College of William & Mary Law School

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 the underlying asset Exercise Method American -- exercisable by owner at any time prior to the expiation date Physical; or Cash Settlement — payment of cash in the amount by which the option is in-the-money American; or European — exercisable by owner 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 Shareholder t Single Stock return! At maturity. maximum of l) zero and 2) (put strike minus stock price) x number of optiortinfront premium Shares as collateral (if client borrows apinst the Loan (Optional) Counterparty 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. Shareholder Single Stock teLIJITIS At maturity, maximum of. I) zero and 2) (put strike minus stock price) x number of options I At maturity, maxitnum of I) zero and 2) (stock price minus call strike x number of options Shares a s collateral Tan Nitconai Counterparty 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. Put exercised and call expires Call exercised and put expires Both put and call expire Single Financial Contract Probably a capital gain; possible to ensure that gain is capital by selling contract Probably a capital loss; if loss is treated as ordinary it is subject to 2% misc. itemized deduction; possible to ensure that loss by selling contract prior to maturity, straddle rules apply to defer losses No tax event Two Separate Option Contracts Gain on put, net premium paid, is short term capital gain; premium from call is short term capital gain Amount deemed paid for put is long tam capital loss; excess of cash paid on call over premium deemed received is a capital is capital loss (which would be long term if straddle rules apply); straddle rules apply to defer losses and may apply to defer loss on call Premium deemed received from call is 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) (2) (3) 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 The investor does not participate in any upside appreciation on tb.) position above the call strike price 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 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. (5) 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: Share-, pledged as collateral Upfront payment ifSM < hedcol value. SM x k undalying alums 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 of real 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 seven-year commitment. Although the units can be borrowed against, usually up to about 35% of their value, this strategy is not designed to produce cash flow. F. A by-product of the exchange fund's inherent illiquidity is that it may offer estate planning advantages. Some discount could be taken with respect to any transfer of units because full redemption might not be possible until the end of seven years. In addition, several recent funds have offered an estate freeze feature, pursuant to which the investor accepts a longer lock-up, generally around 15 years, and divides his or her shares into common and preferred units. Besides the discount available because of the restrictions on getting out of the fund, the fact that the fund consists of unrelated investors allows a &tete to be structured that is not subject to Chapter 14 of the Code. Thus, the investor can accomplish an estate freeze by keeping preferred units carrying a fixed cumulative, but not compounded, dividend and giving away common units representing all appreciation over and above that fixed rate. IV. Charitable Remainder Trusts A. The benefits of a charitable remainder trust ("CRT") as a diversification strategy are well known and will not be repeated in any detail in this outline. Basically, because the trust is a tax-exempt entity, the contributed assets (often a single, highly appreciated stock) can be sold without any immediate tax consequences. Instead, the gain is realized (after any ordinary income) by the non-charitable ibis 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. I 3 - EFTA01091845 beneficiaries only as paid out in the form of annuity or unitrust payments. The benefits of this deferral can be enhanced by using a net income charitable remainder unitrust, either with a make-up provision ("NIMCRUT") or without ("NICRUT"). B. The opportunities offered by CRTs were broadened recently by the publication of final regulations approving the use of "FLIP" unitrusts. FLIP trusts are trusts that are NIMCRUTs or NICRUTs to a certain point and then "FLIP" into regular unitrust status. This allows the deferral of an income-only trust to be combined with the certainty of a normal unitrust. Although FLIP unitrusts were never mentioned in the Code or regulations, people started using them years ago, often as retirement fluid substitutes. In proposed regulations in May of 1997, the IRS required that a FLIP trust be composed of at least 90% unmarketable mats and that the FLIP be triggered only by the sale of those assets. The final regulations dropped the unmarketable asset requirement and provide that the FLIP must be triggered on a specific date or by an event the occurrence of which is not within the control of the trustee or any other person. Thus, for example, the attainment of a certain age, the sale of unmarketable assets, the