EFTA01091832.pdf

College of William & Mary Law School Scholarship Repository William & Mary Annual Tax Conference Conferences, Events, and Lectures 2004 Capital Market Exits: Planning for Restricted and Control Securities George F. Albright Repository Citation Albright, George F., "Capital Market Exits: Planning for Restricted and Control Securities" (2004). William 6, Alary Annual Tax Conference. Paper 10$. http://scholarship.law.wm.edu/tax/105 Copyright c 2004 by the authors. This article is brought to you by the William & Mary Law School Scholarship Repository. http://schobrship.law.wm.eduitm EFTA01091832  William & Mary Tax Conference The Entrepreneurial Endgame: Exit Strategies November 19, 2004 Capital Market Exits: Planning for Restricted and Control Securities George F. Albright, Jr. M . Morgan Private Bank I. Pre-Transition Event A sale of the company's stock to the public in a registered offering, or an acquisition of the company for cash or the publicly traded stock of an acquiring company provide shareholders attractive wealth transfer planning opportunities. In such case the value of closely held stock can be expected to rise as a result of the liquidity event: when stock becomes marketable following the IPO, or when shares become entitled to a proportionate share of the "enterprise" value of a company upon the company's sale. Similarly, at some point in time following an IPO, stock that was restricted in the hands of insiders will rise in value as a result of the lapse of such restrictions. Wealth transfer planning strategies implemented in a timely fashion in anticipation of such events can produce significant transfer tax and, in the case of charitable transfers, income tax savings. A. Gifts Gifts of company stock prior to a liquidity event, even if made at a stock value much higher than would have applied in the case of an earlier "cheap stock" gift, has the attraction of definitively "freezing" value as of the date of the gift and unconditionally shifts all post-gift appreciation to the gift recipient. In the case of a taxable gift, the effective rate of tax payable will also be reduced as a consequence of the "tax exclusive" method by which gift tax is calculated, assuming that the donor lives for three years following the date of the gift so as to avoid inclusion of the gift tax paid in his/her estate for estate tax calculation purposes. As in the case of early stage gifting, the effectiveness of non-freeze pre-IPO or pre-acquisition gifting can be enhanced through the use of a family limited partnership, while also accomplishing other family objectives such as consolidation of management of family wealth and continued family control. If Company stock is contributed to a FLP prior to the liquidity event and gifts are made in the form of limited partnership interest, the gifting is leveraged as a consequence of discounts available in connection with the valuation of a limited partnership interest. However, as noted earlier, care should be taken to ensure that the loss of QSBS status of the Company stock which results from the contribution of such stock to a FLP does not occur inadvertently. Similarly, gifts made to defective grantor trusts offer the additional attractions of possible future This educational presentation is intended for discussion among professionals only and is not intended for and should not be distributed to clients. It is not to be construed as legal, tax, or financial advice. Before acting on any matter discussed here, appropriate professional advice should be obtained. EFTA01091833  gift leveraging through the donor's payment of income tax attributable to the gifted stock, greatly enhanced QSBS rollover planning flexibility and the opportunity for additional gift-leveraging through installment sale techniques. B. Freeze Strategies Not surprisingly, however, clients are seldom enamored with the prospect of actually paying gift tax, particularly during an era in which call for the repeal of "death taxes" have increasingly become part of the political debate. Thus, planning in the pre-IPO and pre-acquisition setting often involves the use of "freeze" planning techniques designed to leverage the effectiveness of the limited available federal gift tax annual exclusions and the applicable credit exemption equivalent, and to minimize any gift tax liability actually incurred. A grantor retained annuity trust (a "GRAT"), an installment sale to a defective grantor trust and a partnership freeze each have attractive planning attributes in this setting. Each requires that the post-transfer compound rate of return of the asset transferred exceed the particular discount rate used to value the gift made employing the freeze technique. Those rates differ for each technique, as do other planning considerations. 1. Grantor Retained Annuity Trust. A GRAT is a trust under the terms of which the donor retains the right to receive annual fixed payments (the "annuity") from the trust for some period of time, after which any remaining trust property is distributed to (or continues to be held in trust for the benefit of) whomever the trust instrument specifies (the "remainder beneficiary") Because the donor retains the right to receive the annuity payments, the value of the gift to the remainder beneficiary not um fill value of the property placed in trust, but rather the value of that property less the present discounted value of the donor's retained right to receive the prescribed annuity payments. The Section 7520 rate is used to calculate the present value of those payments. It assumes, in effect, that the GRAT's total compound investment return will equal the rate used to make the present value calculation. Therefore, if a GItAT's investment