Swap Funds

Research Paper: “Swap Funds” Section 351(e)

Presently the law states that a contribution of property to a corporation does not result in gain or loss to the contributing shareholder if the contributor is part of a group of contributors who own eighty percent of the voting stock of each class of stock entitled to vote. Certain Internal Revenue Code sections provide exceptions to this general rule for deferral of gain and loss. One such exception requires that gains or losses be recognized upon a contribution by a shareholder to a corporation that is an investment company under §351(e). Many wealthy investors may have a large amount of stock of one company that may have appreciated in value, and for them to diversify their portfolio may cause serious tax consequences. The investors can sell the stock and incur capital gains on the amount that exceeds their basis in the stock and then use the proceeds to buy a variety of stocks to diversify their portfolio. Investors look for some way to diversify without incurring the capital gains, and for years there was a way to do just that. If there are a number of individuals each with large holdings in different types of stock, they could form a mutual fund or a regulated investment company, which is treated like a corporation for tax purposes. This is essentially like a §351 exchange; the mutual fund receives all the various stocks of the individuals, which is considered property, then issues the individuals the new fund’s stock. With this transaction the investors have essentially diversified their portfolios while maintaining some interest in the original shares, and they have escaped capital gains because of §351. These funds were known as “swap funds,” and until 1976 they escaped taxation. In 1976, Congress added §351(e) to the Internal Revenue Code, which excludes under §351 transfers to investment companies.
  For years people were creating “swap funds” to diversify their portfolios, and...