Academic journal article Journal of Accountancy

What Happened to Limited Partnerships?

Academic journal article Journal of Accountancy

What Happened to Limited Partnerships?

Article excerpt

In the 1980s, limited partnerships (LPs) were touted as the investment vehicles of the future. Investors heard sales pitches for oil and gas, real estates, cattle feeding, master recording disks, equipment and aircraft leasing and cable television. Investors seldom hear such pitches today. This article describes the tax and financial factors that contributed to the rise and fall of LPS as well as what happened to the billions of dollars invested in LPS in the 1980s. CPAs should find opportunities for client service in both the demise of LPs and the creation of new investment vehicles to replace them.

LIMITED PARTNERSHIPS DOMINATE THE 1980s

The heyday of LPs was 1983 through 1989. During this time economic and tax factors, aggressive marketing and a touch of greed made LP sales soar. Exhibit 1, page 39, shows the dollars generated by LP sales from 1970 through 1995. Exhibit 2, page 40, focuses on two industries that dominated these sales: real estate and oil and gas.

Most early LPs were private or nonpublicly traded. One or more general partners managed the business and assumed personal liability for its debts and obligations, while limited partners provided the bulk of the capital. LPs were attractive to investors because they offered the benefits of direct ownership -- income potential and tax breaks -- without management responsibility and personal liability. Limited partners could lose no more than their original investment.

Private LPs commanded a substantial initial investment -- from $20,000 to $150,000. Nonpublicly traded LPs generally required an initial investment of only about $10,000, although some interests sold for as little as $2,000.

Brokerage firms fueled sales with aggressive marketing. Partnerships commanded the highest commissions and firms offered representatives special incentives to push sales further. Brokers responded by actively marketing LPs, to the point of depicting risky partnerships to conservative investors as "safe" and "a means of capital preservation."

THE IMPACT OF TAX FACTORS

The LPs of the early 1980s were tax driven, promising a huge return on a relatively small investment. The pass-through nature of partnerships (Internal Revenue Code sections 701 and 702) made it possible for investors to realize tax benefits. Limited partners could use the deductions intended for ongoing businesses -- depreciation, interest and investment tax credits -- to offset not only LP income but also ordinary income from salary and other investments.

With the accelerated depreciation provisions in the Economic Tax Recovery Act of 1981, real estate LPs became particularly attractive. Most were highly leveraged, and nonrecourse debt (the partners bear no risk of economic loss) was treated as a depreciable cost. Investors expected annual tax benefits and rental income, plus capital gains when the underlying properties were sold in 7 to 10 years.

THE DEMISE OF LPs

Tax law changes, increased audit scrutiny by the Internal Revenue Service and falling real estate and oil and gas prices brought an end to the glory years. By late 1989, some analysts had estimated that if all real estate LPs were liquidated, 70% or more would lose money. Nearly one-third had not paid out any cash for six months. Limited partners suddenly found themselves with illiquid investments producing little or no return. Master limited partnerships (MLPs) were marketed to preserve some of the tax benefits, but they, too, suffered from tax law changes. And neither vehicle could escape the softening real estate market.

In the early 1970s, Congress and the IRS had begun to attack abusive tax shelters -- those defying economic reality with inflated appraisals, unrealistic allocations and tax benefits far in excess of economic benefits. The Treasury Department found in increasing number of wealthy taxpayers paying only 5% to 10% of their positive income (salary, interest, dividends and income from profitable business and investments) in taxes because of shelters. …

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