return exceeds that rate, the excess return will pass to the trust remainder beneficiary free of additional transfer tax. This educational presentation is intended for discussion among professionals only and is not intended for and should not be distributed to clients. It is not to be construed as legal, tax, or financial advice. Before acting on any matter discussed here, appropriate professional advice should be obtained. EFTA01091834  2. Installment Sale to a Defective Grantor Trust. An installment sale of Company stock, or of a limited partnership interest in a FLP holding such stock, can also be an effective pre-IPO or pre-acquisition wealth transfer technique. In this case, the note must provide that interest will be paid at the appropriate applicable federal rate given the term of the note. Since the Section 7520 rate used to value even a short-term GRAT remainder is equal to 120% of the mid-term AFR, an installment sale is superior to a GRAT from a discount rate perspective. As in the case of a GRAT, because of defective grantor trust status, appreciated assets may be used to hind note payments without income tax consequences, and interest payments to the seller will not give rise to seller interest income (or an interest deduction for the trust payor). 3. Freeze Partnership. In many cases a freeze partnership structured to comply with the requirements of Section 2701 of the Code will be an attractive pre-IPO or pre-acquisition planning vehicle. As in the case of an installment sale for a note with deferred principal payment, a freeze partnership permits a slower payout from the freeze entity that a short term GRAT since the underlying capital allocable to the frozen interest remains invested in the partnership. Thus, the duration of the freeze can be extended without either the risk of estate inclusion (which characterizes a GRAT), or the risk of possible gain recognition at the seller's death (as a result of termination of grantor trust status in the case of an installment sale to a defective grantor trust). Like an installment sale, and unlike a GRAT, a freeze partnership can also be used in connection with GST planning. The freeze partnership has the additional advantage that preferred extending the time when all assets can remain in the freeze entity (for example, while restrictions lapse and the asset value rises). Like the GRAT or installment sale to a defective grantor trust, the freeze partnership may also distribute appreciated assets in kind without gain recognition. H. Post-Transition Event: Diversification Strategies Based Upon Hedging Transactions A. Overview The hedging and monetizing strategies (other than exchange funds and charitable remainder trusts) detailed in this presentation involve private transactions which often encompass the purchase of sale of customized equity options. In contrast, the options that most investors are familiar with are listed on an exchange ("listed options"), such as the Chicago Board of Options Exchange (CBOE) or the American Stock Exchange (AMEX), and generally have predetermined strike prices, maturities, exercise styles and settlement methods. Over-the-counter ("OTC") equity options are private agreements negotiated directly with financial institutions that can be customized to meet an investor's needs and objectives. As a result, the flexibility of privately negotiated structures relative to exchange-traded products is important in the areas of maturities, stock This educational presentation is intended for discussion among professionals only and is not intended for and should not be distributed to clients. It is not to be construed as legal, tax, or financial advice. Before acting on any matter discussed hat, appropriate professional advice should be obtained. 3- EFTA01091835  prices, size, settlement and exercise methods, with particular attention to: Exchan e Traded OTC Settlement Physical — physical delivery of Physical; or the underlying asset Cash Settlement — payment of cash in the amount by which the option is in-the-money Exercise Method American -- exercisable by American; or owner at any time prior to the European — exercisable by owner expiation date only on the expiration date Note: The Taxpayer Relief Act of 1997 effectively eliminated strategies such as short against the box, which essentially eliminated exposure to the underlying stock. Transactions entered into after June 8, 1997, which "substantially eliminate risk of loss and opportunity for gain" trigger constructive sale treatment and result in tax on the embedded gain. B. Six basic diversification strategies remain: 1. Put options 2. Covered Calls 3. Collars 4. Advance forward contracts 5. Exchange Funds 6. Charitable Remainder Trusts The first three are hedging transactions and involve limiting the risk associated with holding a single stock through the use of derivatives. Diversification is achieved by borrowing against the hedged position. C. Put Options Buying a put option gives the shareholder the right, but not the obligation, to effectively sell his or her shares to the counterparty at some predetermined price (the strike price) at some future date (the maturity date). Buying puts protects the shareholder in the event that the value of the underlying shares falls below the strike price on the option. This educational presentation is intended fur discussion among professionals only and is not intended for and should not be distributed to clients. It is not to be construed as legal, tax, or financial advice. Before acting on any matter discussed here, appropriate professional advice should be obtained. EFTA01091836  At maturity. maximum of l) zero and 2) (put strike minus stock price) x Shareholder number of optiortinfront