Section 351 ETFs let investors defer tax on concentrated stock

Advisors are using Section 351 conversions to transfer large, appreciated stock positions into newly launched exchange-traded funds and defer immediate capital gains when tax diversification tests are met. The IRS requires that no single security exceed 25% of the fund and that the five largest holdings together not exceed 50%.

A Section 351 conversion involves contributing appreciated securities to a newly formed ETF in exchange for shares in that fund. If the resulting fund satisfies the IRS diversification thresholds and other technical requirements, the contribution can avoid triggering capital gains taxes that would arise from selling the positions outright.

Registered investment advisors and family offices have led early adoption, while some wirehouse brokers face additional compliance reviews or platform restrictions that limit use of the strategy. Advisors working with clients who hold long-term, concentrated stock in companies such as Google, Microsoft or Apple cite the strategy as a way to reduce single-stock exposure without immediate taxable sales. One advisor in Greenwich, Connecticut, plans to launch a Section 351 exchange in November and expects it to absorb tens of millions of dollars of single-stock positions alongside other seed capital.

Deal flow has taken two main forms. In syndicated exchanges, investors who do not have a prior relationship with the manager contribute stock to seed a new ETF. In non-syndicated exchanges, an advisor moves a client’s existing separately managed account into an ETF vehicle the advisor controls. Brittany Christensen, head of business development at a firm that helps create ETFs, described the difference as one between outside contributors and clients who already have a fiduciary relationship with the manager.

A growing number of capital markets and technology platforms aim to connect advisors with ETF sponsors and to streamline Section 351 transactions. The founder of one centralized portal said the approach helps advisors balance the duty to diversify client portfolios with the desire to avoid steep, immediate tax bills for clients who otherwise leave positions untouched.

Industry groups and managers are seeking clearer guidance from the Treasury Department and the IRS. The Investment Company Institute requested formal guidance, saying in a May letter that clearer rules would give managers greater tax certainty when using Section 351 to seed ETFs and to scale strategies from separate accounts.

Practitioners report operational hurdles, including structuring seed capital, coordinating transfers and custody, and meeting back-office requirements to launch a fund. Advisors and ETF service providers said they are working through those logistical and compliance challenges. Andy Pratt, managing partner at a registered investment advisor, observed, “What the IRS and Treasury define as ‘diversified’ probably isn’t what an advisor would define as ‘diversified.'” Another advisor described the conversions as a marketing opportunity to demonstrate capability with specialized tax and structuring work.

As more advisors pilot Section 351 exchanges, regulatory clarity, operational capacity and client demand will influence whether the technique is used more widely for wealthy investors with concentrated equity holdings.