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Financial Planning > Tax Planning

No Taxation With Diversification

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We all know that it makes sense to diversify, but it’s not always as easy as it sounds. Clients with concentrated equity positions tend to have a low cost basis in those positions, which makes the tax cost of diversification unattractive at best. But continuing to hold a concentrated position to avoid paying the income tax required to diversify may end up being more costly than the tax bill itself.

There are plenty of lessons I can point to where the holders of concentrated positions saw the value of their investment plummet, for one reason or another (Enron being one of the most obvious). What if there were a way to help your clients diversify concentrated equity without the taxes associated with selling and subsequent reallocation? There is—it’s known as an exchange fund (a.k.a. stock swap fund). 

An Exchange Fund Defined

An exchange fund is a private placement limited partnership that allows clients to contribute certain concentrated positions to the partnership in exchange for shares of interest in the fund. The contributed positions are pooled with other concentrated positions and assets. The shares of interest in the exchange fund represent a proportional share of all assets in the fund. To be considered an exchange fund, the fund cannot hold more than 80% of its assets in individual securities. The other 20% (or more) of assets must be held in qualifying assets (i.e., illiquid assets typically consisting of real estate). 

The primary benefit in using a vehicle like this is outlined in section 721 of the Internal Revenue Code, which states that the exchange of concentrated positions in return for shares of interest in the fund is a nontaxable event. This means clients can immediately diversify their concentrated risk without incurring capital gains tax at the moment of exchange. 

Six Key Points to Consider

Although exchange funds aren’t new, they also aren’t very well known. That’s why it’s important to understand the following before considering their use: 

  • Exchange funds are only available to accredited investors and qualified purchasers who have at least $5 million in investable assets.
  • The management and servicing fees may vary from fund to fund.  
  • Not all positions will be accepted into an exchange fund. Each fund manager has an investment mandate and maintains a list of acceptable securities.
  • Shares of the exchange fund are illiquid. Once the contribution is made, clients are subject to a seven-year holding period to attain the benefit of the tax-free exchange. Clients who leave the fund early could face severe penalties.
  • At the end of the seven-year holding period, clients may redeem their shares for a pro rata allocation of the stocks in the fund. Each client’s original basis in the concentrated position is allocated across the shares received.
  • An exchange fund is a tax-deferral mechanism, not a way to avoid taxes altogether. When the client eventually sells the diversified shares of stock, the client will incur capital gains tax on the proceeds received above his or her original basis. 

The inherent risks of owning a concentrated equity position are well known, and the continued strength in equity markets (notwithstanding the markets’ recent volatility) is further exacerbating that risk.

For the right client, an exchange fund may offer an excellent method for diversifying concentrated risk without an immediate tax bite.


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