premium Counterparty Shares as collateral (if client borrows apinst the Loan (Optional) t Single Stock return! The shareholder (put buyer) would pay the counterparty (put seller) an upfront premium, based on the strike and term of the put. The counterparty, in return, would agree to pay, at the maturity of the option, the difference between the strike price on the option and the value of the underlying shares. If the value of the underlying shares were greater than the strike price at maturity, the shareholder would lose the entire premium paid for the option. I. Tax treatment of puts. For cash settled puts, if the option expires unexerciscd, the premium paid for the put is a capital loss. If the put was used to hedge a long position in the underlying stock, straddle rules apply and the loss (which would be long term if the shares have been held for more than one year) cannot be deducted for tax purposes until the underlying shares are sold. If the put is exercised, the cash received (the put strike less the market price of the underlying stock) net of the premium paid for the put is a short term capital gain and is taxable immediately. If the shareholder borrows against the put (and the proceeds of the loan are used for investment purposes), interest expense is deductible on a current basis to the extent dividends are received on the underlying shares; interest expense in excess of dividends received is added to the tax basis of the shares. 2. Borrowing against the put. If the shareholder wants to borrow against put, the use of loan proceeds will determine the level of collateral required. If he or she intends to use the proceeds to purchase margin stock (i.e. publicly traded equities), Regulation U of the Board of Governors of the Federal Reserve Board, pursuant to the Securities Exchange Act of 1934, requires an initial collateral value of 2:1. To help reach that level of collateral, the lender can use the securities purchased by the loan proceeds as additional collateral for the loan. The proceeds of each successive loan can be borrowed against in a similar manner (i.e., stocks worth 10 covered by an at the money put supports a borrowing of 5, the stock purchased for 5 supports a farther borrowing of 2.5 and so on). This educational presentation is intended for discussion among professionals only and is not intended for and should not be distributed to clients. It is not to be construed as legal. tax, or financial advice. Before acting on any matter discussed here, appropriate professional advice should be obtained. -s- EFTA01091837  If the proceeds of the loan are not used to purchase margin stock, Regulation U would not apply, and a lender would generally lend about 90% of the hedged value of the shares (i.e., 90% of the put strike). The loan would typically be priced at a spread over LIBOR. 3. Diversification. Often the loan proceeds are used to invest in a diversified portfolio. Thus the put allows an amount equal to roughly 90% of the put strike price less the cost of the put to be diversified. The cost of a put can be reduced by using a "put spread." This provides a defined level of downside protection while reducing the upfront premium. The investor buys a put at one price and sells a put at a lower price. This effectively caps the maximum payout, which reduces the premium. For example, the investor might buy a put at 100 (the current value) and sell a put at 70.1f the price at maturity is between 70 and 100, the investor receives an amount equal to 100 less the stock price. If the price is less than 70, he receives 30 (100-70). If the price is greater than 100, he receives nothing. D. Selling Covered Calls 1. A different strategy involves selling a call on the underlying stock. The idea is that the amount received for the call can be reinvested in other assets, thus enhancing the return of the underlying stock and providing a limited amount of downside protection (i.e., the premium received effectively protects the investor against a decline in price equal to the premium). 2. At maturity, the investor (call seller) or must pay the counterparty (call buyer) the difference between the market value of the stock and the call strike. The investor's goal is to set the strike price just high enough so that he does not think the option will be exercised yet he realizes the largest possible premium (the higher the strike price, the lower the premium received). The break even price is equal to the strike price plus premium received by the investor. However, the investor does run the risk of having the stock called away. E. Collars I. Cashless Collar. A cashless collar effectively consists of buying a put and selling a call with matching maturities. Like the put, it provides protection against a decline in the stock price below some pre-determined level. However, it also reduces or eliminates paying an upfront premium for that protection by selling some of the upside in the underlying stock. This structure essentially locks in the value of the stock to a price range (or "collar") that is defined by the strikes on the put and the call. The This educational presentation is intended for discussion among professionals only and is not intended for and should not be distributed to clients. It is not to be construed as legal, tax, or financial advice. Before acting on any matter discussed here, appropriate professional advice should be obtained. EFTA01091838  shareholder would indicate the level of downside protection required (e.g., a put option with a strike 10% below the current stock price) and, for a cashless transaction, the strike on the call would be set to generate a premium that exactly offsets the premium paid for the put. It must be emphasized that a