Section 351 ETF conversions defer taxes and ease diversification

Financial advisers are using Section 351 exchanges to move concentrated client stock into newly launched ETFs. The transfers can let contributing investors defer capital gains taxes while converting holdings from separately managed accounts into a fund.

To qualify for tax deferral, the resulting fund must meet IRS concentration tests: no single security can exceed 25% of the portfolio, and the five largest holdings cannot total more than 50%.

Registered investment advisers and family offices have led these transactions. Some advisers at large broker-dealers face additional compliance reviews or platform limits that make participation harder.

There are two common deal structures. In a syndicated exchange, outside investors contribute appreciated securities to seed a new ETF. In a non-syndicated exchange, a manager moves clients who already have a fiduciary relationship into an ETF using the same investment approach.

Managers say the technique can solve a client problem: owners of highly appreciated single-stock positions can gain diversified exposure without triggering immediate tax bills. One manager plans to launch a Section 351 exchange in November to accept outside highly appreciated positions alongside existing discretionary assets.

New platforms have appeared to connect advisers, ETF sponsors and investors and to handle capital raising and operations for these deals. Some advisers report many investors keep concentrated holdings idle to avoid taxable events, and they view exchanges as an option to address that.

The Investment Company Institute has requested guidance from the Treasury and IRS to provide tax certainty for members using Section 351 transactions to seed ETFs or scale strategies. Industry participants say clearer rules could increase interest from larger asset managers. Some advisers note that current concentration tests are explicitly specified and question whether future changes would be applied retroactively.

Practitioners emphasize that these transactions require close attention to tax rules, fiduciary duties and compliance processes. At present they are most feasible for firms and advisers with experience handling complex, highly appreciated client holdings.