Raymond Holst
351 Exchanges: Tax-Free ETF Conversions
Ray Holst is a tax attorney at Practus, a fully virtual law firm of about 60 attorneys located across the United States. Ray has been practicing tax law since 2002, working at some of the largest New York firms and doing a stint at Morgan Stanley. His background is specifically in financial products and financial institutions taxation, and he joined Practus in summer 2023. On this episode of Behind the Ticker, Ray breaks down the 351 exchange, a tax-efficient mechanism for converting separately managed accounts, hedge funds, and other investment vehicles into ETFs without triggering capital gains taxes.
What a 351 Exchange Actually Is
A 351 exchange, named after Section 351 of the Internal Revenue Code, allows investors to contribute appreciated securities into a newly formed ETF without triggering a taxable event. It's the same legal mechanism that has existed for decades in corporate formations and other contexts. What's relatively new is its application to ETFs. Ray explains that the basic structure involves investors transferring their portfolios of securities into an ETF in exchange for ETF shares. Because it's treated as a contribution to a corporation in exchange for stock, it qualifies as a non-recognition event for tax purposes.
The practical application is powerful. Imagine an advisor running an SMA with $50 million in appreciated stocks. If they want to move that portfolio into an ETF, selling those positions would generate a massive capital gains tax bill. A 351 exchange allows the transition without that tax hit. The investors receive ETF shares with a carryover basis (the original cost basis transfers to the new shares), so the tax isn't eliminated permanently, but it's deferred. And once inside the ETF wrapper, the portfolio can take advantage of the ETF's structural tax efficiency going forward, which is where the real compounding benefit kicks in.
Who Should Be Looking at This
Ray identifies several ideal candidates for 351 exchanges. The clearest case is an SMA manager with concentrated, highly appreciated positions who wants to move into the ETF structure. It also works well for hedge fund managers looking to convert their strategies to a more accessible format, or for family offices that have accumulated large portfolios of individual stocks over decades and want the liquidity and tax efficiency of the ETF wrapper.
One critical rule: the securities contributed must be consistent with the ETF's investment strategy. You can't dump a random collection of stocks into a focused sector ETF. The contributed portfolio needs to align with what the fund is supposed to hold. There are also requirements around diversification and the number of contributing investors, though Ray notes that the rules are more flexible than many people assume. Practus brings deep expertise in 40-Act companies (mutual funds, ETFs, closed-end funds, interval funds) combined with Ray's specialized tax background to manage these technical requirements.
Why ETF Tax Efficiency Is Driving Industry Growth
Ray explains the structural advantage that's driving explosive ETF growth. The key mechanism is the ability to rebalance portfolios without triggering taxable events through the creation/redemption process. If you hold an SMA and want to sell IBM and buy Apple, you realize the gain on IBM and owe roughly 20% in taxes. That means only $80 of your $100 value gets redeployed. In an ETF, the same rebalancing can generally be accomplished through in-kind creation/redemption without generating a taxable event for shareholders. You're moving $100 of value from one security to another without the tax haircut. Over years of compounding, this structural advantage becomes enormous.
Ray notes that some legislators, particularly Senator Wyden, have questioned whether this tax treatment should continue. There's been discussion about potentially changing the rules around Section 852(b)(6), which is the specific provision enabling tax-free in-kind redemptions. While no changes have been enacted, it's worth monitoring for anyone building long-term plans around ETF tax efficiency. Ray sees 351 exchanges becoming increasingly common as more asset managers and advisors recognize the benefits of moving existing strategies into the ETF wrapper while the current tax rules remain favorable.
Key Takeaways
- A 351 exchange allows investors to contribute appreciated securities into a new ETF without triggering capital gains taxes. The tax is deferred with carryover basis, then the ETF's structural efficiency takes over.
- Ideal candidates include SMA managers with concentrated appreciated positions, hedge fund managers converting to ETF format, and family offices with decades of embedded gains.
- Contributed securities must align with the ETF's stated investment strategy. Diversification and investor requirements exist but are more flexible than most people assume.
- ETFs can rebalance through the creation/redemption mechanism without triggering taxable events, moving $100 of value between securities without the 20% tax haircut that SMAs face.
