What Happened to Limited Partnerships?

The jewel of the 1980s has lost its brilliance.

  • ONCE TOUTED AS THE INVESTMENT vehicle of the future, limited partnerships are seldom pitched to investors today. Instead, clients and the CPAs who advise them are looking back at the tax and financial factors that contributed to the downfall of LPs in areas such as oil and gas, real estate and equipment leasing.
  • THE HEYDAY OF LPs WAS 1983 THROUGH 1989. Aggressive marketing made sales soar. Brokerage firms offered high sales commissions and investors were told the risky partnerships were a safe way to invest.
  • THE TAX REFORM ACT OF 1986, combined with increased Internal Revenue Service audit scrutiny spelled the beginning of the end for tax-oriented LPs. Extension of the at-risk limitations to real estate tax shelters and the passive loss provisions in the TRA gave the IRS the weapons it needed.
  • TODAY, A LIMITED SECONDARY MARKET exists for some public LPs. However, the requirement for investors to recapture most of the previous tax benefits upon disposal could leave many with substantial tax bills.
  • MANY LPs HAVE OUTLIVED THEIR LIMITED partners, leaving heirs to cope with valuing them for estate tax purposes and to decide whether to hold or sell. Ensuring that LPs are not overvalued requires careful research by CPAs—finding a reasonable value can be troublesome. Discounts of 60% or more are not uncommon.
  • MOST NEW LPs TODAY ARE MARKETED for their income potential rather than tax benefits. Most investors have moved on to other investments with greater promise.
LEE KNIGHT, PhD, is E. H. Sherman Professor of Accountancy at Troy State University, Troy, Alabama.
RAY KNIGHT, CPA, JD, is a senior manager at KPMG Peat Marwick in Atlanta.

In the 1980s, limited partnerships (LPs) were touted as the investment vehicles of the future. Investors heard sales pitches for oil and gas, real estate, 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.

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, shows the dollars generated by LP sales from 1970 through 1995. Exhibit 2, 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 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.

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 an 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. Besides the revenue loss, Congress was concerned that extensive shelter activity contributed to public concern that the tax system was unfair and to the belief that only the naive and unsophisticated paid taxes. This attitude not only undermined compliance but also encouraged expansion of the tax shelter market.

The Tax Reform Act of 1986 (TRA) was the most successful congressional action in curbing sales growth. Some even suggest that earlier legislation actually fueled the growth of abusive shelters by spurring promoters to develop increasingly exotic deals to satisfy the markets hunger for tax savings. Such shelters had little chance of success except by winning the audit lottery—by not being selected for IRS audit.

In the late 1970s and early 1980s, the IRS stepped up its efforts. Agents were instructed to scan advertisements for abusive shelters and notify investors that they could not take certain deductions or tax credits. Special audit procedures were applied to shelters generating tax benefits clearly in excess of economic benefits, with the intent of moving promptly to settlement or litigation. In 1983, approximately 325,000 tax returns involving potentially abusive shelters were under audit (compared with 400 returns 10 years earlier), with an estimated annual revenue loss of $3.5 billion. More than 18,000 tax shelter cases were in Tax Court, representing one-third of the courts docket and $1 billion in taxes.

Before the TRA, the most common IRS litigation weapon was the "not engaged in for profit" test of IRC section 183. If an LP was found to lack a profit motive, investors could not deduct expenses and losses (see Deegan v. Commr , 49 TCM 1421, 1429 [1985], affd 787 F2d 825 [2d Cir 1986] or Polakof v. Commr , 49 TCM 1300, 1307 [1985]). This weapons success was limited because the courts could not settle on a concise, unambiguous legal standard for the test.

The IRS also launched criminal investigations on LP promoters. Some were prosecuted for peddling false appraisals and fictitious nonrecourse notes (see Deutsch [SD Fla], 599 F2d 46 [5th Cir 1979] or United States v. Whipple , CR-81-0036J [Utah]). Others were criminally prosecuted for backdating documents (see United States v. Jeffers [SD W Va]) or, worse, not acquiring the assets on which the tax shelter deductions were based. In United States v. Loney , CR 82-083-1 (ED Wash 1982), revd 719 F2d 1435 (9th Cir 1983), deductions were taken for intangible drilling costs allegedly never incurred by any of the limited partners. In United States v. Senft , 83 CRM 732 (SDNY 1983), a shelters principals were indicted for allegedly using nonexistent Treasury securities to generate over $130 million in losses. The schemes were as outlandish and creative—and fraudulent—as the market and the tax laws would allow.


