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Tax-Efficient Diversification of Highly Appreciated Stock Positions with 351 ETF Exchanges

Presented by Philip Toews and Eben Burr

Many investors today face a common challenge: portfolios dominated by highly appreciated stock positions that have generated substantial unrealized gains over the past decade. While diversification may be desirable from a risk-management standpoint, selling concentrated positions can trigger significant capital gains taxes.

In this session, Philip Toews and Eben Burr explored the mechanics, benefits, limitations, and planning opportunities associated with Section 351 ETF exchanges, a little-known tax strategy that can allow investors to contribute appreciated stock and ETF holdings into a newly launched ETF without triggering immediate capital gains recognition.

The presenters explained how syndicated 351 ETF exchanges work, compared them to exchange funds and traditional diversification approaches, discussed IRS diversification requirements, and demonstrated how advisors may use these structures to help clients diversify concentrated positions while maintaining tax deferral. The session also explored how hedged equity ETFs can potentially reduce downside risk while providing continued market participation.

The discussion emphasized that Section 351 exchanges are not appropriate for every investor and involve significant planning, coordination, and portfolio analysis. However, for clients with substantial embedded gains, concentrated stock exposure, or highly appreciated custom-index portfolios, the strategy may offer a compelling alternative to outright liquidation.

Key Topics and Expanded Insights

Understanding the Section 351 ETF Exchange

What Is a 351 Exchange?

Section 351 of the Internal Revenue Code generally permits taxpayers to transfer qualifying property to a corporation in exchange for stock without immediately recognizing gain or loss, provided certain requirements are met.

The presenters described the modern ETF application of this rule as a tax-efficient diversification strategy that allows investors to contribute stocks and ETFs into a newly formed ETF during its initial launch phase while preserving their embedded gains.

Key Takeaways

• The strategy is often compared to a 1031 exchange for real estate, although the mechanics differ significantly.
• Investors exchange appreciated securities for shares of a newly launched ETF.
• Capital gains taxes are deferred rather than eliminated.
• Original cost basis generally carries over into the ETF shares received.
• Holding periods also carry over, preserving long-term capital gains treatment where applicable.

Planning Implications

This strategy may be particularly attractive for:

• Investors holding concentrated technology positions.
• Founders or executives with appreciated company stock.
• Clients with large embedded gains in taxable accounts.
• Investors trapped in highly appreciated direct-indexing portfolios.
• Clients reluctant to diversify due to tax consequences.

Why Concentrated Stock Positions Create Planning Challenges

The presenters noted that the past decade's strong equity market performance has created significant concentration risk for many investors.

Examples discussed included:

• Nvidia
• Broadcom
• Meta
• Amazon
• Other large-cap growth and AI-related stocks

Advisor Considerations

Many investors now face competing objectives:

1. Reducing concentration risk.
2. Avoiding large tax liabilities.

This creates a planning dilemma where clients remain invested in positions they no longer want because the tax cost of selling feels prohibitive.

Key Advisor Takeaways

• Concentration risk should be evaluated independently from tax consequences.
• Tax deferral opportunities can create flexibility in diversification decisions.
• The client's overall risk profile should drive planning discussions, not tax considerations alone.

Straight 351 Exchanges vs. Syndicated 351 Exchanges

The presenters distinguished between two primary types of Section 351 ETF exchanges.

Straight 351 Exchanges

These generally involve a single advisory firm contributing model portfolios into a newly launched ETF.

Potential benefits include:

• Operational efficiency.
• Simplified trading.
• Improved tax management.
• Enhanced scalability.

Syndicated 351 Exchanges

The session primarily focused on syndicated exchanges.

These involve:

• Multiple advisory firms.
• Multiple investors.
• A new ETF issuer.
• Contributions from numerous portfolios.

Why Syndication Matters

Syndication allows multiple investors' concentrated positions to offset one another, helping create a diversified ETF portfolio that may not be achievable using a single investor's holdings alone.

IRS Diversification Requirements and the "25/50 Rule"

One of the most important technical discussions involved diversification requirements that govern ETF-based Section 351 exchanges.

The 25/50 Diversification Test

The presenters explained that:

• No single issuer may represent more than 25% of the contributed portfolio.
• The top five positions combined may not exceed 50% of the portfolio.

Examples Discussed

An investor could potentially contribute:

• Multiple concentrated positions.
• Broad-market ETFs.
• Diversified equity holdings.

However, portfolios dominated by a single stock position may fail diversification requirements.

Practical Limitation

An investor holding:

• $10 million of SpaceX stock representing 95% of total assets

would likely not qualify for meaningful diversification through a 351 exchange unless substantial additional diversified assets are available.

Advisor Takeaway

The first step is often a portfolio analysis to determine whether holdings satisfy diversification requirements before pursuing the strategy.

Eligible Assets and Structural Limitations

Generally Eligible

The presenters noted that the following typically qualify:

• Individual stocks
• Equity ETFs

Generally Ineligible

Examples discussed included:

• Mutual funds
• Cryptocurrency
• REITs
• Commodities-based holdings

Planning Consequences

Advisors should evaluate:

• Asset eligibility
• Position concentration
• ETF mandate compatibility
• Overall diversification requirements

before assuming a portfolio qualifies.