- Ray has practiced tax law since 2002 at major NY firms and Morgan Stanley. Practus is a virtual firm of about 60 attorneys with deep ETF and 40-Act expertise.
Listen to the full conversation on Spotify, Apple Podcasts, or YouTube.
Full Transcript
3,891 wordsMachine transcribed from Brad Roth's conversation with Raymond Holst, with speakers identified automatically. Timestamps link to that moment on YouTube. Lightly cleaned, otherwise unedited.
Behind the Ticker is brought to you by UX Wealth Partners. If you're a TAMP user and you're sick and tired of the legacy technology they are run on and you want more customization and flexibility, as well as an AI-driven model marketplace, UX Wealth Partners is your destination. On top of that, they have institutional trading. So if you are an ETF issuer or an SMA provider looking for outsourced institutional trading, UX Wealth can also be your destination. So check out uxwp.com to find out all the ways UX Wealth Partners can help grow and make your practice more efficient.
Welcome to Behind the Ticker.
Today we have on Ray Holst. He is from Practice and he is an attorney specializing in 351 exchanges. We're reading a little bit more about the power of a 351 exchange. We go through why you would want to do one. What are some of the best examples of where you would choose to do a 351 exchange? And we talk about some of the rules and intricacies that help facilitate these transactions. So without further ado, please welcome Mr. Ray Holst.
Hey, Ray. Welcome to the show. Glad to be here. Thanks for inviting me.
Read the full transcript (56 more sections)Collapse transcript
So before we get started, why don't you tell everybody a little bit about your background and how you ended up at Practice? Sure.
So I've been practicing tax law since 2002, worked at some of the largest New York firms, did a stint at Morgan Stanley. So my primary background has always been in financial products, financial institutions, taxation. Recently, and by recently I mean summer 2023, I joined Practice, which has a very strong focus in the ETF mutual fund market, what lawyers call 40-act companies. So with my expertise and experience in other aspects of financial products and financial institutions, it was a really good fit.
Regarding Practice, we're about 60 attorneys. We're completely virtual. So we're located all around the United States. I have partners in Chicago, San Francisco, New York, Miami. And it was founded, the original genesis was something called the 40-act group. And I think that goes back to about 2011, maybe 2013. But with COVID and the use of Zoom and models, I think clients have really understood that it can be done virtually. And it just affords us the opportunity to work from wherever we want, whenever we want.
So I found it a really great experience.
It also saves on the high-priced real estate.
That's exactly right. instead of funding your favorite real estate owner's summer home, hopefully you can keep a little bit more for your mortgage.
Yeah, I love it. So I always like, before we get into the nitty-gritty here, I always like to ask, what do you like to do when you're not working? It depends on what season it is.
But generally, I do two things for fun. I ski in the winter and I fish in the summer. I do a lot of offshore fishing with a lot of guys I grew up with. I'm based in Huntington, Long Island. So we go out of the South Shore through Fire Island Inlet. And we fish the Hudson Canyon. And we do a lot of tuna fishing, a lot of sword fishing. for the winters, it's wherever the snow takes me. So, yeah, I've skied at multiple places, but that's what I do for fun.
Yeah, I love it. It's getting to be ski season in the Northeast. So I geared up this weekend and getting ready for that. I heard it snowed in upstate New York this week, and I don't think I'm ready for that.
I heard Vermont got about a foot of snow. So, yeah, it's coming.
So we're going to focus on 351 exchanges today. There's been a lot kind of in the ETF, sphere about them recently with MebFavor, launching his new fund. And so let's just start at the very top. What is a 351 exchange and how does it apply to an ETF?
Well, being tax lawyers, we always need to speak in code. So what is 351? 351 is simply the provision in the Internal Revenue Code, which is used to create a corporation. And I'll give you a simple example. I have $50. You have a property with a fair market value of $50. We both contribute that into the corporation exchange for corporate shares. It's 50-50 because we've contributed equal value. However, you bought that property, let's say, five years ago for $25. So you have $25 of built-in gain in that property that you're contributing.
And if you meet the requirements of 351, 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 and you want to sort of take the next step and move those into a public vehicle. And ETF wrapper is a great way to do that. So you have managed this portfolio. It's done great.
