Investment advisers who manage client assets in separately managed accounts (SMAs) may encounter challenges scaling their products or executing certain strategies within an SMA. Advisers may want to consider supplementing their product suite with mutual funds, which don’t have these limitations.
SMA holdings can be transferred in-kind to a newly organized mutual fund as a tax–free transaction. Assuming the transaction will benefit the SMAs; this is also an efficient approach to seeding a fund. Generally, the impacts of the transaction are:
• Each SMA retains its cost basis and holding period, which are allocated to fund shares
• The fund receives the carryover basis and holding period of the contributed assets
• SMAs with net depreciation receive a downward basis adjustment
• Gains generated by subsequent sales of contributed assets are taken pro rata by all fund shareholders at the time the gains are distributed by the fund
Seeding a new mutual fund from an SMA is most likely to prove beneficial if the adviser intends to retain investors’ assets in the fund. Disposing of the assets soon after they are contributed reduces the benefits of delaying the realization of gains. In extreme cases there may be no net tax advantage, only an allocation of realized gains among the contributing SMAs.
ASSESSING THE UNREALIZED POSITION OF EACH SMA
Before planning the transaction, an adviser should review the unrealized position of each SMA and the expectations for retaining or disposing of the assets it may contribute to the fund. With this information, an adviser can identify which SMAs will benefit and to what extent.
The adviser’s review also may reveal risks. For example, SMAs with built-in losses (those in net depreciation) may wish to take losses in order to avoid a downward basis adjustment for the loss positions in the fund. Yet these SMAs could be harmed if they then invest cash into the fund and receive a portion of the gain generated from the sale of assets contributed by other SMAs. Advisers should consider all aspects of the transaction as part of their fiduciary responsibility to customers.
An adviser also may want to consider liquidating highly appreciated tax-exempt accounts prior to the transaction in order to avoid the subsequent realization of the gain in the fund and its distribution to all shareholders. Generally, this is not advised for ERISA and IRA accounts.
There are a number of other detailed considerations and rules related to this type of transaction; however an assessment of the above considerations should help advisers decide whether to consider converting SMAs into a mutual fund.
TAX-FREE TRANSACTION SUMMARY
A tax-free transaction is permissible under Section 351(e) of the Internal Revenue Code if (i) the SMAs collectively own 80% or more of the fund after the transaction and (ii) each SMA contributes a diversified portfolio to the fund.
To be diversified, an SMA must not have more than (i) 25% of its total assets invested in the securities of a single issuer and (ii) 50% of its total assets invested in the securities of five or fewer issuers. For this purpose, the transaction includes a look-through into the underlying assets in mutual funds held by an SMA. Total assets exclude cash and cash items, but an SMA could contribute all cash and still be diversified.
Generally, the process of seeding the fund through a tax-free in-kind investment of SMAs goes as follows:
• Identify the transfer date or period (up to 90 days)
• Identify SMAs:
- Obtain written authorization from all SMAs; each participating SMA will be required to complete an application for the mutual fund
- Identify SMAs to be transferred in cash
- Identify the assets of SMAs to be sold before the transfer
• Ensure the fund’s prospectus allows the transaction and the investment policies permit holding contributed assets
• Test all SMAs for diversification - one percent of the assets transferred can be non-diversified
• Accounts that become owners of one percent or more of the fund will need to file a routine statement with their federal income tax return noting the Section 351 transaction
CONCLUSION
While the process of converting SMAs into a mutual fund may be complex, it is possible. A fund administrator experienced in these types of transactions can guide you through the process and considerations. An adviser can benefit from the efficiency of managing a mutual fund as opposed to numerous SMAs, and from the distribution potential of a mutual fund that is not limited by account size and strategy constraints. The SMAs benefit not only from the tax-free aspects of the transaction, but also from the potential scale of a mutual fund.
This is only a summary and is not tax advice.
