Mark P. Gergen (UC-Berkeley) & Adam Nguyen (UC-Berkeley), Exchange Funds at the Back End, 187 Tax Notes Fed. 293 (April 14, 2025):
In this article, Gergen and Nguyen explore the application of section 731(c) to distributions of publicly traded securities from an exchange fund.
The impetus for this article is a phone call one of us received from a reporter inquiring about Cache, a new player in the exchange fund field that has significantly lowered the minimum wealth and investment requirements for investing in an exchange fund. Exchange funds (aka swap funds) have been around since the middle of the 20th century. They enable a group of people who have concentrated positions of appreciated stock in different companies to diversify by combining their stocks in a pool. These pools used to be organized as corporations, but tax partnerships have long since taken over as the preferred vehicle. By lowering minimum wealth and investment requirements, Cache is making exchange funds available to people who aren’t particularly wealthy but have a large nest egg concentrated in one company. Individuals who received equity compensation are the classic example.
The Cache website tells people that after seven years a participant can liquidate their interest in the fund by taking a distribution of a diversified portfolio of publicly traded securities — without tax. We wondered how this was possible under section 731(c), which treats marketable securities as cash for purposes of partnership distributions. If someone contributes stock of one company with basis of $10 and fair market value of $100, then receives a basket of marketable securities worth $100 after seven years, why doesn’t the distribution cause the distributee to recognize $90 of gain under section 731(a)(1)? We couldn’t find an answer to this question in the handful of published papers on exchange funds. These papers invariably focus on the front end and avoiding section 721(b) in connection with forming the fund. Section 721(b) overrides the usual rule of nonrecognition that applies to contributions of property to a partnership when the partnership would be treated as an investment company if incorporated (an investment company partnership). There is no discussion of the back end. The seven-year holding period referenced by Cache is clearly designed to avoid a participant recognizing built-in gain on contributed stock under section 704(c)(1)(B) and section 737’s seven-year lookback as well as section 707’s shorter two-year presumption. But what of section 731(c)?
This article seeks to answer that question.
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