You have a lot of built-in gain. So when you want to get your clients into that ETF, you don't want to have them experience a taxable event. So a 351 in this space generally has two requirements. First one is really simple to meet. It says the transferors, meaning the people putting property into the corporation, have to own 80% vote and value of the corporation after the transfer. Generally, it's 100% because everyone's participating at the same time. Everyone transfers in their existing securities portfolios. They take ETF shares back. So it's 100%.
So we never really run into problems. There are some outliers, but we never run into problems with that prong. 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 25-50 tests. And so you look at each transferor. So if you're running separately managed accounts, maybe you have 50 accounts. You have to look at each account individually. It's not the aggregate portfolio. But you look at each person that's considered a transferor. And as I said, for this diversification test, there are two tests.
The largest securities position that is being transferred can't be greater than 25% of the total. And the top five holdings of the securities that the client has can't be greater than 50%. Now, cash and cash-like items aren't included in that denominator because, you could see how you could gain the system by, just pumping in cash. So we're looking at actual securities. Not to get too technical, but if your client has an existing mutual fund that's going to get transferred in the 351, generally we look through that mutual fund to the underlying holdings and treat the transferor as owning their pro-rata share as that as well.
But those are really the two requirements. From a tax perspective, it's, a tried and true technology, nothing all that novel about it. Even the documentation that is used to make this happen is fairly simple. The actual heavy lift comes from the fact that because you have clients that are transferring securities to the ETF, all that tax information has to go from the current custodian, into the new fund administrator. And the ETF shares that the transferor receives have to be held in a brokerage account.
So make sure, if you're dealing with SMAs, they all have brokerage accounts. And they get what's called a carryover tax basis. So whatever their securities were, if they had, $50 a basis in Apple, $100 a basis in IBM, all that basis now has to be allocated to the shares that they receive. And holding periods, deal with the fact of long-term gains and short-term gains. Generally, you need to hold property longer than a year to get the 20% long-term capital gains rate.
So the 351, at its core is just a tax play, really?
I wouldn't use the word play, but it's a mechanism by which you can seed an ETF without the recognition of gain for your clients.
And so when you're seeding an ETF using a 351 exchange, how does that kind of, does it change the structure of the ETF at all? Or like what, you had gone on about how the cost basis moves over, but are there any other additional steps as far as a 351 that you'd have to pay attention to?
From the actual legal perspective, it's a fairly straightforward transaction. what is really important is anyone considering such a transaction, they need to partner with someone that's done these before that can bring all the constituents to the table. In working on these transactions, we generally hold in the beginning biweekly calls, and then we go to weekly calls. Because you want to make sure all that information that needs to be exchanged, that's all been done sort of beforehand, and it's hardwired. So when you get ready to push the button and execute the trade, it doesn't blow up.
All the information flows properly. Everyone has what they need. So that's why it's important to actually have people that you're working with that have done these transactions. I think practice now has done close to 100 of these transactions. So you want people that have done them before because we have seen issues crop up. So I'm not saying we've seen every issue that's come along, but I think we've seen most of them.
So are there any specific asset classes or types of, SMA or mutual fund strategies where a 351 exchange is, like, particularly beneficial or even more commonly used?
The 351 aspect of it will not limit what assets come in. I think what assets the ETF can hold will depend upon the market maker for the ETF because you do in-kind create redeems. And they need to be able to sell those underlying assets. So generally, and it's not really a tax reason, but it's for those market maker reasons, that you need a marketable security that goes into the ETF. And an ETF is allowed to own other ETFs and mutual funds.
So those sorts of securities don't present a problem.
So could a 351 exchange influence, like, the liquidity or even the tax efficiency of an ETF post-launch?
No, the 351 is just the mechanism to see the ETF. Going forward, once it's up and running, you have the same sort of requirements and market ecosystem that you have in any other ETF. So it's really about seeding the ETF, getting your clients into that vehicle, which, we believe there are a number of advantages of getting the clients into that as opposed to keeping them outside an ETF. One being tax efficiency, which is probably the biggest one. But it's really about just getting the ETF up and running.
