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Spreading Risk Without Triggering Taxes

Let’s say you have one stock that dominates your portfolio. Perhaps you bought $15,000 worth of Microsoft in 1989 and today your investment is worth more than $1.4 million. Or maybe you founded a small networking company on a shoestring and Cisco Systems recently bought you out for $10 million...in Cisco stock.

A prudent investor in these situations would want to diversify. The catch is that if the investor sells, Uncle Sam will take at least 20% of the gain, and maybe more. The state may take a bite, too. But there is, at least for now, a financial product that allows you to have your cake and eat it, too. The product is called an “exchange fund.”

In an exchange fund (also known as a swap fund), a group of wealthy investors pools large blocks of highly appreciated stock to form a partnership. Each investor contributes his or her undiversified, publicly traded stock (usually in blocks of $1 million or more) in exchange for a commensurate share of the partnership. The investor’s exchange of his undiversified stock for a share of what will become, with the inclusion of other investors’ holdings, a diversified portfolio, is not a taxable event if the fund is properly structured.

In order to be eligible for this tax-free-exchange treatment, more than 20% of the partnership’s investments must be illiquid “qualifying assets,” typically real estate partnerships. The portfolio borrows cash against the contributed securities to purchase the real estate partnerships.

Like a mutual fund, the exchange fund has an investment manager whose job is to decide which stocks to hold in the fund’s portfolio. The shares you offer may or may not be accepted. Each fund sets its own selection criteria. We reviewed one fund that requires contributed securities to: 1) be listed on a national stock exchange, 2) trade for at least $10 per share, and 3) have a market capitalization of at least $500 million with at least three years of continuous operations. Once the security has cleared these hurdles, the investment manager considers whether the proposed investment is likely to perform well and whether this particular stock would be a good match with the others that have been offered to the fund. The manager wants to avoid over- and under-exposure to various industries, regions and asset classes.

Portfolio construction is especially important to an exchange fund because, in order to preserve the tax deferral, the manager will try to avoid selling any of the original holdings during the life of the fund.

When the proposed portfolio has been assembled, each investor receives an “inspection report” that describes the size of the fund and lists the stocks that have been tentatively accepted. The investor has several business days in which to back out of the deal if the proposed portfolio does not seem attractive. Otherwise, the deal closes and the investor becomes a partner in the exchange fund. To avoid Securities and Exchange Commission registration requirements, exchange funds usually are offered only to “qualified purchasers.” Individuals are deemed to be qualified purchasers if they own at least $5 million in investments.

Paying to Play

The placement fees and ongoing expenses vary from fund to fund. The investor is typically charged an up-front fee of 1% to 3% on a $1 million investment. These fees are usually reduced or eliminated for larger investments. Management fees and other ongoing expenses for these portfolios are somewhat high, considering that the portfolio employs a passive investment management strategy. The funds we have evaluated usually have annual fees and expenses of 0.5% to 1% of gross assets, which includes the illiquid “qualifying assets” without any reduction for the offsetting margin loan.

Exchange funds also vary in their redemption and withdrawal policies. Some funds allow a limited partner to withdraw contributed securities immediately, while others make it expensive to withdraw any earlier than seven years after initial contribution. In one fund we analyzed, no redemptions are permitted during the first three years of participation. If an investor seeks to withdraw after three years but prior to seven years in this fund, the investor receives the lesser of the partnership’s net asset value or the market value of the securities the investor originally contributed. Another fund, which permits withdrawals at the partnership’s net asset value from inception, levies a 1% fee on all assets redeemed during the first three years.

All funds permit some free withdrawals in certain situations regardless of the number of years in the partnership. Events triggering these free withdrawals include the death of the investor or a takeover of the company whose stock he contributed.

After seven years, most exchange funds will redeem partnership interests with shares of at least ten different securities contributed to the partnership. This is a grand coup. For the price of the initial placement fee and tolerable ongoing expenses, seven years later an investor can walk away with a diversified portfolio without triggering any taxes. The investor’s low cost basis is transferred to the redemption shares, but no taxable event has occurred. If the investor holds the distributed shares until death, his heirs receive a stepped-up basis that ultimately forgives the capital gains tax.

Wall Street’s Winning Record

Swap funds have come under fire repeatedly over the years. Until now, Wall Street has always found a way to adapt the product to fit the changes in the law and still achieve the crucial tax-free-exchange treatment. But this may not be the case in the future.

Legislation that was introduced last year by Rep. Richard E. Neal (D-Mass.) would likely eliminate exchange funds as they presently exist. Neal’s proposal states that “Any transfer of marketable stock or securities to any entity would be a taxable event, if that entity is required to be registered as an investment company under the securities laws, or would be required to register but for the fact that interests in the entity are only offered to sophisticated investors, or if that entity is formed or availed of for purposes of allowing investors to engage in tax-free exchanges of stock for diversified portfolios.”

Of course, the issue is going to be heavily lobbied, especially by such major players in the exchange fund arena as Goldman Sachs, Morgan Stanley Dean Witter and Donaldson, Lufkin & Jenrette. Neal’s legislation went nowhere in 1999 and prospects are uncertain during this election year, but the window of opportunity may well be closing.

If you enjoyed this article, be sure to check out Palisades Hudson’s books, The High Achiever’s Guide To Wealth and Looking Ahead: Life, Family, Wealth and Business After 55. Both are available in paperback and as e-books.