cashless collar is not costless. The cost is built into the spread. At maturity, maximum of. I) zero and 2) (put strike minus stock price) x number of options I Shareholder At maturity, maxitnum of I) zero and 2) (stock price minus call strike x number of options Counterparty Shares a s collateral TanNitconai Single Stock teLIJITIS 2. On the maturity date, one of three things will happen: a. If the stock price at maturity is between the two strike prices, no payment will be due by either party and the collar will expire worthless; b. If the stock price is below the strike on the put, the shareholder will receive a cash payment from the counterparty equal to the difference between the put strike price and the stock price multiplied by the number of the shares on which the collar is written; or c. If the stock price is above the strike on the call, the shareholder will be obligated to make a payment to the counterparty equal to the difference between the stock price and the call strike price multiplied by the number of shares. Since the counterparty has credit exposure if the stock price is above the all strike at maturity, it will require collateral to secure the transaction. 3. Tax treatment of cashless collar The following chart depicts the potential tax treatment of an over-the-counter cash settled collar where the shareholder is long the stock and the shares being hedged have been held for more than one year. It should be noted that there is a This educational presentation is intended for discussion among professionals only and is not intended for and should not be distributed to clients. It is not to be consuual as legal, tax, or financial advice. Before acting on any matter discussed here, appropriate professional advice should be obtained. EFTA01091839  considerable amount of uncertainty with regard to tax treatment. The appropriate treatment will depend on whether the transaction is viewed as a single financial contract or two separate contracts. If viewed as a single financial contract, any gain or loss would likely be capital (although it is possible the gain or loss is ordinary). In addition, if the shareholder borrows against the collar, straddle rules apply to defer any interest paid on the loan in excess of the dividend income received on the hedged shares. Single Financial Contract Two Separate Option Contracts Put exercised Probably a capital gain; Gain on put, net premium paid, is and call expires possible to ensure that gain short term capital gain; premium is capital by selling contract from call is short term capital gain Call exercised Probably a capital loss; if loss is Amount deemed paid for put is long and put expires treated as ordinary it is subject to tam capital loss; excess of cash paid 2% misc. itemized deduction; on call over premium deemed possible to ensure that loss by received is a capital is capital loss selling contract prior to maturity, (which would be long term if straddle straddle rules apply to defer losses rules apply); straddle rules apply to defer losses and may apply to defer loss on call Both put and No tax event Premium deemed received from call is call expire short term capital gain; premium deemed paid for put is long term capital loss; straddle rules apply to defer losses 4. Borrowing against the collar. If the shareholder wants to borrow against the hedged position, the use of loan proceeds will determine the level of collateral required. If the shareholder intends to use the proceeds to purchase margin stock (i.e. publicly traded equities), Regulation U requires an initial collateral value of 2:1. To help reach that level of collateral, the lender can use the securities purchased by the loan proceeds as additional collateral for the loan. In this way, the total borrowing approach the value of the collateral stock, as defined above. If the proceeds of the loan are not used to purchase margin stock, Regulation U would not apply, and the lender would generally lend about 90% of the hedged value of the shares (i.e. 90% of the put strike). The loan would typically be priced at a spread over LIBOR. 5. Constructive sale considerations. In June 1997, the Taxpayer Relief Act changed the tax rules governing certain hedges of appreciated equity positions. The Act categorizes as a "constructive sale" any transaction which substantially eliminates both risk of loss and opportunity for gain (e.g., an equity swap or short against the box). Transactions which preserve significant upside potential or downside risk for the holder (i.e., puts and properly constructed collars) should not constitute constructive sales. To help clarify the constructive sale legislation, the Conference Committee asked the Treasury to issue regulations that would provide standards for when collar transactions would result in constructive sales. The Committee stated that it This educational presentation is intended for discussion among professionals only and is not intended for and should not be distributed to clients. It is not to be construed as legal, tax, or financial advice. Before acting on any matter discussed here, appropriate professional advice should be obtained. • 8- EFTA01091840  expects that these guidelines will be applied on a prospective basis except in cases that are clearly abusive. These regulations have not yet appeared. While it is difficult to determine what may be considered abusive, it is generally believed that the legislative history of this provision indicates that a collar would not be considered a constructive sale unless it eliminated substantially all of die taxpayer's risk of loss and opportunity for gain with respect to the appreciated equity position. As a conservative "safe harbor," collars are typically structured so there is at least a 15% to 20% probability that the stock price at maturity is between the two strikes. 