So as we look at the ETF industry as a whole, right, how do you believe, and I know this is a broad question, how do you think the ability to do a 351 exchange in an ETF impacted kind of like the overall growth of the ETF industry, particularly in new product launches and conversions?
Yeah, I think it gives asset managers that have been building their book of business, their AUM, it gives them a mechanism by which they can take the next step in their career development by going to a publicly traded vehicle that offers their clients liquidity, ability to easily margin the ETF shares. And, the difference between ETF and historic mutual funds is the tax efficiency of an ETF. That's really what I believe is driving, the explosive growth in the ETF market.
Not to get too deep into the weeds, but ETFs have the ability to sort of rebalance their portfolios and whether it's an active strategy or a passive strategy, it doesn't matter. But they have generally the ability to rebalance their portfolios without having a taxable event. So 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, has taken a 20% tax hit probably. And so now you only have $80 to go into the other security. With respect to ETFs, ETFs can generally rebalance their portfolios using technology in the marketplace that it isn't a taxable event.
So they can sell the $100 of the IBM and move that $100 of value into Apple without recognizing any tax.
So, the entire ETF space is pumping tax efficiency of, having an ETF over an SMA or in a mutual fund, right? So looking ahead, do you see any changes in tax law or regulation that could impact the use of 351 exchanges in the ETF market?
People take varying positions as whether, what I'm speaking of, these create, redeems, and it's under code section 852B6 for the tax geeks out there. But, people take various positions, whether it's a good thing, bad thing. I'm not going to comment on that. But to give you, some background in that, Senator Wyden, who I think was heading up maybe the Finance Committee at the time in 2021, he put forth a proposal to do away with this code section 852B6, which the ICI pushed back on tremendously as well they should, basically saying you're going to blow up the ETF industry if you remove this.
ETFs are, ETFs are, being used by common investors. This isn't something that you guys should be pursuing. And I don't think, the current proposal has, has much, has any legs, but it's out there. So the idea is who knows what the future holds, but for now ETFs can generally be much more tax efficient than your average mutual fund. Yeah.
So we have a lot of asset managers and even financial advisors who some of these financial advisors are actually thinking about launching ETFs on their own because they've got client accounts and they want that tax efficiency. So for them who are thinking about getting into the ETF space, could you kind of walk us through a simple real world example of, how a 351 exchange might work and also the steps that they need to take in order to properly facilitate it?
Right. So I generally deal with, the tax aspects of it. And although, we do our diligence to make sure the diversification tests are met, there are, there's very few documents involved from the actual tax side. Probably the biggest lift, if you're thinking about it, is, filing your prospectus with the SEC going through that approval process. I think the minimum, and I'm not a securities lawyer, but I think the minimum time period on that is 75 days. So, you need to consider all that if you're shooting for a specific time as to when to launch.
Really, there are a lot of fund administrators out there that you want to partner with. You want to find someone that has done this transaction before that can show you that it's been successful. You don't want to launch a fund and then, two years later you're closing it because you haven't had market makers that are interested in it. You're, a whole host of reasons why funds close down. You want to get to market. You want to obviously have good performance and increase your AUM. That's, that's what most managers want to do.
So, if they're, again, looking at this process in terms of creating their ETF, is facilitating a 351 exchange going to cost more money? Is it going to take more time? can you maybe get into that a little bit?
Yeah. So, obviously there are costs for all your, for all your providers. when you reach out to your fund administrator, they're going to charge you a certain amount to get the fund up and running. Obviously, you're going to need lawyers. You're going to need securities lawyers. They're going to charge a certain amount. You're going to need tax lawyers. They're going to charge a certain amount. You're going to need accountants. So, you have to figure in all those costs into your cost-benefit analysis. But the idea is, look, at the end of the day, what are you doing for your clients? You're giving your clients an ETF share that they can monetize at any time on the marketplace.
They can margin it. And what's good from you is if an SMA account holder wants a redemption, well, guess what? You have to sell their securities and give them cash. And that takes AUM out from your pool. But with an ETF, they're selling that share in a secondary market. So, it's going from party A to party B. It's not a redemption against the fund. So, the ETF itself maintains that asset base, the AUM under management. And in addition, obviously, the tax efficiency of the ETF structure is really what's driving the explosive growth.