Cost Basis Carryover and Tax Treatment

A major benefit of the strategy is tax deferral.

Key Tax Consequences

The presenters explained that:

• Embedded gains are not eliminated.
• Taxes are deferred.
• Original cost basis carries over.
• Original holding periods carry over.

Example

If an investor contributes multiple tax lots of Broadcom stock acquired at different times and prices:

• Each tax lot carries forward proportionally into the ETF.
• Cost basis information remains attached to the investor's ownership.
• Future sales generally retain long-term gain treatment if applicable.

Important Clarification

The strategy provides tax deferral—not tax avoidance.

Eventually:

• ETF shares may be sold.
• Gains may be realized.
• Taxes may become due.

ETF Liquidity Versus Traditional Exchange Funds

The presenters spent considerable time distinguishing ETF-based 351 exchanges from traditional exchange funds.

Exchange Fund Characteristics

Typical exchange fund features include:

• Private investment structures.
• K-1 reporting.
• Limited transparency.
• Multi-year lockups.
• Restricted liquidity.

ETF-Based 351 Exchange Characteristics

Potential advantages include:

• Daily liquidity.
• Transparency.
• Standard ETF reporting.
• Public market trading.
• No long lockup periods.

Advisor Implication

For clients seeking diversification without surrendering liquidity, ETF-based exchanges may be more attractive than traditional exchange funds.

Hedged Equity ETFs as a Diversification Destination

A significant portion of the webinar focused on the presenters' use of hedged equity ETFs.

Objectives of Hedged Equity

The presenters described several goals:

• Reduce downside exposure.
• Improve risk-adjusted returns.
• Preserve meaningful equity participation.
• Manage investor behavior during market declines.

Desired Characteristics

The presenters suggested a target profile of:

• Approximately 70% upside capture during bull markets.
• Roughly 50% downside capture during moderate declines.
• Potentially lower downside participation during severe bear markets.

Advisor Consideration

While hedged equity strategies may reduce downside risk, advisors should carefully evaluate:

• Costs.
• Hedging methodology.
• Long-term return expectations.
• Client suitability.

Market Valuations and Diversification Timing

The presenters argued that current market conditions increase the relevance of diversification planning.

Metrics discussed included:

• The Buffett Indicator (total market capitalization relative to GDP).
• CAPE valuation measures.
• Elevated concentration among mega-cap technology stocks.

Planning Implications

Clients with large concentrated positions may be particularly vulnerable if:

• Valuations contract.
• Market leadership rotates.
• Individual holdings experience sharp declines.

Advisor Takeaway

Tax considerations should not prevent appropriate risk management.

Operational Logistics and Implementation Process

The webinar provided substantial detail regarding implementation.

Typical Process Includes

1. Portfolio analysis.
2. Diversification testing.
3. Custodial Letter of Authorization.
4. Brokerage statement review.
5. Tax lot reconciliation.
6. Contribution agreement execution.
7. Final portfolio balancing.
8. ETF launch and asset transfer.

Timing Considerations

Because participation generally occurs at ETF launch:

• Planning often begins months in advance.
• Contributions are finalized shortly before launch.
• Ongoing portfolio changes may require re-analysis.

Legislative and Regulatory Considerations

A participant asked whether Congress is considering changes to Section 351.

The presenters noted that legislative discussions have focused primarily on large corporate transactions and merger-related uses of Section 351 rather than ETF-based diversification structures used by advisors and individual investors.

Advisor Caution

Tax laws can change.

Advisors should:

• Confirm current rules.
• Review legal documentation carefully.
• Consult tax counsel where appropriate.

Practical Advisor Takeaways

• Identify clients with concentrated stock positions and significant unrealized gains.
• Evaluate whether tax concerns are preventing appropriate diversification.
• Review portfolios against Section 351 diversification requirements.
• Compare ETF-based 351 exchanges to exchange funds and alternative diversification strategies.
• Consider partial diversification when full diversification is not possible.
• Understand that cost basis carries forward and taxes are deferred, not eliminated.
• Review liquidity needs before selecting any diversification solution.
• Carefully evaluate ETF issuer experience and investment strategy.
• Consider whether hedged equity strategies align with client objectives.
• Coordinate tax, investment, and estate planning considerations when working with highly appreciated assets.

External Reference Sources

Internal Revenue Service – Transfers to Corporations (IRC Section 351)
https://www.irs.gov/publications/p542

Cornell Law School Legal Information Institute – Internal Revenue Code Section 351
https://www.law.cornell.edu/uscode/text/26/351

U.S. Securities and Exchange Commission – Exchange-Traded Funds (ETFs)
https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/exchange-traded-funds-etfs

FINRA Investor Insights – Exchange-Traded Funds
https://www.finra.org/investors/insights/exchange-traded-funds

Investment Company Institute – ETF Resources
https://www.ici.org

Morningstar – ETF Investing Research
https://www.morningstar.com

Internal Revenue Service – Capital Gains and Losses
https://www.irs.gov/taxtopics/tc409