If you’ve received a significant share of company stock, or your positions have grown meaningfully post-IPO, you may be searching for strategies to mitigate downside risk and diversify your portfolio. However, selling appreciated stock can create significant tax implications—ultimately impeding your desire to sell.
For certain high-income individuals, there is a way to defer tax liability while achieving diversification. Exchange funds can provide protection from single stock concentration, but there are important considerations to weigh before moving forward with this strategy.
What is an Exchange Fund?
An exchange fund is an investment vehicle developed to assist investors with low-basis concentrated stock, allowing them to mitigate single stock risk by exchanging some or all of their concentrated stock position into a diversified portfolio in a non-taxable transaction. It can be used on its own to diversify your holdings or as part of a multi-layered diversification strategy.
This tool is particularly useful for employees and executives with overly large positions of company stock who would like to avoid selling their shares currently and triggering a taxable event (which may result in hefty capital gains).
Participating in an exchange fund may help some investors mitigate concentration risk and achieve other meaningful benefits, but it comes with some important considerations and caveats, including a lack of liquidity and stringent investor criteria.
Who May Benefit From Exchange Funds?
Exchange funds are generally an attractive option for people who have accumulated meaningful positions of a single stock. Often this includes employees and executives of companies with lucrative holdings from equity compensation awards—though it may also be useful for investors who’ve seen significant growth in one particular stock within their portfolio.
Some common examples of investors who may benefit from exchange funds include:
- Corporate executives who receive large portions of their compensation package as equity.
- Long-term employees with low-basis stock and post-IPO stock appreciation.
- Other early-stage, long-term employees who accumulate stock over many years of purchases through various equity compensation programs.
It’s important to note that in order to participate in an exchange fund, you need to satisfy certain criteria including importantly being an accredited investor or qualified purchaser.
You can meet the “accredited investor” criteria as an individual investor if you have either:
- $1 million or higher net worth (excluding your primary residence), or
- Income over $200,000 (or $300,000 if married) over the past two years, and you anticipate the same income for the current year.
A qualified purchaser will be an individual who owns at least $5 million in investments, again excluding primary residence. This term may also apply to trusts or institutional buyers, though their investment minimums are often larger.
How Does an Exchange Fund Work?
An exchange fund is structured as a limited partnership, and participants are considered “partners” in the fund. Typically, as we mentioned earlier, these participants are executives or highly compensated employees with significant holdings in company stock. Each investor contributes shares of a single stock to the fund.
In exchange for the shares, they receive a partnership interest in the fund—an interest that includes a diversified portfolio of stocks. Typically, the exchange fund is intended to model a popular index, such as the S&P 500. For this reason, supply and demand do come into play, as the fund manager must be cognizant of how the holdings are balanced. If a fund is oversubscribed to a certain position, you may not be able to contribute your stock immediately (or at all). Instead, you may need to hold off until a new fund is created that can accommodate your offerings.
Once your stock has been exchanged within the fund, you receive a pro-rata share of the entire portfolio. The immediate and most desired investor benefit is the ability to transform a single company stock position into a diversified basket of securities that attempts to track a popular index in a single transaction.
Once you’ve contributed a portion (or all) of your company shares into an exchange fund, your portfolio’s future performance will be subject to the exchange fund’s overall, diversified performance (as opposed to your individual stock performance).
Breaking Down the 7-Year Timeline
To be eligible for the tax benefits offered by exchange funds, the IRS has mandated that partners are committed to a seven-year holding period. After year seven, an investor can elect to redeem from the fund based on their pro-rata share, receiving a diversified portfolio of stocks in a non-taxable transaction. They can also elect to continue in the fund.
What If I Want to Get Out Early?
Exchange funds are not suitable for those looking to access liquidity in the short term. Once you’ve contributed your shares, the partnership will typically require a lock-up period (different than the IRS mandated lock up) during which time you cannot access the funds. This is done to help ensure the fund mirrors the intended index and protects all participants’ interests—since selling off shares quickly could disrupt the fund’s carefully curated balance. It’s not unusual for lock-up periods to last two years or longer, during which you’ll likely incur an early redemption fee.
If you choose to withdrawal early, you’ll often be distributed your proportionate value of your original shares, and such early withdrawal can result in the loss of tax deferral as well as fees or penalties imposed by the fund provider.
How Is an Exchange Fund Taxed?
Let’s review the tax treatment of your employer stock based on the typical timeline of participation:
Initial Contribution: The initial exchange of stock for a partnership interest in the exchange fund is a tax-free event, free of capital gains or recognized income.
Commitment period (7 years or longer): While invested in the fund, you will be subject to the annual taxable events associated with the fund itself, which will be reported on a K-1 at year-end. Typically, exchange funds are invested to maximize after-tax returns and mitigate taxable events.
Redemption: The tax treatment of your stock is similar at redemption as it was when you made the initial contribution. When you choose to withdraw from the fund, your fund share is a tax-free exchange.
Going forward, the cost basis of your redeemed fund share will be determined by your cost basis of the original employer stock at the time of contribution plus any increase in basis during the life of the fund.
