We wrote earlier this year about strategies to diversify out of highly appreciated stock, including a solution called Section 351 exchange.
While a 351 exchange allows you to defer (not eliminate) taxes by exchanging a “diversified” portfolio of appreciated stocks for a diversified ETF, there are risks to be mindful of. The takeaway is to engage in this type of transaction only with experienced ETF sponsors who also can reliably grow their fund after launch.
In this post, we elaborate on what we see as the biggest risks with 351 exchanges: losing the tax benefit, hidden costs, and losing control of investment decisions.
The critical risk: failure to qualify and losing the tax benefits
The purpose of a 351 exchange is to defer paying taxes on appreciated stocks by not selling them. However, if this transaction does not meet all the IRS requirements, the exchange is taxable, essentially as if you had sold your original shares.
There are two key pieces of the IRS requirements for a 351 exchange:
The Diversification Test: The exchanged portfolio must be diversified. No single holding can exceed 25% of the total portfolio, and the top five holdings must collectively represent less than 50% of the portfolio’s value.
The Control Immediately After Rule: The group of investors seeding the new ETF must collectively own more than 80% of it immediately after the exchange.
If your exchange fails either of these tests, among other IRS rules, the transaction will be treated as a taxable event.
Hidden costs after the exchange
In a 351 exchange, investors typically exchange a diversified portfolio of stocks for shares of a new ETF. The new ETF charges an annual management fee to run its strategy. However, if the fund remains too small or the ETF manager fails to attract enough assets into their fund, investors may face additional hidden costs.
For context, ETFs are managed tax efficiently (without realizing capital gains) because of the broker (also known as an Authorized Participant, or AP) working behind the scenes.
This AP makes money by facilitating trades in both ETF shares and in the underlying basket of securities comprising the fund.
In small funds with limited investor demand or trading activity of their ETF shares, the AP needs to charge more for their trades. This means wider bid/ask spreads (less liquidity) and therefore higher transaction costs for the fund. Furthermore, the AP will likely also charge the fund manager higher costs for trading activity inside the fund. These hidden costs show up over time through lower returns which can offset some or all of the benefit of deferring taxes in the first place.
In short, work only with established managers who have a proven record of attracting billions in assets and in turn have good relationships with their APs. This ensures cost effective trading of your ETF and the underlying portfolio, therefore minimizing the risk of hidden costs.
Smaller risk: Loss of control
One additional risk to consider is losing control of investment decisions as you go from holding individual stocks that you control to an ETF managed by someone else.
To us, the best strategy for such an ETF is one that is closest to a passive index. Since your primary goal of engaging in a 351 exchange is to defer taxes, the ideal investment strategy is one you can hold forever, and get the step-up in cost basis upon your death.
In contrast, an active strategy is certain to go through long periods of underperformance, with manager turnover and strategy changes, leaving you stuck with a low basis position that you may not want.
The final assessment: Take the long view and perform your due diligence
A Section 351 exchange remains a valuable and efficient tool, offering the liquidity and low cost that other diversification strategies lack. However, given the high stakes, where an operational error can trigger immediate taxes, it is crucial to approach this strategy with meticulous due diligence.
The key to mitigating risk lies in partnering with an established fund sponsor that has a proven investment, business and operational track record navigating the exact legal, tax, and operational complexities of the Section 351 exchange.
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