3 Tax-Friendly Investments for Wealthy Clients

QSBS Rules and Restrictions

However, there are a number of rules and restrictions to be aware of. In order to qualify for this exemption, investors must meet a number of requirements including: 

• Shareholders cannot be other corporations. Individuals, trusts and some pass-through entities qualify as eligible shareholders.
• The holding period requirements can cause clients to hold the shares longer than they might otherwise do in the event the company's shares skyrocket in value early on. Holding for the tax benefits might cause them to lose some appreciation if the shares ultimately decline after some early gains. 
• The shares must have been issued by a domestic C-corporation that is not a hotel, restaurant, financial institution, real estate company, mining company or a business involved in law, engineering or architecture.
• The shares must have been issued after Aug. 10, 1993, in exchange for money or property, not for stock or as compensation for services rendered to the company.
• As of the date of the stock issuance, the company must have at least $50 million in assets.

Additionally, small companies can be risky. While there are notable small companies like Apple that made it big, that is not always the case. Clients must weigh the risks of investing in a small company against the potential gains. 

It's important to stress both the potential risks and rewards and to help ensure that clients do not over-invest in any single small company. 

Exchange Funds

Exchange funds, also known as swap funds, are private funds designed as a solution for investors with concentrated stock positions. They are typically created by a large bank, an investment company or other financial institution. 

Exchange funds offer the option for investors with a concentrated position to exchange their shares for shares of the fund. This could include clients with concentrated positions in their company shares due to receiving stock compensation from their employer, allowing them to defer any capital gains on the shares swapped into the fund. Any capital gains will then be paid on shares of the exchange fund, if applicable, when these shares are sold. 

Exchange funds can invest up to 80% of their assets in stocks and bonds that trade on public exchanges, while at least 20% of the fund's assets must be invested in qualifying assets such as real estate holdings. 

Typically, an exchange fund might invest in a portfolio with similar holdings to a major index like the S&P 500. There are also private exchange funds that allow investors to diversify concentrated private-equity holdings. 

Exchange Fund Benefits

Potential pros of an exchange fund include: 

• The ability to diversify a client's concentrated position without triggering current tax consequences.  
• The ability to invest in a professionally managed, diversified portfolio.
• The potential for higher returns since the full amount of a concentrated position is invested with no current tax reduction. 
• Under current rules in the event of a client's death, heirs would receive the shares with a step-up in basis. 

Exchange Fund Drawbacks

Potential cons of an exchange fund include:

• In some cases, investors in an exchange fund may be required to be an accredited investor or a qualified purchaser.
• While swapping some or all of a client's shares in a concentrated position for a more diversified portfolio can have advantages in terms of diversification, it may carry an opportunity cost if the concentrated shares end up outperforming the exchange fund portfolio.
• Liquidity restrictions. Exchange funds typically require investors to hold the shares for at least seven years. Early redemptions are subject to penalties and may include shares of the stock originally contributed to the fund. 
• There could be risks associated with the real estate component of the fund in certain market environments. 
• Some exchange funds have high fees and expenses.

There are certainly pros and cons associated with an exchange fund, and these need to be weighed against each other before advising a client with a concentrated position to invest here. 

Conclusion 

Qualified opportunity funds, qualified small business stock and exchange funds all offer certain tax advantages to investors and may be appropriate for some clients. 

Depending upon a client's situation, there may be other options to defer or offset taxes on certain investments. A 1031 exchange can be a good solution for real estate, a 1045 for qualified small business stock, and an installment sale or a variety of charitable strategies. 

Clients, with individual situations, depend on financial experts to find the right strategies to help them invest as tax-efficiently as possible while minimizing their risk.