The exchange fund 7-year "lockup" is likely a myth
Investors often have liquidity... with some conditions
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Disclaimer: This is educational content. It is not investment, tax, or legal advice. It is not an endorsement of any strategy or product vendor. Consult an adviser about your particular circumstances, the partnership in question, and the conditions, risks, and tradeoffs.
It’s fashionable to dunk on exchange funds for lack of liquidity.
A traditional exchange fund is a partnership that accepts individual stocks from several different persons, forming a more or less diversified portfolio without incurring tax, in exchange for partnership interests.
Exchange funds have been around for decades and are popular for their simplicity and how fast they transform a concentrated public stock position into more diversified exposure.
That said, many advisers don’t like exchange funds because they feel their clients’ assets have to trudge through a 7-year “lockup.”
“The tax law requires a 7-year holding period for the tax benefits,” Srikanth Narayan, the founder of Cache, which manages several exchange funds, told me, while also explaining it’s possible for “an investor can get out with their stock a month after joining.”
The point of this article is to make the case that “lockup” is likely a heavy-handed choice of words in this context.
But, there are several intertwined concerns partners need to weigh when exiting before the end of year seven:
It is usually possible to access liquidity before the end of seven years
There are usually fund disincentives meant to maintain the integrity of the fund by discouraging early exit
A partner will nearly always get their exact shares back
Any diversification benefits are gone
There might be some gain recognition depending on what is distributed
There may also be a reporting requirement if redeemed within 2 years
“Be careful when distributing marketable securities,” Martin E. Mooney wrote in a Frost Brown Todd blog post, which is why it’s important to have an adviser or attorney closely examine the facts and circumstances for the strategy and specific fund in question.
While there are other considerations (e.g., cost, customization, tracking error, etc.), the speed of diversification is compelling, and so the “lockup” is worth unpacking.
At the highest level, this boils down to tax rules and fund disincentives. This article talks mostly about tax rules as the motivating force for the seven-year investment, and briefly mentions fund rules, but saves that topic for a future article.
Where does the 7-year “lockup” idea come from? And what other rules should investors know about? That’s what we’ll get into next.
The 7-year misunderstanding
§721 generally governs tax-free contributions into a partnership.
§731 generally governs tax-free distributions from a partnership.
Lots of shenanigans are possible in partnership contributions and distributions, so lawmakers created the disguised sale (§707) and anti-mixing-bowl (twins §704 and §737) rules to prevent investors from avoiding tax.
The classic example of a disguised sale is when a partner contributes appreciated stock to a partnership and the partnership immediately gives them cash.
It’s not technically a sale… but the disguised sale rule means it’s taxed like one.
Within two years of contribution, there are some special rules requiring partners to explain why they received a distribution. More on this in a minute.
Until the end of year seven, the so-called “anti-mixing bowl” rules kick in.
An example is when a partner contributes appreciated stock and, before the end of seven years, receives another partner’s stock, cash, or other property they did not contribute.
In this case, the anti-mixing bowl rules effectively prevent partners from exchanging property without recognizing gain.
There are other details to keep in mind, like income and expense allocations, and many tax rule exceptions to exceptions, and also fund disincentives, that all deserve a close look from a qualified adviser/lawyer.
But the origin of the seven-year misunderstanding, I think, helps us see why it’s generally not a “lockup.”
The Frost Brown Todd blog post I mentioned earlier has a checklist for non-cash property distributions and is worth reviewing closely, but let me just call out this chunk, which reiterates the points I made above more formally…
Sections 704(c) and Section 737 of the Code [anti-mixing bowl rules] operate in tandem to prevent disguised exchanges of property between partners. In general, under Section 704(c) of the Code, when a partner contributes property with a value that differs from its tax basis [😃 nearly always the case with an exchange fund], the contributing partner will be allocated any unrealized gain or loss associated with the property when the property is sold. Section 704 extends its reach in the circumstance in which property with built-in gain is contributed by a partner and [here’s the part we care about 👉 ] the same property is distributed to another partner within seven years of the initial contribution…
Emphasis and [comments] by Tax Alpha Insider
Before the end of seven years, distributing mixed assets almost certainly requires, to some extent, someone to pay tax.