birth of a child, and (interestingly) marriage or divorce are acceptable triggering events. A decision by a trustee or financial advisor or request from a beneficiary is not. If the trust is a NIMCRUT, no make-up may be made after the conversion date. The determination of when to use a NIMCRUTNICRUT and when to use a FLIP trust depends upon the goals of the grantor. Generally, the FLIP trust is appropriate when the aim is a steady income stream after a certain date (for example, a retirement fund, as mentioned above). A NIMCRUT/NICRUT provides greater flexibility and potential tax deferral. C. Historically, CRTs structured as non-affiliates (i.e., with independent trustees) have been used to achieve diversification with tax deferral and, perhaps just as important to executives, no filing requirements other than a Form 4 or Form 5 showing the initial donative transfer to the trust. I. In March 1999, the SEC published a Telephone Interpretation (Division of Corporation Finance Manual of Publicly Available Telephone Interpretations Supplement —March 1999, Rule 144, IS Rule 144 (a) (1) (2). telephone interpretations are a less formal set of interpretations than "no action" letters) taking the position that when the grantor/beneficiary of the CRT is an affiliate, the trust shall be deemed an affiliate, even if there is an independent trustee. 2. If the trust can qualify as a non-affiliate and if the shares have been owned and fully paid for by the grantor for at least 2 years, under Rule 144(k) of the Securities Act of 1933. There is no Form 144 filing requirement at the time of a sale and no volume limit on sales (although the trust's sales will count against the grantor's volume 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. 14- EFTA01091846 If the trust is considered an affiliate, the same 144 rules applicable to the grantor will apply to the trust. 3. The Telephone Interpretation relies heavily on the idea that the grantor has retained a current income interest in the trust and, therefore, the sale of securities is on his behalf. Thus a NIMCRUT/NICRUT might produce a different result, as no sale would be required and the receipt of income would be dependent upon a decision by the trustee to take the action necessary to produce income. 4. In any event, it is unclear how authoritative the interpretation should be considered. Its holding is contrary to the SECS traditional position and may be a case of a not-too-well thought out response to a question that shouldn't have been asked in the first place. 5. Regardless of the resolution of the Rule 144 issue, a CRT with an independent trustee should be exempt from the short-swing profit rule of Section 16 (b) of the Securities Exchange Act of 1934 because it is a gift (Rule 16b-5). The initial transfer to the trust is reportable on either Form 5 or 6 (Rule 16a-3 (1) (1) (i); but if the trustee of the CRT is an independent person (i.e., neither the grantor nor a family member living with him), neither the grantor nor a family member has investment control over the trust, and the trust does not own more than 10% of the outstanding shares of the company, transactions by the trust should not be reportable by the grantor and should not trigger the short-swing profit rule (Rule 16a-8). V. Restrictions and Limitations A. Diversification strategies are not inherently subject to security law restrictions and limitations other than those that are part of the structures themselves (e.g., an exchange fund is a private offering for which only qualified purchasers are eligible). As a practical matter, however, a very high percentage of those seeking diversification hold restricted stock or are considered to be "insiders" under the securities laws; often they are shareholders in newly public companies, and are also subject to contractual lock-up" periods. Accordingly, a brief review of the pertinent restrictions is helpful in understanding when a diversification strategy is appropriate. 1. Rule 144. Rule 144 of the Securities Act of 1933 governs the sale of restricted and control securities. Restricted Securities are shares acquired for investment in a nonpublic transaction from the company or from an affiliate of the company. Control Securities are securities acquired by an affiliate in any manner, including open market purchases. An affiliate is defined as any person or entity that directly or indirectly controls the management and/or activities of the issuing company. Affiliates usually include a company's senior management, 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. 15- EFTA01091847 directors, and beneficial owners of more than 10% of the company's stock (this is a factual determination, hence, a 10% shareholder who is not in control may not be considered an affiliate). The following apply to sales of restricted stocks: a. Anyone (affiliate or non-affiliate) who sells restricted stock must wait one year after they have paid for the stock in full before selling ("holding period"). In an IPO situation, sellers must wait until at least 90 days after the company's IPO (usually extended to 180 days contractually). There are limits on the number of shares that can be sold in any three month period ("volume limits") equal to the greater of 1% of the class of securities outstanding and the average weekly reported trading volume during the four preceding weeks. These limits apply until the shareholder has not been an affiliate for three months, and has held the shares for at least two years. The "manner of sale" restriction prohibits the selling broker from soliciting buyers other than brokers who expressed interest within the last 60 days and customers who expressed unsolicited interest within the last 10 days. A Form 144 must be sent to the SEC no later than the day of the trade. All of these restrictions, except the holding period, also apply to control stock. 