By Victor Haghani, James White and Jerry Bell ¹
ESTIMATED READING TIME: 5 min.

This article is for informational and educational purposes only. It does not constitute tax, legal, or investment advice, and should not be relied upon as such. Consult a qualified tax advisor or attorney before making any decisions based on the information presented here.

Investors have learned to love the ETF as an investment vehicle, and for good reason. ETFs can offer exceptional liquidity, built-in tax efficiency and low fees, making them an attractive choice for long-term investors.

A challenge faced by many investors is that they hold low-basis assets with substantial unrealized gains in taxable accounts. Even if there’s an ETF they’d rather own,² selling those legacy positions to buy their preferred ETF typically triggers a significant tax bill, often making the switch economically unattractive.

As regular readers of Elm research know, we tend to be cautious about investment strategies that prioritize tax benefits over expected risk-adjusted return – such as Direct Indexed Tax-Loss Harvesting, Leveraged Long-Short Tax Loss Harvesting and Exchange Funds. We think 351 ETF Exchanges have the potential to offer investors better expected risk-adjusted returns and tax benefits to boot.

Thanks to Section 351 of the US tax code, investors can contribute their appreciated assets directly into an ETF structure without realizing gains at the time of transfer (subject to a variety of requirements). The result can be ETF shares that reflect your original cost basis, with no (or de minimus) tax hit on the conversion.

In this note, we’ll briefly explain the mechanics, limitations, and potential benefits and risks of a 351 Exchange to seed a new ETF with appreciated assets.

What is a §351 Exchange?

§351 of the US Internal Revenue Code allows investors to contribute property, such as stocks and other ETFs (Exchange Traded Funds), to a newly formed corporation, which can be a new ETF, in a tax-free exchange – if specific rules and tests are met. This approach allows investors to maintain market exposure, while moving into a more desirable investment strategy or investment vehicle without triggering capital gains tax. Taxes are postponed – not eliminated – until you eventually sell the new ETF.

The intention of Section 351 is to encourage the formation of new corporate activity by allowing investors in a new venture to contribute assets to the venture without triggering capital gains taxes at the time of formation.³

Put simply, you can contribute an investment portfolio and “seed” the launch of a new ETF without realizing capital gains at the time of conversion. The ETF can then, in the ordinary course of its investment strategy, use the create/redeem mechanism to rebalance the portfolio without realizing capital gains, unlike a partnership or traditional exchange fund.

Qualifying criteria for a §351 Exchange

Investors can contribute a basket of securities (stocks, bonds, ETFs), and will then receive shares in a new ETF, deferring taxes on the embedded gains in the contributed assets.

Specific IRS rules must be met to get tax-deferred status on the exchange: no single security can exceed 25%, and the top five stocks taken together must not exceed 50% of the contributed portfolio’s value. If they are all single stocks, there must be at least 11 individual holdings. This test must be met on an investor-by-investor basis. ETFs are looked through for this test, so an investor could contribute one ETF (assuming it had enough underlying holdings) and meet the test.

Mutual funds cannot be contributed as part of a 351 exchange. There is also a control requirement which states that the initial investors in the new ETF must own at least 80% of the ETF immediately after the exchange. A 351 exchange is a one-time event at the launch of the newly seeded ETF.

Section 351 also requires that there not be a pre-established plan or intention for the new ETF to dispose of the contributed assets, except in the ordinary course of business. This condition is an important constraint on 351 Exchanges and those managing them.

Is a 351 Exchange right for you?

A 351 exchange is a complex transaction subject to IRS regulations, SEC requirements, and potential market risks. Investors should consult with qualified legal, tax, and financial professionals to assess whether a 351 exchange aligns with your specific circumstances and investment objectives. You also will need to make an assessment of any tax risk involved in the transaction.

Like many popular tax strategies, these transactions have received attention from the US Treasury Department, as recently highlighted in this Bloomberg piece: “Treasury Takes Aim at Booming ETF Move That’s Slashing Tax Bills”

Another important consideration for participating in a 351 exchange is that you must really like the new ETF that you’re exchanging into – both in absolute terms and relative to what you currently own – because you’re likely to hold it for a long time. It can be challenging to know exactly how the new ETF will be managed, due to the requirement that the new ETF not have a plan to dispose of the contributed assets, many new §351 ETFs have extremely broad investment mandates, such as “the fund will be actively managed to deliver equity exposure”.

Assuming you clear the above hurdles, then a 351 exchange can make sense if you also:

• Hold portfolios of individual stocks or ETFs that have performed well but have grown unbalanced, no longer align with your market views, or no longer fit your risk preferences.
• Previously participated in single-stock direct indexing or tax-loss harvesting programs and find yourself with diversified but unwieldy holdings—requiring ongoing monitoring of corporate actions and often incurring relatively high management fees.
• Seek greater simplicity, improved cost efficiency, enhanced liquidity, or a transition from self-managed to professionally managed investing.

For investors with appreciated assets, we do not believe there is a specific threshold of appreciation that is needed for participation to make sense, conditional on the hurdles above being met.

351 Exchanges versus other forms of tax-aware investing

We are firm believers that the tax tail should not wag the investing dog and have expressed our reservations about aggressive tax-motivated investing strategies that are reasonably expected to generate lower-quality returns, in exchange for often overstated tax benefits (see here, here, and here). In many situations, we believe it can pay to pay capital gains tax, or even ordinary income tax as in a Roth conversion, which tends to be under-appreciated by the mainstream investment community.⁴

In practice, we regularly help clients with complex legacy holdings – whether single-name stocks, ETFs, mutual funds, or portfolios with hundreds of appreciated positions and thousands of tax lots – by incorporating them into Elm SMAs in a tax-efficient and deliberate way. We map each legacy instrument to a combination of Elm asset buckets, holding what you already own in place of what we would otherwise buy, and we work with each client to find their preferred tradeoff between tracking error and realized gains — both on the initial rebalance and on an ongoing basis. There are no diversification rules or restrictions on the number of names involved, and accounts can be customized in virtually unlimited ways to reflect each client’s unique situation.

Our current thinking on 351 exchanges

Given all the the right circumstances, we think a 351 ETF Exchange can be a sensible investing decision in its own right, with potential tax benefits as a bonus. But we stress that individual offerings are not generic, must be scrutinized closely, and as we’ve described there’s a pretty long list of tests which should be met to ensure participation is right for you.

After evaluating with experts and our clients the benefits and risks (especially including the recent extra Treasury and IRS scrutiny) of sponsoring this type of 351 conversion, we’ve decided not to pursue it ourselves at present, though we’ll be keeping an eye on the regulatory landscape and may reevaluate at a later date. We welcome conversations on this topic, so if you’d like to discuss this with us, please reach out at clients@elmwealth.com with any questions you may have, or to set up a call.

1. The content on this page is being provided for educational purposes only. It does not constitute any form of investment advice, or any form of recommendation to buy or sell any securities or adopt any investment strategy mentioned herein. Any tax related commentary is general in nature and should not be considered tax advice.
   This material does not have regard to specific investment objectives, financial situation and the particular needs of any specific reader. Any views regarding future prospects may or may not be realized. Past performance is no guarantee of future results.
   
2. Or a different ETF, if their appreciated assets are already in ETF form.
   
3. There are some parallels with what’s known as the “1031 exchange,” a tax-deferred swap of one investment or business-use real estate property for another “like-kind” property, allowing real estate investors to roll proceeds of a sale into a replacement asset without currently recognizing taxable capital gains.
   
4. Perhaps because though it is often tax-beneficial for clients, it also reduces investment management fees paid by clients.