-risk rules, or the passive loss limitation. Almost by definition, an investor in a limited partnership is engaging in a passive activity. See Chapter 43 for discussion of the passive activity loss rules and the at-risk rules. A partner's basis is generally the amount that was paid for the partnership interest, with adjustments. The basis is increased by any further contributions to the partnership and by his distributive share of taxable income, tax-exempt income, and the excess of the deductions for depletion over the basis of the property subject to the depletion. A partner's basis is reduced by distributions from the partnership and by his distributive share of losses the partnership may suffer. (4) A limited partner may not deduct partnership losses in excess of his basis in the limited partnership as of the end of the year. Any excess losses may be carried forward to future years. (5)

The generic definition of a passive activity is one in which an investor does not "materially participate" in its management or activity. Rental investments involving real estate, equipment, and other property are treated as passive activities regardless of whether or not the taxpayer materially participates. There are certain exceptions to the passive loss restrictions for investors actively participating in real estate rental activities. These involve the amount of time and personal service that the taxpayer spends in the activity. These exceptions are gradually phased out for higher-income taxpayers.

ALTERNATIVES

1. Real estate investment trusts (REITs) typically operate as publicly-traded, closed-end investment companies. In the real estate area they generally own and operate a diverse portfolio of investments that may include assets such as shopping centers, apartment complexes (including low-income housing), and construction loans. REITs offer investors certain tax advantages (the avoidance of double taxation at the corporate level, for example) and also the benefit of limited liability similar to limited partnerships.

2. Mutual funds offer investors many of the same advantages of limited partnerships, including diversification, professional management, and certain tax benefits. Mutual funds raise capital by selling shares in the fund and then use the money to purchase a diversified portfolio of common stock. The funds are managed by experienced investors, and they themselves are not taxed as long as they pass on virtually all of their income and capital gains to the fund's shareholders.

WHERE AND HOW DO I GET IT?

1. Financial newspapers such as the Wall Street Journal or Barrons and major daily newspapers like the New York Times regularly carry announcements concerning limited partnerships.

2. Information on large-scale master limited partnerships or publicly traded limited partnerships is available from the SEC or the exchange where the partnership's shares are traded.

3. Publicly traded partnerships are sold by stockbrokers and other licensed securities dealers. Potential investors must be given a copy of the partnership's prospectus with information such as financial data, management information, transaction costs, and legal costs associated with the offering.

WHAT FEES OR OTHER ACQUISITION COSTS ARE INVOLVED?

An individual who purchases an interest in a limited partnership can expect to pay the promoters of the partnership a sales commission as well as various legal and management fees. These charges should be carefully spelled out in the partnership agreement, and investors should examine them carefully. The greater the amount of these fees, the less money is available to invest in the enterprise and the smaller the potential return.

Another concern in this area is that some limited partnerships are structured so that a large proportion of their gains go to the management and the general partners, rather than to the limited partners.

HOW DO I SELECT THE BEST OF ITS TYPE?

Investors considering an investment in a limited partnership should evaluate the following factors:

1. Nature of the Investment--Limited partnerships are formed to invest in a wide range of business fields with varying degrees of risk. Three of the most common areas are real estate, energy resources, and equipment leasing.

Even within each of these three areas risk levels can be quite different. For example, a partnership that invests in quality real estate such as a fully-rented shopping center may have a low level of risk, while another that speculates on raw land investments may have a very high degree of risk. An investor should be familiar and personally comfortable with the types of investments that the partnership has made in the past and plans to make in the future.

2. Partnership Terms and Conditions--A careful reading of the partnership agreement is essential, and an investor should rely on legal and accounting expertise if needed. The purpose of the partnership and the relationship between the general partner and the limited partners are critical factors that need to be specified in detail and understood by all participants.

Especially important is a clear understanding of how and when payments are to be made by the limited partners, and how the cash is to be handled. Can the limited partners be assessed for additional contributions, and under what circumstances? When and how are distributions to the limited partners to be made? What fees and other charges are involved, including promoter's fees and expenses? Can the general partner be terminated or replaced, and how is the partnership to be disbanded?

3. Track Record of the General Partner--In general, limited partners are passive investors who only contribute funds to the partnership. The real success or failure of the enterprise depends almost exclusively on the skill and expertise of the general partner. Every investor should be familiar with the general partner's background, his ability to engage in the proposed business activities, and his prior experience in similar partnership arrangements. Is the general partner an individual or a corporation? Is there depth of management in case one person dies or becomes incapacitated?

WHERE CAN I FIND OUT MORE ABOUT IT?

Unfortunately, due to the unique nature of each limited partnership, there is very little information available to potential investors beyond the partnership agreement itself. This is especially true when the general partner is an individual rather than a corporation.

However, investors can ask to see the partnership agreements and financial records of the general partner's previous operations. They can ask for both personal and bank references, and to be put in contact with investors in previous limited partnerships operated by the general partner.

In those relatively rare circumstances where a master limited partnership or a publicly-traded partnership is involved, the investor can request information from the Securities and Exchange Commissions or the exchange where shares in the partnership may be traded.

QUESTIONS AND ANSWERS

Question--How does a limited partnership differ from a real estate investment trust (REIT)?

Answer--One important distinction is that the REIT is typically organized as a corporation rather than a partnership. Another major difference is that a board of directors elected by investors governs and operates a REIT. A limited partnership that invests in real estate is managed by a general partner. Also, the majority of REITs in the U. S. are publicly traded.

Question--What's the difference between a public and a private limited partnership?

Answer--A public limited partnership is registered with the SEC and is offered to the general public through broker/dealers. Private limited partnerships can have no more than 35 limited partners in order to avoid the requirement of SEC registration.

CHAPTER ENDNOTES

(1.) IRC Sec. 7704.

(2.) IRC Sec. 701.

(3.) IRC Sec. 704.

(4.) IRC Sec. 705(a).

(5.) IRC Sec. 704(d).
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Title Annotation:Tools of Investment Planning
Publication:Tools & Techniques of Investment Planning, 2nd ed.
Date:Jan 1, 2006
Words:2718
Previous Article:Chapter 26 Collectibles.
Next Article:Chapter 28 Private placements and venture capital.

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