Does a corporation pay dividends from after tax or pre-tax income?
Unless a company is giving away over 90% of its earnings in distributions, any corporate income will be taxable. In this sense, corporations are double taxed because if a company just pays a dividend, they will pay taxes on the income and the shareholder will pay taxes on the dividends. If a company has a loss for the year, that means it can't pay dividends.
Are partnerships taxable like corporations?
No - Partnerships are not taxed
A partnership is never taxed as an entity, but the income distributed to each of the partners is taxable to each of them individually.
Who are the two members of a limited partnership?
General Partner and Limited Partner
The general partner is the one who is directing the activites of the partnership and has unlimited liability. The limitied partners do not have personal liability for the actions of the general partner.
What document must be filed for a partnership to be legal?
Certificate of Limited Partnership
This usually has to be filed with the Secretary of State of the state in which the partnership is based, and must list all the partners.
What must be included on the Certificate of Limited Partnership?
- each partner's level of ownership
- partners's share of income - may differ from level of ownership
- date the partnership is expected to end
- distribution of assets upon termination - may be different than level of ownership
What purpose does the partnership agreement serve?
This document spells out the purpose of the partnership and what responsibilities each party has. It is signed by all partners and is separate from the documents filed with the Secretary of State.
What are the specific duties and powers of the general partner?
- can change the management fee
- determines when cash distributions are made to the partners
- makes all decisions
- can approve new limited partners and must approve transfer of interest of limited partners
What limitations do general partners usually have?
- Must maintain some level of interest in the partnership - usually minimum of 1%
- Has a non-compete with the partnership
- If the GP dies, the partnership dissolves and a new agreement has to be submitte
- The only thing the GP has to ask limited partner's permission for is to accept a legal judgement against the partnership
What are the general rights of the limited partner?
- Has the right to inspect the books
- Has a right to vote for/against sale of partnership
- Can sue the GP if terms of agreement are violated
- Right to their income and share of assets as stated in the limited partnership agreement
What are some of the requirements of limited partnership?
- capital contribution
- Must pay-in additional capital if the GP requires it
- Unlike the GP, the limited partner can be in competition with the partnership since they are making no control decisions
If the partnership is dissolved, in what order are creditors paid off?
- secured lenders
- general creditors
- the limited partners
- the general partner
What are the tax forms filed by the General Partner?
K-1 Filed with IRS
This document outlines the income and losses of the partnership. This is not filed for partnership taxation purposes but to show the income the partners must file on their own, individual taxes.
How are limited partners taxed on the distribution of assets?
Calculation of the Basis
The basis describes the initial value of the limited partner's ownership and includes cash, property, and any recourse debt the limited partners have accepted.
What actions can decrease the value of an investor's basis, raising their potential tax liability?
- Distributions - Cash or asset distribution will reduce the LP's basis and upon sale will be taxed on the difference between the lowered basis and sale price.
- If the partnership repays any of the recourse or non-recourse debt the partner may have applied for
- Net losses are deducted from the basis and if losses push the basis below zero, the basis stays zero and the remaining loss can be carried forward against future income
Note that the basis can never go below zero.
What are the unique tax issues faced by real estate partnerships?
- For Real Estate partnerships, non recourse lending IS included in the basis. Mostly this is because the lending is secured by property. This increases the value of the basis without being personally liable and decreases possible taxes
- Depreciation is on a straight line basis
- Certain tax credits are available for building low income housing that reduce taxes for the investor
Land with no improvements on it has a unique set of risks and may not be suitable for all investors. What are those risks?
- No depreciation to reduce the basis
- No cash flow and possibly negative cash flow
- Possible changes to the land beyond control such as flooding or zoning changes
Know that among all the types of limited partnerships, those focusing on real estate are the riskiest.
Partnerships focused on housing development have a unique set of risks. What are they?
- New construction is always high risk
- Risk of no buyers once complete
- Huge negative cash flow during building process
- Limited or zero deductions during the construction
Some partnerships are created for the sole purpose of building government housing. What are the unique risks of those partnerships?
- Less rent risk because they are government subsidized
- Additional opportunities for tax credits
- There are usually higher maintenance cost associated with these projects
There are three types of Oil and Gas partnerships - what are they?
What are some of the features of an exploratory oil and gas partnership that may alter suitability?
- Exploratory means the partnership will use investment to search for previously unknown oil
- Very high risk - no guarantee of finding anything
- Drilling costs are deductible to investors
What are the unique challenges of a developmental oil and gas partnership?
- These are not as risky because they are drilling to develop known oil and gas - they are drilling new wells next to wells already working
Drilling costs are not deductible but would be lower anyway since there is no exploration going on
- Since a land owner knows there is oil nearby, they would charge a lot more for the rights to drill - potential high up front costs to investors before any return.
What are some of the challenges for investors in current income oil and gas partnerships?
- These are partnerships formed to purchase working wells and gas lines
- Lowest risk of the three types but has least appreciation potential
- Some income sheltered by the depreciation of the equipment purchased and depletion of natural resource as oil and gas is used up
The GP of oil and gas projects can demand some unique compensation arrangements. What are they?
- The GP can demand a disproportionate share of income based on their unique skill or track record
- Overriding Royalties - this means the GP gets paid first no matter how much has been spent to set up the well and how much the limited partners have paid in
- Working interest - GP agrees to pay for some of the setup costs in return for an option to exercise that paid capital into a larger portion of proceeds
How can an investor become a limited partner?
Submit Subscription Agreement
This is like an application to become a limited partner. Mostly the GP is concerned with the finances of a potential investor and how liquid they are.
If a registered representative is recommending a LLP through a dealer, what are they required to consider?
- Suitability - This will come up time and time again on the series 7 exam
- The investor's financial situation
- Do the tax advantages of the partnership apply to the investor?
- Can the investor sustain a total loss without altering their risk tolerance or retirement timeline?
What type of order can a broker never accept from a potential investor in an LLP?
This is because the registered representative is supposed to perform suitability analysis on the customer, and presumably in an unsolicited bid that has not been performed.
A tax deduction for using natural resources such as timber or oil that may be central to a company's income.
A recognition by the IRS that fixed assets break down and need repair; depreciation is a way to reflect that capital cost by lowering the tax bill.
direct participation plan
An LLP that will pass all income on to investors and will itself be tax exempt.
equipment leasing limited partnership
A type of direct-participation agreement that will buy equipment and then enter into agreements to lease that equipment to other companies, typically over a long time.