Exhibit 1
Limited Partnership Sales

Extension of the "at-risk" limitations of IRC section 465 to real estate tax shelters and the new passive loss provisions in the TRA finally gave the IRS the weapons it needed to clamp down on abusive tax shelters. As the new provisions became effective, the downward spiral in LP sales began. Extending the at-risk limitations to real estate shelters meant a limited partners basis in an LP could not be increased for his or her share of partnership debt (1) unless the partner was personally liable for repayment or (2) if the lender had an interest other than as a creditor. This extension did not apply if the taxpayer used qualified nonrecourse debt—basically, arms-length, third-party commercial financing secured by the real property (IRC section 465(b)(6)(A)).

Congress enacted this exception because it believed a commercial lender would not intentionally overvalue real property if it had only a security interest. Notwithstanding the validity of this belief, it left the door open for sophisticated promoters to structure real estate shelters to obtain an increase in tax basis for nonrecourse financing.

The new passive loss rules, however, all but nullified this opportunity. Section 469 prohibited limited partners from offsetting tax losses from LP investments (passive activities) against income from nonpassive activities—salaries, for example—unless they disposed of their entire interests in LPs. Without this tax benefit, LPs other than mature ones producing passive income lost their attractiveness.


Exhibit 2
Real Estate and Oil and Gas Prices

For a short time in the mid-1980s, master limited partnerships offered a way to cope with the TRA. The passive loss rules applied to MLPs but were less devastating because most were created to produce income from the outset. Under the TRA, this was passive income that could be used to offset passive losses. With the maximum corporate income tax rate higher than the maximum individual rate and no tax at the entity level for MLPs, large-scale businesses could reduce their tax liabilities by organizing as MLPs rather than as corporations.

The Revenue Act of 1987 (the RA) ended the tax advantages of MLPs. The most significant change provided that certain MLPs would be taxed at the partnership level as corporations. Thus, the limited partners would no longer benefit from taxation only at the partner level. As corporations, income at both the entity and owner levels would be considered portfolio income rather than passive income.

The Search for Deep Pockets

In 1993, federal and state regulators accused Prudential Securities of widespread fraud in selling LPs totaling more than $7 billion to over 400,000 investors during the 1980s. To settle the charges, Prudential agreed to establish a restitution fund starting at $330 million, pay $41 million in fines, assume unlimited liability to investors allegedly misled by the firms sales practices and waive the normal statute of limitations for such claims. By early 1996, Prudential had paid $490 million to investors under previous litigation, pumped more than $660 million into its restitution fund and paid close to $15 million to a number of California investors. Prudentials final legal tab for marketing LPs in the 1980s is expected to exceed $1.5 billion.

In late 1994, the Securities and Exchange Commission also began investigating PaineWebbers sales practices in marketing $2 billion of LPs between 1980 and 1992. Without admitting wrongdoing, PaineWebber agreed to pay $292.5 million to investors, $10 million in fines and $30 million in costs. This settlement, while not lenient, was less harsh than Prudentials in that it included $120 million already paid to investors, $125 million to settle two private class-action lawsuits and a $40 million (capped) SEC fund.

The SEC apparently approved of PaineWebbers prompt response to customer complaints and its attempts to police itself. In early 1993, the company installed a new computer system to monitor customer accounts and potential abuses and began offering reasonable settlements to clients with legitimate claims rather than forcing them into arbitration. PaineWebber also hired several respected former regulators—including a former SEC enforcement attorney as general counsel—to negotiate settlements with clients and regulators.

Other major brokerages—Lehman Brothers, Dean Witter and Merrill Lynch—reportedly are undergoing similar investigations. If wrongdoing is found and the settlements approach Prudentials, or even PaineWebbers, LP investors may yet recover their investments. New York Life Insurance Co. offered full refunds to approximately 28,000 investors to settle a class-action lawsuit involving over $396 million in oil and gas LPs sold by a broker-dealer subsidiary.

The one-two punch of tax reform and falling real estate and oil and gas prices left LP investors with few options other than to hang on or sell in the secondary market. Some who opted to hang on still may hold LP interests as a long-dormant part of their portfolios. It is to these individuals that CPAs can offer their expertise. Making a rational decision about disposing of an LP interest by sale or abandonment or continuing to hold it—even until death—means the financial and tax consequences of each alternative must be considered carefully. While none of the alternatives is likely to recoup the original investment, informed decisions with a CPAs help can minimize the losses a LP investor might incur.

