When you sell shares, you realize a capital gain or loss regardless of how you're paid (in cash or in stocks that Sequoia gave you instead). If you get stocks, their basis is what you "paid" for them, i.e. the value of the Sequoia shares you just traded in. So if you flip those stocks immediately, you have no additional gain or loss.
So where did the gain on the underlying stocks go? The general rule is when a company (such as a mutual fund) sells stocks it owns, it recognizes a gain or loss. It might sell stocks to raise cash for your redemption. Or it might "sell" you those stocks directly (redemption in-kind) to meet your redemption request.
But there's one special line in the tax code (
IRC 852(b)(6)) that says this general rule doesn't apply to redemptions in kind for registered investment companies (mutual funds, ETFs). Poof! No cap gain - no gain passed through to you, no gain for the fund.
Your "on the other hand" description is right, but usually not as much of a problem as it might appear. If you've owned the shares awhile, your shares may have gone up 2
5% since you bought them, while the fund is planning a 20% gains distribution. If you were to redeem your shares, you would wind up recognizing a 2
5% gain, rather than get the 20% distribution. So you might grin and bear it - at least you're not recognizing more gain than you actually made with the investment. Expensive, but not really unfair.
Investors who held their shares for fewer years (say their share prices are up 1
5%) are the ones who would be inclined to sell. Otherwise, they would recognize gains greater than what they'd made in the fund. As you wrote, that means that more gains would be distributed to the remaining shareholders. So instead of a 20% distribution, the fund might wind up making a 23% distribution. Still not enough to induce you (with 2
5% share appreciation) to sell, but there could be a few other shareholders with 22% appreciation who would now decide to sell. Ultimately, an equilibrium point is reached.
All this assumes people are astute about their tax situations and act rationally. That's your laugh for the day.
