Because of the runup in stock prices over the past decade, you might find yourself with an oversized or “concentrated” position in your company’s publicly traded stock – as an owner, employee, or former employee. If that’s the case, congrats. Acquired over many years due to vesting rules and selling restrictions, company stock can be a fantastic wealth-building tool. But it also carries substantially higher risk.
If you want to be less tied to the fortunes of just one company, no matter how great it is, it’s worth exploring how to diversify your oversized position tax-efficiently. One strategy is to transfer some of the stock to an “exchange fund.”
Exchange Funds: Rediscovered for the 2020s
Not to be confused with Exchanged-Traded Funds (aka ETFs), exchange funds were first created in the late-1960s. These are private funds, set up as Limited Partnerships (LPs), that allow you to transfer some portion of publicly traded stock that you own to the fund in exchange for participation in a diversified portfolio.
The managers actually add your shares into the fund (they do not sell) – plus the shares of hundreds of other contributors – to create and maintain a diversified stock fund that mirrors a diversified stock index, such as the S&P 500. If this sounds hard to execute, it definitely is. That’s why of the many exchange funds out there, less than a handful are large and liquid enough to be good options.
The twin benefits of exchange funds: diversification + tax-deferral. The exchange fund’s diversified portfolio is likely to offer more peace of mind: lower price volatility and less downside risk relative to a single-stock investment. And you can get that diversification without a tax bill: transferring highly appreciated stock to a properly structured exchange fund is not taxable at the federal level.
Still, exchange funds are definitely not for everyone, literally. You must be an “accredited” investor (at least $1 million in net worth excluding you primary residence) and transfer stock that’s listed on a US or major foreign exchange (although restricted securities may be accepted at a discount). Plus there’s usually a minimum of $500,000 to $1 million (this can be in multiple securities each worth at least $100,000).
If you do qualify, these are the major issues to consider:
***Market risk. The stock you transfer could outperform the exchange fund. This happened with certain stocks in 2020, especially in tech and healthcare. But over the long term, the diversification provided by the fund is likely to enhance the risk-adjusted return of your equity holdings as whole.
***Real estate exposure. Per the IRS, exchange funds must invest 20% of their holdings in “qualifying assets” that are not stocks. In almost all cases this is done through real estate, which is usually direct investment in high-quality multi-family residential, a sector that has proved resilient in economic downturns.
***Changes in tax law. Capital gains tax rates could rise in the future, especially for higher-income Americans. If that is the case, it may make more sense to sell and pay gains taxes now on portions of a concentrated position, instead of transferring to an exchange fund.
***Redemption restrictions. When you redeem exchange fund shares, you will get back either the shares of the stock you contributed and/or other stocks that you can then hold or sell. To get the full benefit of an exchange fund – a diversified portfolio of at least 10 mega-cap stocks — you typically need to hold the exchange fund for at least seven years. You can redeem before that, but there might be a fee and what you get back may not be diversified.
What Happens When You Redeem
Typically, the major exchange funds allow for daily redemptions, but there are different restrictions on how these are facilitated and possible penalties for redeeming before seven years. Generally speaking and using as example a major exchange fund we have reviewed, the restrictions are as follows:
Before Year 3 – 1% redemption fee. You typically get back the shares you contributed in an amount that matches the gain/loss in the fund shares. If you transferred $1 million in Microsoft and the value rises 25% to $1.25 million while the fund shares gain only 5%, you would get back $1.05 million in MSFT stock (not $1.25 million) minus the redemption fee.
Year 3 to 7 — No redemption fee. Typically, you would get back the shares you contributed PLUS other stocks in the fund in the amount of any gains. If the fund has lost value in that time, you get back fewer shares than you contributed based on the amount of the loss.
After Year 7 – No redemption fee. You will get back a pool of securities – at least 10 different mega-stocks that are very likely the largest holdings in the fund – including perhaps shares in the stock you contributed if it happens to be among the top 10. The amount will be the value of the stock you contributed plus the change in fund value, be it positive or negative.
Taxes When You Sell: As long as you continue to hold the stock or stocks you get back from the exchange fund, no taxes are due. When you do sell, the original cost basis will be allocated across the securities you received. Example: If you transfer company stock that cost you $100,000 to acquire and after seven years get back 10 securities from the fund, each security would have a $10,000 cost basis. In case of death, your heirs will inherit shares in the fund at current market value, so no capital gains owed under current tax law.
The Bottom Line
Managing concentrated positions — be it in specific equities, real estate, or even in artwork and collectibles — is a key part of the investment and risk-management work we do here at Laird Norton Wealth Management. There are a wide variety of tools and strategies we use to reduce risk and strategically diversify client portfolios tax-efficiently. But no strategy will work well if it’s not aligned with your needs and goals. If you have concentrated positions and want to explore what’s possible, please reach out to us here at LNWM to discuss how we can help.