A Guide to Managing Concentrated Stock with Exchange Funds

For highly compensated employees, executives, and private equity partners, managing wealth often means navigating the complexities of concentrated stock holdings and tax implications. In this guide, we explore Exchange Funds—a powerful financial tool. Discover how Exchange Funds enable diversification of concentrated stock while deferring taxes and learn how Adero Partners has helped clients implement this strategy to optimize and grow their wealth.

What is an Exchange Fund?

An Exchange Fund, also known as a Swap Fund, is designed for high-net-worth individuals who receive a significant portion of their compensation in non-cash forms like stock options, restricted stock units (RSUs), founders’ stock, or carried interest.

How do Exchange Funds Work?

  • Initial Contribution: Individuals holding a concentrated position contribute their highly appreciated stock to a limited partnership (i.e. an Exchange Fund).

  • Exchange: In return,they receive partnership units in the Exchange Fund equal to the value of their contributed stock.

  • Diversification: The Exchange Fund accepts stocks from a variety of other companies to reduce concentration risk. Each partnership unit is a representative slice of the pooled contributions from all participants.

  • Management: The Exchange Fund is professionally managed and tracks a broad market index such as the S&P 500 or Nasdaq 100.

  • Tax Deferral: Importantly, the contributed stocks are not sold. Participants continue to defer capital gains taxes while participating in the long-term growth of the index.

  • Qualifying Assets: To qualify for the tax deferral benefits, the US tax code requires the Exchange Fund to hold a 20% interest in other “Qualifying Assets”, typically diversified multi-family and industrial real estate.

  • Redemptions: After 7 years, the participant can request a redemption from the Exchange Fund and will receive a diversified basket of 20-30+ stocks.

Suitability Considerations for Exchange Funds

  • Investment Time Horizon: To receive the full benefit of the Exchange Fund’s favorable tax structure, participants need to hold their interest for at least 7 years.

  • Early Redemptions: For the first 7 years, redeeming participants receive the lesser of: the contributed stock return or the index return. Early redemptions are made in-kind with the original stock being returned along with the original cost basis. These in-kind redemptions are non-taxable.

  • Qualified Redemptions: After 7 years, redeeming participants receive the index return, even if the contributed stock outperformed the index. This compromise is worthwhile given the diversification benefits and downside protection provided by the Exchange Fund. Qualified redemptions are made in-kind with a basket of 20-30+ stocks along with the original cost basis applied pro rata. These in-kind redemptions are also non-taxable.

  • Employee Trading Policies: Many companies have favorable policies in place to allow current employees to participate in Exchange Funds. However, some companies explicitly forbid them. Employees should carefully review their company’s trading policy before considering an Exchange Fund investment.

Adero Client Case Study 1

Tech Executive with Concentrated Stock

Meet Ava, a seasoned executive at a leading Silicon Valley technology company. Over the years, Ava has received a significant portion of her compensation in the form of incentive stock options (ISOs) and restricted stock units (RSUs). Shortly after joining the company, she decided to early-exercise her options and enroll in the company’s employee stock purchase plan (ESPP). She now holds a substantial number of shares with a very low tax basis. The value of her stock holdings has grown exponentially and now represents over 90% of her total net worth.

Ava's challenge is clear: she wants to protect and grow her wealth but reduce her vulnerability to the inherent risks of a single company. However, selling her stock outright would trigger substantial capital gains taxes and erode her wealth.

This is where the Exchange Fund becomes an attractive option. Instead of selling, Ava decides to contribute a significant portion of her stock holdings to an Exchange Fund. By doing so, she greatly reduces the overall exposure to her employer without paying a hefty diversification tax.

Adero Client Case Study 2

Private Equity Partner with Carried Interest

Meet Arjun, a general partner at a late-stage growth equity fund. Four of the fund’s portfolio companies had successful IPOs in 2021 and Arjun received his share of carried interest as in-kind distributions of public stock. These stocks are now well past the initial lock-up period and are freely tradeable. However, Arjun’s cost basis is essentially zero and his management fee income puts him in the top tax bracket.

Arjun is facing a difficult dilemma: he wants to manage his downside exposure to these four individual companies while avoiding a significant tax liability.

By using an Exchange Fund, Arjun can achieve both goals. Arjun contributes the four stocks to an Exchange Fund to reduce his concentration risk while preserving the benefits of pre-tax compound growth.

Additional Use Cases for Exchange Funds

  • Managing Self-Directed Investments: You are a long-term investor holding highly appreciated stock you purchased, inherited, or received from a former employer. Use an Exchange Fund to rebalance the overweight stocks in your self-directed portfolio.

  • Hedging Short-Term Gains: You made a timely bet, however, selling before the 1-year mark will trigger ordinary income tax. Use an Exchange Fund to diversify now and extend your holding period for long-term capital gains.

  • Moving to a Zero Tax State: You live in a high-tax state and have low basis stock. Use an Exchange Fund to avoid state tax until you are ready to move, then take redemptions once you establish residency in a new state.

  • Optimizing Estate Planning: You want to leave a legacy for your family while minimizing taxes. Use an Exchange Fund to defer tax and receive a step-up in cost basis.

Conclusion and Resources

In conclusion, Exchange Funds offer a compelling solution for highly compensated individuals grappling with the challenges of concentrated stock holdings. They provide diversification, tax deferral, and professional management which makes them a powerful tool in financial planning.

For more information on Exchange Funds, you can explore these resources:

Discover how Adero Partners can help
Optimize Your Wealth with Exchange Funds

Contact Aaron White - aaron@aderopartners.com

The material presented is for educational and illustration purposes only. The case studies provided are meant to reinforce the understanding of the educational material provided. The material presented is not meant to be a recommendation and or solicitation to buy or sell any securities. Adero Partners is an investment advisory firm registered with the Securities and Exchange Commission (“SEC”). SEC registration does not imply a certain level of skill or expertise.

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