In a recent episode of “Behind the Ticker,” Raymond Holst from Practus LLP discussed the intricacies of 351 exchanges and their relevance to the ETF industry. Holst, a tax attorney with over 20 years of experience, joined Practus in 2023, bringing extensive expertise in financial products and taxation. Practus, a fully virtual law firm with attorneys across the United States, specializes in ETF and mutual fund markets, offering tailored legal and tax solutions.
About Raymond Holst and Practus
Holst explained that a 351 exchange refers to a provision in the Internal Revenue Code allowing for the transfer of property into a corporation in exchange for shares without triggering immediate tax recognition on built-in gains. This mechanism is particularly useful for asset managers looking to convert separately managed accounts (SMAs) or private funds into an ETF wrapper. The process enables investors to transfer diversified securities portfolios into an ETF while maintaining their original tax basis and avoiding taxable events.
Investment Strategy and Approach
Key requirements for a successful 351 exchange include maintaining at least 80% ownership in voting and value by transferors post-exchange and adhering to diversification rules. Holst elaborated on the 25/50 diversification test, which ensures that no single security exceeds 25% of the portfolio and the top five securities do not exceed 50%. These safeguards are essential to comply with tax regulations and ensure the exchange qualifies under the 351 provision.
Holst emphasized the importance of partnering with experienced professionals for 351 exchanges, noting the complex coordination required among custodians, fund administrators, and legal advisors. While the process is tax-efficient, it involves significant logistical work, particularly in transferring tax information and establishing proper valuations. Once completed, however, ETFs formed through 351 exchanges operate like any other ETF, offering investors liquidity, marginability, and tax advantages.
Portfolio Construction and Implementation
For asset managers considering launching an ETF using a 351 exchange, Holst highlighted the long-term benefits, including improved tax efficiency and operational flexibility.
Deeper Dive: Insights from the Full Conversation
Beyond the headline strategy, the full conversation between Brad and Raymond Holst covered several additional themes worth highlighting for advisors and investors.
On Process and Philosophy
Everyone transfers in their existing securities portfolios. They take ETF shares back. So it's a hundred percent. So we never really run into problems. There are some outliers, but we never run into problems with that problem. The other prong is that what is being contributed needs to be a, if it's marketable securities, needs to be a diversified portfolio. And what that means is there's two tests. They're generally referred to as the twenty five fifty tests. And so you look at each, each transfer.
Obviously, as the portfolio continue, hopefully the strategy produces positive returns, that's going to increase the NAV and the price at which the ETF shares are traded, but you're not going to recognize that tax until you actually sell the ETF shares. So, let me ask one final question I probably should have asked earlier. So, and this goes back to maybe walking through a real-world example, let's say, I'm going to try to make this very simple. I have an SMAM only running Apple.
Market Context and Positioning
If you have an SMA account and you want to get at IBM and go into Apple, well, when you sell those IBM shares, obviously you have gain or loss, you take the proceeds of that, which, you know, is taking a 20% taxid probably. And so now you only have $80 to go into the other security with respect to ETFs. Can generally rebalance their portfolios using technology in the marketplace that it isn't a taxable event, so they can sell the $100 the IBM and move that $100 value into Apple without recognizing any tax.
And so let's just start at the very top. What is a three fifty one exchange and how does it apply to an ETF? Well, being taxolors, we always need to speak in code. So what is three fifty one? Three fifty one is simply the provision in internal revenue code, which is used to create a corporation. And I'll give you a simple example. You have a property with a fair market value of fifty dollars. We both contributed that into the corporation exchange for corporate corporate shares.
It's fifty fifty because we've contributed equal value. However, you bought that property. Let's say five years ago for twenty five dollars. So you have twenty five dollars of built-in gain in that property that you're contributing. And if you meet the requirements of three fifty one, what it says is when you contribute that property, you don't have to recognize that gain at that time. What happens is you get a carryover basis in the shares that you receive. So with respect to an ETF and doing the initial seeding, the idea is you're an asset manager and you have separately managed accounts or maybe you have a private fund.
Notable Insights
"So that's why it's important to actually have people that you're working with that have done these transactions."
"One being tax efficiency, which is probably the biggest one, but it's really about just getting the ETF up and running."
Key Takeaways
- Key requirements for a successful 351 exchange include maintaining at least 80% ownership in voting and value by transferors post-exchange and adhering to diversification rules.
- The conversation explores important themes in etf structure relevant to today's advisor landscape.
- The conversation explores important themes in etf structure relevant to today's advisor landscape.
What This Means for Advisors
For financial advisors evaluating options for client portfolios, this conversation with Raymond Holst highlights important considerations around etf structure. Understanding the strategy behind each fund—not just the ticker—helps advisors make more informed allocation decisions and better communicate the rationale to clients.
Listen to the Full Episode
This article is based on an episode of Behind the Ticker, hosted by Brad Roth, Founder and CIO of THOR Financial Technologies. For the full conversation with Raymond Holst, including additional nuances and details, listen on Spotify, Apple Podcasts, or watch on YouTube.