Yeah. so, I'm just – as I'm listening to you and the pros and cons, right? I think for an advisor, the pro here is I think it gives you – you're going to spend more money, but it's going to give you a pool of assets and a story to be able to move those assets. And really, for the client, in order for them to move, it makes it less difficult because they're not going to have an immediate tax liability because they want to be an original investor or first-time investor in your ETF. That's exactly right.
If you have long-term clients and they've been with you and they really appreciate the strategy that you've been executing and the returns they've been seeing, you're just moving that account into a new wrapper and you're going to continue to execute that strategy. So, they're going to stay with you. It's frictionless to them, so they're okay with it. And it gives them certain advantages, namely that if that portfolio needs to be rebalanced, it can be done in such a way that there isn't a tax hit to them at that time. Obviously, as the portfolio continues, 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. 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 SMA. I'm only running Apple. It's 50% allocated to Apple and it's 50% allocated to NVIDIA, right? And I convert it into the ETF and I take my basis with me, okay? Now, as part of the ETF rebalance, I sell one of those positions. Let's say I sell Apple and I buy IBM, right? How – now what – how do they continue to monitor and follow basis adjustments? And this might be too technical. Over time, so that when the client does eventually sell their ETF, they have to realize the gain.
Sure. So, let's start with your example first. Your example wouldn't work in a 351 simply because you're transferring two positions. If you're transferring two positions, one's got to be greater than 50%, right? So, putting that aside, let's say you put in a diversified portfolio because that's what we need for the past, the 351 test. So, whatever your tax basis is in all those securities, it's called tax lot. So, even if you own Apple, you may have bought Apple at, 100 years ago at $75, right? And now it's – I don't even know what the term.
They took a number. Yeah, 1,000, let's say. And you buy it again. Well, now you have two different tax lots. And, you have Apple, you have IBM, you have Walmart, a whole bunch of different securities. So, you'll have a whole bunch of different tax lots. And those individual tax lots get sort of aggregated and broken up among the ETF shares that you receive. So, when you do sell those ETF shares down the road, it will be based on that historic tax basis that you had in the underlying securities. Similarly, when the ETF takes those securities, it's going to take a carryover basis for those securities.
However, the disposition of those securities with the tax efficiency means it could be done without recognizing tax. So, although they need that information, it generally won't create – it won't be relevant because they'll dispose of those securities and create, redeem without recognizing the tax.
So, simply stated, I think I understand this, on the date of launch, let's say you're launching at NAVS 25, right? Right. Your cost basis might be reflective of a NAV, and I'm making up a number, lower than 25, right? And will that show your tax basis? Exactly.
Okay. So, ETFs generally launch at $25 a share. And let's say I have $2,500 in value. So, I'm going to put $2,500 in the 351 exchange. In exchange, I'm going to get 100 shares. So, I'm going to have 100 shares of the ETF. Now, I have to take all my historic tax information and allocate it to those 100 shares. And that's really – in transacting a 351 exchange, that's really where the heavy lift is. And you have to make sure your custodians are at the plate, the fund administrators are at the plate, your advisors are at the plate, because it is a huge information exchange.
But outside of that, it's a fairly simple process going forward.
All right. Well, I got it now. So, well, Ray, I really appreciate your time. Before I let you go, where can people learn more about you and learn more about the firm?
So, the firm is Practice LLP. It's practice.com. Practice is spelled P-R-A-C-T-U-S. I'm told the genesis of that was Practice With Us. It was a marketing thing. But, yeah, like I said, we are a completely virtual law firm. We have a mail drop in Kansas, our IT, our marketing, a few other departments. But the actual attorneys sit all around the country. We're easily accessible. We've all worked at big law firms. We're very familiar with the spaces that we practice in.
And it's a great place to work. I'll make a pitch for lawyers out there that are listening to this. If you're thinking about making a move and trying something different, reach out to us. It's a great place to work.
Well, Ray, again, thank you so much for spending some time with me today. Thank you. Have a great day.
Have a great day.
Daily Market Intelligence
The Signal
Brad Roth's daily market brief — systematic signals, ETF positioning, and what the data is actually showing.
Subscribe Free →