Potential Benefits and Considerations of Exchange Funds
With a general understanding of how exchange funds work and who they may benefit, let’s get into the possible pros and cons of pursuing this sophisticated diversification strategy.
Benefits
Exchange funds enable investors to achieve a more desirable level of diversification without triggering a taxable event. An exchange fund can mitigate single stock risk by swapping such stock for a diversified portfolio allowing you to mitigate risk quickly while controlling when (or even, if) you sell your shares of company stock. While exchange funds include a seven-year commitment period, there’s no requirement to sell as soon as the seven-year mark hits.
You have the flexibility to stay invested in the fund until you believe it’s the right time to sell off your shares—say if you’re experiencing a lower-than-usual tax year. While you wait for the optimal time to offload your shares, an exchange fund enables you to avoid some of the concentration risk that comes with keeping too many eggs in one basket for an extended period of time.
In addition to mitigating concentration risk and potentially deferring tax recognition, an exchange fund can also be a useful tool for estate planning. Since there’s no obligation to redeem your share of the fund after the seven-year commitment period, you have the option to continue participating in the fund indefinitely—which could serve you well as part of a wealth transfer strategy.
If your beneficiary receives the fund share as an inheritance, they will enjoy a step-up in cost basis and not have to pay taxes on any appreciation within the fund so far. The original cost basis is replaced with the value of the fund share on the day of your death, meaning your loved one could immediately redeem and sell the shares with potentially little to no tax liability (or continue to let them grow).
Just keep in mind that the value of the fund share does count toward your federal estate tax exemption limit, which currently is $13.99 million for 2025 and is adjusted annually.
Considerations
As with most other funds or investment opportunities, it’s important to understand what you’re investing in and what fees are involved.
We mentioned earlier that exchange fund access is limited to accredited investors and qualified purchasers. Even if you meet the investor criteria, these funds tend to have significant minimums (often $1 million or more) and space is often limited, so it may be necessary to confirm the fund’s appetite for the specific security.
With the lockup period in play, liquidity can also become a concern. To avoid early redemption fees, the soonest you’re able to access your funds penalty-free is seven years. For some, the lack of liquidity can be a challenge, particularly since it’s hard to predict how your financial circumstances will evolve in the coming years. You need to be sure your other assets can cover your potential liquidity needs—or accept that you may be stuck paying an early redemption fee if access to the exchange fund becomes necessary.
In order to maintain their preferential tax treatment, exchange funds must keep certain illiquid “qualifying assets” in the portfolio, such as real estate. The qualifying assets need to make up at least 20% of the portfolio’s total gross assets. As an investor, this is important to know since those qualifying assets may have varying levels of risk compared to traditional stocks.
Other Strategies for Reducing Concentration Risk
An exchange fund is a strategy that can be used in tandem with other diversification strategies to mitigate a concentrated position.
This is why you may want to consider other available strategies as well, including simply selling the stock outright and paying the resulting tax bill.
Let’s explore some other common strategies for reducing single-stock risk:
Consider Your Cost Basis and Holding Period
When you’re interested in liquidating stock, it’s important to evaluate all the shares you’ve acquired and compare their:
- Cost basis
- Holding period
- Taxable gain
Suppose you have shares at a capital loss and/or a small capital gain. If that’s the case, it’s reasonable to consider that your best option for selling shares is to sell them first—while retaining all lower basis shares (and higher tax impact shares) for later. In fact, you may be able to sell some shares at a loss and some at a gain, netting the two for minimal tax impact upon a sale.
Other times, selling high cost-basis long-term shares up to a prescribed tax threshold could be a fine strategy.
Fulfill Your Charitable Giving Goals
If you are charitably inclined, you may be interested in donating low-basis shares directly to a charity or a donor-advised fund (DAF).
Some charitable contributions—like donations to a DAF—generate an immediate tax benefit in the year of contribution, but offer no other financial incentive.
Other strategies, like a CRT (charitable remainder trust), can provide a tax deduction in the year of contribution and produce current (or future) income for you and your family.
Generate Cash Flow Through Lending
Other times, you may consider simply lending against a concentration position using a securities-backed line of credit. Much like a home equity line of credit against your house, you may be able to borrow against the value of your stock.
Doing so can create quick access to liquidity while avoiding a sale—ultimately generating cash flow that can be used elsewhere.
Thinking About Moving Forward? Next Steps to Take
The decision to participate in an exchange fund should be made carefully, particularly considering the lack of short-term liquidity. Start by evaluating your stock position and understanding what options you have available to mitigate concentration risk.
If you believe an exchange fund is an appropriate avenue to pursue, evaluate potential funds (remember, it may take some time to find one that fits your needs). Once you decide which shares to contribute and how much, it’s important to monitor performance and consider how you’ll leverage this tool to make thoughtful decisions regarding your tax liability.
If you’d like to discuss exchange funds in more detail or learn how we can help you optimize your equity compensation, we encourage you to reach out to our team today.
This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product.
The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions. This content is provided as an educational resource. The Zajac Group, LLC shall not be liable for any errors or delays in the content, or any actions taken in reliance thereon.
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