2. Hedging Rule 144 stock. Generally, restricted stock should not be hedged until at least 30 days after the private placement in which it is received. In practice, the contractual lock-up probably restricts hedging for a longer period. The industry consensus is that it is not necessary to file a Form 144 for a cash-settled hedging transaction. There is no rule that specifically requires affiliates or non-affiliates to follow the "volume limits" when hedging, but many advisors believe those limits apply implicitly. Affiliates' hedging trades will eventually become known through filings under Section 16 of the Securities Exchange Act of 1934 and hedging trades by affiliates or non-affiliates may become known through Section 13 (d) filings. 3. Section 13(d). Section 13(d) of the Securities Exchange Act of 1934 applies to all beneficial owners of more than 5% of a class of publicly traded voting equity and requires that an investor file an initial report of ownership with the SEC after the 5% threshold is crossed and subsequent amendments when more than 1% of the class is bought, sold, or pledged. Pre-IPO holdings can often be reported on Schedule 13G, rather than the more detailed Schedule 13D. Schedule I3G has two additional advantages over Schedule 13D: it usually only needs to be filed annually and amendments can often be handled in the annual filings rather than within 48 hours, as Scheduled 13D requires. However, if the owner's level of ownership changes by more than 2% of the outstanding shares of the class in any 12-month period, the owner will have to file 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. 16. EFTA01091848 reports on Schedule 13D. Buying put options and selling call options are generally considered a "sale" of shares whenever the options arc exercisable within 60 days and must be reported promptly at that time by a seller who file Schedule I3D if "material" (a transaction that include 1% or more or a class of public equity is considered "material"). Whether the option is exercised or not should also be promptly reported by the seller, if material. 4. Contractual lockup. Separate and different from Rule 144, in an IPO situation the company and/or the underwriter may ask the shareholder to sign an agreement that prohibits selling, and sometimes hedging, the stock for a period of time that can be as short as 90 days or as long as one or two years (180 days is typical). If one has the ability to influence the language used in your specific agreement, language should be drafted that does not unduly limit the ability to hedge the shares. 5. Section 16 (and insider trading rules). If the shareholder will be an insider or an affiliate of a newly public company, the shares he or she owns are subject to the complicated Section 16 "shod swing profit" rules, which are meant to discourage insider trading and require insiders to give up any profits on purchases and sales that are made within 6 months or each other. These rules can apply to transactions before an IPO (e.g., if shares are purchased 3 months before TO and sold 2 months after). The insider is liable not only for his or her own trades, but also for trades made by any person or entity deemed to be the same "person" as the insider. Examples of this include a family member who shares the insider's residence and a trust for which the insider acts as trustee and in which the insider has a "pecuniary interest." Since most hedging strategies are reportable as a "sale" under Section 16 (requiring that a Form 4 be filed within 10 business days of the start of the month following the hedging transaction; note that a variety of news services such as Bloomberg monitor these filings and may report the transaction as a sale) at inception, an insider will always need to consider whether he or she has made any purchases in the 6 months before the hedging trade or anticipates making any purchases in the 6 months after the inception of the trade. In addition, it is likely that insiders would need to report a "purchase" of the shares at maturity of a hedging trade. Accordingly, a hedge should be structured with a term greater than six months. There should also be other assets available to satisfy any obligation at maturity since the individual would have to wait six months after the maturity of the hedging transaction before selling shares in order to avoid short swing profit issues. This educational presentation Ls 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. I7- EFTA01091849 Finally, if the shareholder is considered an insider or affiliate, the counterparty will need to confirm that the company does not have any p