6. Unwinding Collars. A shareholder may want to "unwind" a collar before maturity if the stock has declined substantially and the shareholder thinks it was bottomed- out. For example, if he executes a 2-year $90/$130 collar when the share price is $100 and one year later the price has dropped to $70, he may want to cash out. The shareholder may then want to execute another collar at the new price, although if he truly believes the price will go no lower, that might not be prudent. Alternatively, if the shareholder has become bullish on the stock he may want to get out of the collar. For example, if the $100 share subject to the $90/$130 collar has run up to $135 with 12 months left to maturity, he may want to buy back the call option for, say, $11 (the $5 intrinsic value plus the plus the time value of the 12 months before maturity). If the price at maturity turns out to be more than $141 ($130 call strike plus $11 unwind cost), unwinding will have been the way to go; if not, he should have held on to the collar (with the benefit of hindsight). 7. Put Spread, Call Spread Collars. As described above with respect to put spreads, collars can be structured using spreads. In addition to the put spread, the investor would sell a call option at a strike above the current value and buy a call at a still higher price. In that way the shareholder would receive appreciation up to the lower strike, give up the appreciation between the two strikes and receive the appreciation above the higher strike. Thus, the investor can create a call spread set to generate a premium to offset the put spread, while achieving a substantial amount of downside protection and retaining a lot of the upside. 8. Advantages and Risks of Collars a. Advantages (I) The investor has limited downside protection on the position from the high put strike price down to the low put strike price (2) The investor participates in appreciation on the position up to the call strike price (3) The investor retains ownership and voting rights on the position This educational presentation is intended for discussion among professionals only and is not intended for and should not be distributed to clients. It is not to be construed as legal, tax, or financial advice. Before acting on any matter discussed here, appropriate professional advice should be obtained. -9- EFTA01091841  (4) Regular common cash dividends are generally retained by the Investor (5) The costless put spread collar permits the investor to participate in more upside than the standard costless collar (6) If the investor executes a costless put spread collar, no upfront option premium is paid (7) The investor has flexibility in determining the minimum and maximum value range of the position (8) Cash settlement of the OTC costless put spread collar also defers a sale of the position b. Risks (I) Unlike a standard costless collar, the downside protection is capped in a put spread collar. the investor is only protected between the high put strike price and the low put strike price (2) The investor does not participate in any upside appreciation on tb.) position above the call strike price (3) The investor will also be exposed to the price difference between the current market price and the high put strike price (as with a standard costless collar) (4) The seller of the collar must be able to borrow and sell short shares of the position in order to offer the transaction (5) Generally, an investor will only be able to collar 5 times avenge daily trading volume F. Prepaid Forward Contracts 1. A prepaid forward contract locks in a minimum price for the stock, which is paid upfront, and allows the seller the opportunity to participate in some portion of the potential upside in the stock. At maturity, the shareholder simply delivers some or all of the shares hedged, depending on the stock price, or cash of equivalent value. In the interim, the shareholder continues to receive any dividends paid on the stock and retains the voting rights associated with the hedged shares. The shareholder defers any capital gains tax liability which may arise from the sale of the stock for the term of the trade. Final Stock Price Amount Owed Final Stock price < hedged value Market Value of shares Hedged value <fmal stock price<upside limit Hedged value of shares Final stock price > upside limit Hedged value of the shares plus the appreciation above the upside limit This educational presentation is intended for discussion among professionals only and is not intended for and should not be distributed to clients. It is not to be construed as legal, tax, or financial advice. Before acting on any matter discussed here, appropriate professional advice should be obtained. 10- EFTA01091842  2. Potential Tax Treatment As previously mentioned, in June 1997, the Taxpayer Relief Act changed the tax rules governing certain hedges of appreciated equity positions. The Act categorizes as a "constructive sale" any transaction which substantially eliminates both risk of loss and opportunity for gain (e.g., an equity swap or short against the box). Transactions which preserve significant upside potential or downside risk for the holder (i.e., puts and properly constructed collars) should not constitute constructive sales. A prepaid forward contract like the one described, which preserves significant upside potential in the stock, should not trigger a capital gain on the underlying shares when the transaction is entered into. Instead, the transaction would only give rise to a taxable event when the shareholder closes out the transaction by delivering the shares. The shareholder would have long