Concentrated Stock

What is a Section 351 exchange?

Section 351 of the Internal Revenue Code allows property to move into a corporation in exchange for its stock without recognizing gain. The condition is that the transferors together control the corporation immediately after the exchange. In the fund context this is used at the launch of a new ETF. A group of investors contributes securities, receives ETF shares, and generally does not pay tax at that moment. The original cost basis carries over, so the gain is deferred rather than forgiven. Whether any particular transfer qualifies depends on facts specific to the investor and should be reviewed with a tax advisor.

Can I contribute a single concentrated stock position to a 351 ETF conversion?

Usually not on its own. The rules governing transfers to investment companies generally make the exchange taxable if it results in diversification of the transferors' interests. A contribution avoids that outcome when the portfolio being contributed is already diversified. The test allows no more than 25 percent of value in one issuer and no more than 50 percent in the five largest. A single large position fails that test. This is the most common misunderstanding we encounter. An investor holding one appreciated stock is typically looking at an exchange fund or a tax-aware long/short program instead.

How is a 351 conversion different from an exchange fund?

They solve different problems. A 351 conversion suits an already diversified but low-basis portfolio and produces liquid ETF shares with no lockup. An exchange fund is built to absorb a genuinely concentrated position and requires a seven-year commitment in return. A 351 conversion is also only available during a sponsor's launch window, while exchange funds subscribe more regularly.

Does any of these structures eliminate the tax?

No. All three defer tax rather than eliminate it. A 351 conversion and an exchange fund both carry the original basis forward. In a long/short program, losses used to offset a sale are typically paired with reduced basis elsewhere in the portfolio. Deferral still has value, because the portfolio compounds on a larger base in the meantime. Separate provisions of the tax code can prevent deferred gains from ever being realized. The basis step-up at death and charitable gifts of appreciated stock are the common examples, and all three structures leave them available.

Can these structures be combined?

Yes. They are not mutually exclusive. Some investors contribute part of a position to an exchange fund and apply a tax-aware long/short program to the remainder. Others use the program's harvested losses against gains realized elsewhere. That includes gains from selling ETF shares received in a 351 conversion.

How long does a tax-aware long/short sell-down take?

It depends on the size of the position relative to the capital funding the program. Market conditions and the pace of loss generation matter as well, and none of these is guaranteed. The sell-down typically takes one to three years. The expected path is typically modeled with the client before anything is implemented.

What happens if an investor needs to exit an exchange fund early?

Terms vary by fund. Early redemption generally returns the investor's original shares, and some funds return the lesser of the value at contribution or at redemption. Charges may apply, and the diversification benefit largely unwinds. This is the structural price of the tax treatment and applies across sponsors.

What are the main risks of the long/short approach?

Short selling and leverage introduce risks that a long-only pool does not carry, including the possibility that the long/short portfolio loses money. Tracking error against broad market indexes can be significant, and the tax outcome depends on individual circumstances and evolving tax law. These strategies are not suitable for all investors.