Okay, but what about the no-mixing case?
What if I contribute some hypothetical, appreciated AAPL shares and then take back the exact AAPL shares a year or so later?
There are a couple of things to keep in mind in this very simple case:
Entrepreneurial risk
The nature of the distribution, namely…
Who contributed it
What it is
Entrepreneurial risk
Redeeming within two years means the disguised sale two-year lookback provision kicks in by default.
Treas. Reg. § 1.707-3 says: “Transfers made within two years presumed to be a sale.”
The word “Presumed” seems to put the partner, by default, in the position of defending the distribution, “unless the facts and circumstances clearly establish that the transfers do not constitute a sale.”
What are the “facts and circumstances” the partner needs to have ready to make the case that this wasn’t a sale, so gain need not be recognized?
This seems to hinge on the “entrepreneurial risks of partnership operations” (also mentioned in Treas. Reg. § 1.707-3), among other things.
Now we’re in a situation where someone (usually an attorney) has to take a position on whether a contribution to an exchange fund meant entrepreneurial risk1.
This piece makes no such judgment, and, again, readers should consult their adviser/attorney for guidance.
Anyway, I put this exact question about “entrepreneurial risk” to the folks at Cache, who had already thought about it, and they quickly sent me a quote from one of their private placement memoranda.
The relevant points are that, generally, and specifically with respect to the partial PPM they shared, they believe their structuring and management of this particular fund constitute entrepreneurial risk, so that a redemptive distribution within two years would not be treated as a disguised sale.
These early redemptions are an exception, though.
“If there are redemptions due to life events, we can work around that,” Srikanth, of Cache, explained, offering that their partner network and closing frequency would allow them to manage fund risk without much trouble.
Still, they want partners who are okay with a seven-year hold because it aligns everyone’s interests and maintains the integrity of the partnership.
The nature of the distribution
This is a technical point, and is relatively more straightforward in the case we’re working through.
Essentially, the Code provides exceptions when a person redeems the shares they contributed (though different types of property may have different rules, so it’s worth verifying with an adviser).
Who contributed it
26 CFR § 1.737-2(d)(1) says that “Any portion of the distributed property that consists of property previously contributed by the distributee partner (previously contributed property) is not taken into account in determining the amount of the excess distribution or the partner’s net precontribution gain.”
This essentially means, in this specific example, that we don’t have to worry about recognizing gain because the shares were already ours, as long as they’re not mixed with anything else.
What it is
Generally, “marketable securities” are considered cash for distributions. That would be problematic for the disguised sales rules mentioned above. But there’s another exception. §1.731-2(d)(1)(i) says the marketable-securities-as-cash thing does not apply if “The security was contributed to the partnership by the distributee partner.”
I’ve surely left out some cases, and generally, this is where an adviser/lawyer should carefully review the exact circumstances.
But, these considerations seem to satisfy the withdraw-the-same-shares-within-two-years-without-recognizing-gain case.
Zooming out
Back to the original question: Is the 7-year “lockup” really a lockup?
Within two years, the disguised sale rule kicks in, and although there are consequences worth considering, there seem to be circumstances where redeeming originally contributed shares is possible without gain recognition.
After two years, the anti-mixing bowl rules kick in and effectively also say that redeeming originally contributed shares likely does not require gain recognition (though there could be technical reasons gains might need to be recognized, so check with an adviser/lawyer to confirm).
After seven years, partners are generally able to redeem a diversified slice of the partnership without recognizing gain, since the disguised sale and anti-mixing-bowl rules generally no longer apply.
So, the idea of a “lockup” seems overblown, and liquidity is possibly much more readily available as long as partners mind the disincentives and the tax rules.
Note: Cache Financials Inc. (“Cache”) paid to make this article publicly accessible. They had no control over the analysis or content, and Tax Alpha Insider retained full editorial independence.
By the way, would you trust the position spit out by ChatGPT, Claude, Google’s Gemini, Perplexity, etc.? I didn’t think so.
All I heard was Swedish Fish 😋