term capital gain (assuming the shares are held for longer than 12 months at inception) at that time equal to the excess of (i) the proceeds received at the inception of the transaction over (ii) the tax basis of the shares delivered to close out the transaction. Advance Forward Contract Single Stock 4 returns Shareholder At maturity dient Nys an amount in cash or shares equal to: ifSM < hedcol value. Share-, pledged SM x k undalying alums as collateral Upfront payment if hedged value < SM < upside limit. Hedged value x ft undedytng shares if S M > upside limit Fledged value x it underlying shares + (SM — upa‘le Emit)x ft undatyingthn Counterparty SM = Stock price at maturity This educational presentation is intended for discussion among professionals only and is not intended for and should not be distributed to clients. It is not to be construed as legal, tax, or financial advice. Before acting on any matter discovvPil here, appropriate professional advice should be obtained. EFTA01091843  If the transaction is cash-settled, the shareholder would recognize a short term capital gain or loss equal to the difference between the amount received upfront and the cash owed at maturity. A loss would likely be considered a straddle for tax purposes and, if so, would be deductible only when the underlying shares are sold. G. Comparison of Collar with Loan and Prepaid Forward Contract 1. The primary deciding factor is whether the shareholder wants the loan at the time of the transaction or may want to pay the loan off prior to maturity. The prepaid forward contract effectively requires the loan to be made and to remain outstanding because the amount of cash received at the outset reflects the implicit payment of interest over the term. With a collar, the loan may be taken and paid off as needed. 2. If the loan is to be used for investment purposes, the collar is more attractive because interest may be deducted on a current basis up to the amount of dividends received on the shares. With the prepaid forward contract, interest is paid in the form of a discount on the proceeds received up-front and is not deductible. III. Exchange Funds A. Exchange funds are private funds, usually limited partnerships or LLCs, to which an investor contributes a single stock in return for an interest in the fund. Under currcnt tax law, investors may redeem their units after seven years for a pro-rata share of the underlying securities without incurring capital gains tax. They do, however, receive the same basis in those securities as they had in the stocks originally contributed. B. The contribution of securities in exchange for units in the fund does not trigger a capital gains tax and does not require a section 144 filing for a holder of control or restricted stock. A form 4 filing to report a change in beneficial ownership, however, would be required of an insider. In addition, a contribution to the fund in exchange for units is considered a sale for purposes of section 16. Accordingly, a purchase within six months of the exchange could trigger the short-swing profit rules. Also, insiders cannot enter the fund during blackout periods. C. As noted above, redemption after the seventh anniversary of the closing results in the investor receiving a pro-rata share of the underlying securities without any income tax consequences. Prior to seven years, but after two years, an investor may redeem his units in return for an amount equal to the lesser of the fair market value of the contributed securities and the net asset value of the investor's units in the fund at the time of the redemption. If the redemption is accomplished by the distribution of the securities the investor contributed, there is no taxable event. If, however, cash or other securities are distributed, gain is recognized in an amount This educational presentation is intended for discussion among professionals only and is not intended for and should not be distributed to clients. It is not to be construed as legal, lax, or financial advice. Bcforc acting on any matter discussed here, appropriate professional advice should be obtained. 12• EFTA01091844  equal to the least of(i) the excess of the fair market value of the distributed securities over the adjusted basis of the investors units immediately before the distribution reduced by the money received in the distribution, (ii) the excess of the fair market value of the contributed securities over the adjusted basis of those securities when they were contributed, or (iii) the excess of the fair market value of the contributed securities over the adjusted basis of those securities at the time of the distribution. Prior to two years after the closing, the same tax rules apply, but generally the investor can only request, not demand, a redemption. D. Under Section 721 of the Code, no gain or loss is recognized upon a contribution to the fund in exchange for an interest therein so long as the fund would not be treated as an investment company (within the meaning of section 351) if it were a corporation. In order to avoid classification as an investment company, not more than 80% of the assets can be marketible "stock or securities" held for investment. Generally, the non-marketable portion of the funds assets consist ofreal estate, most often preferred equity interests in operating partnerships (or LLCs) affiliated with REITs. These qualify as something other than stocks or securities under section 351 (e). The non-marketable securities typically are purchased with borrowed funds. The manager must not have the intent to reduce the non- marketable portion of the fund below 20%, but after the closing that portion may be reduced. E. A downside to exchange funds is their illiquid nature; a