Lifetime disposal . Uninformed investors may believe the secondary market is the only way to salvage their investments. This market, however, generally involves only public LPs, and prices—although better since 1994 for some real estate LPs—have been far below what investors originally paid. A few savvy speculators have offered investors prices exceeding those in secondary markets but still only for one-third to one-half of the partnerships asset value. While this tactic may benefit the speculator, investors can wind up paying a hefty tax on such dispositions. The law requires investors to recapture most of the tax benefits previously received, including those from nonrecourse financing. Even if the nonrecourse liability exceeds the fair market value of the underlying property, the principal amount is treated as an amount realized from the sale or disposition of the property.

Besides advising LP investors about these tax consequences, CPAs can help them choose the proper way to dispose of a partnership interest. The companies listed in exhibit 3, are active in the secondary market and can be contacted—by the CPA or the client—to solicit the best possible price of the LP interest. Then the bids can be evaluated with due consideration given to the tax consequences.

If there is no secondary market bid for a particular partnership interest or if foreclosure is imminent, an LP investor may be tempted to abandon his or her interest rather than contribute more money to the partnership. Abandonment, however, does not avoid or mitigate the unfavorable tax consequences of disposing of LP interests. Under IRC section 752(b), any decrease in a partners share of partnership liabilities is deemed to be a cash distribution, triggering the section 731(a) distribution on liquidation rule for gain or loss recognition.

Under section 731(a), an LP investor abandoning a partnership interest reports capital gain to the extent his or her share of partnership liabilities exceeds the adjusted basis of the partnership interest. Conversely, the investor has a section 731(a) loss if his or her share of partnership liabilities is less than the adjusted basis. Revenue ruling 93-80 says this loss is a capital loss if there is an actual or deemed distribution to the partner, or if the transaction is otherwise in substance a sale or exchange (except as provided in IRC section 751(b)). The loss or abandonment is ordinary only if sale or exchange treatment does not apply. Thus, if a partner abandons an interest in a partnership that has liabilities in which the partner shares (such as a general partners share of nonrecourse debt), the loss is capital. If this partnership has no liabilities (a rare occurrence) or the partner does not share in them, there is no deemed distribution under section 752(b) and the loss is ordinary.

Transfer by death . If an LP interest is held until death, the heirs are left to cope with valuing the interest for estate tax purposes and deciding whether to sell or hold it. A transfer of an LP interest at death is not considered a sale or exchange under section 751(b). Thus, neither the decedents estate nor the heirs recognize gain or loss on the transfer. The propertys basis to the estate and to the heirs is its fair market value at the date of death or the alternate valuation date.


Exhibit 3
Limited Partnership Secondary Market Companies

Finding a reasonable value for an LP interest is troublesome, at best. A recent study by Hans Schroeder of BEAR, Inc., Steve Kam of Houlihan Valuation Advisors and Curt Smith of Californias Trust and Investment Management Group found that a discount of 25% to 40% of net asset value is common, but actual discounts, as evidenced by secondary market prices, often exceed 60% and can go as high as 90% of net asset value. Cash distributions to investors and cash generated by the LP are the most important factors in determining the discount. LPs with the lowest cash distributions show the highest discounts and vice-versa. The type of property the LP holds also is significant. The discount on a commercial property LP, for example, is around 55%, while that on an equipment leasing LP averages 15%.

Determining the appropriate value of an LP interest requires careful research, for which CPAs are well qualified. For public partnerships, the starting point is the secondary market. Some LP managers and securities firms provide information on any recent transactions. CPAs also can ask secondary market firms for bids, check industry publications or engage someone to estimate the value.

Once a value is established, the heirs must decide whether they want to sell or retain the LP interest. If they decide to sell, the heirs may let the decedents securities firm arrange the sale or contact a market resale firm directly. The step-up in basis inherited by the heirs generally avoids income taxes on predeath appreciation and depreciation recapture.

If the heirs retain an LP interest, they may find themselves saddled with a large tax liability and no cash distributions to pay it if the LPs assets are sold before the partnership is terminated. Fortunately, this situation can be mitigated through appropriate elections by the partnership and the partners.

Like fashion, investment vehicles come and go. LPs havent disappeared but are now marketed for their income potential rather than tax benefits. Except for real estate, mutual funds have become the investment vehicles of choice for small investors.

LPs clearly have lost their brilliance. Promised pots of gold have turned to ashes and many LP investors can expect to recover only a fraction of their original investment. Dollars that once flowed into LPs now are flowing into new and often more sophisticated investment vehicles. CPAs are in a prime position to advise their clients on the unforseen consequences of holding or disposing of LP investments. Without this expertise, clients cannot make informed decisions and economic losses may continue to mount. CPAs also may wish to take the opportunity to advise their clients about the financial and tax consequences of new investment vehicles that may better meet their needs.


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