How ETF conversions unlock diversification, tax deferral in stock portfolios

Advisors looking to help investors diversify concentrated stock positions without triggering a major tax bill are exploring Section 351 conversions, a strategy that might also help them reach prospective clients with similar challenges.

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A 351 conversion or exchange moves a stock portfolio, such as from a separately managed account, to a newly launched ETF and allows clients to defer paying capital gains taxes. But these transactions must meet diversification requirements: No security can exceed 25% of the portfolio, and the five largest holdings cannot total more than 50%.

“What the IRS and Treasury define as ‘diversified’ probably isn’t what an advisor would define as ‘diversified,'” said Andy Pratt, managing partner and director of investment strategy at Reston, Virginia-based registered investment advisor Burney Wealth Management. “A 25% position in one name … most advisors would see a portfolio that looks like that and say, ‘That’s pretty concentrated. We need to do something about that.'”

For advisors, the challenge is often helping clients with exactly those types of highly appreciated, concentrated positions without creating a large tax bill.

“My clients who have concentrated Google stock, concentrated Microsoft stock, Grandma’s Apple stock — they have no way to safely diversify this without paying a tax consequence,” said Andrew D. Urbanski, founder of N10 Holdings in Greenwich, Connecticut and formerly of Wells Fargo Advisors. “We can take in $50 [or] $60 million of those securities along with our $300 million into the 351 and those clients get not only a big benefit on their existing holdings but a big benefit on these outside holdings.” 

Urbanski plans to launch a Section 351 exchange in November. Pratt has done these transactions for clients, as has Keith Dubauskas, managing partner and chief investment officer at Jupiter, Florida-based registered investment advisor One + One Wealth Management. 

Dubauskas said that from what he’s seen, RIAs and family offices are the primary users of 351 conversions, while wirehouse advisors may face additional compliance requirements or platform constraints that can make the strategy harder to implement.

READ MORE: New ‘investor-friendly’ ETFs unlock tax deferral on appreciated assets

Finding clients or business partners

Matt Bucklin founded Palm Beach Gardens, Florida-based capital markets platform ExchangiFi, a centralized portal to connect advisors like Dubauskas with ETF sponsors and facilitate 351 conversions. Financial advisors face a difficult balance between the duty to diversify client portfolios and the need to protect them from steep, immediate capital gains taxes, Bucklin said. To avoid those tax bills, many investors with concentrated holdings allow money to just sit.

In addition to helping certain clients on diversification and tax fronts, 351 conversions could also offer advisors the potential benefit of attracting new high net worth clients.

“It’s a marketing opportunity for us because we get to show these clients that we’re versed in dealing with innovative, sophisticated strategies to help them meet their end goals, and obviously show them that there’s things out there that they could never access on their own, self-managing,” Dubauskas said.

These transactions can be done in two different ways, said Brittany Christensen, SVP and head of business development at Milwaukee-based Tidal Financial Group, which facilitates creating and operating ETFs.

“‘Syndicated’ means I don’t have an existing relationship with the investor that I’m asking to contribute to start my fund, and they don’t necessarily have a relationship with me as a money manager,” she said. “Non-syndicated — I have a fiduciary relationship with these clients. They already understand how I’m investing their money, and I’m just moving it into a more efficient technology with the ETF effort.”

READ MORE: Locked into concentrated capital gains? Exchange funds could help

Regulatory clarity could open 351 ‘floodgates’

Christensen and other industry participants expect that more explicit rules on Section 351 conversions could accelerate adoption of the strategy. The Investment Company Institute (ICI), for example, requested guidance from the U.S. Treasury Department and the IRS.

“Guidance would provide necessary tax certainty for our members who engage, or may consider engaging in section 351 transactions for legitimate business reasons, such as seeding an ETF when a manager seeks to scale a successful investment strategy from separately managed accounts,” Katie Sunderland, the ICI’s associate general counsel for tax law, wrote in a May 29 letter.

In February, Bloomberg reported that the Treasury Department was “in early discussions” about potential guidance on the topic.

Bucklin also sees the prospect of guidance as helpful.

“I believe that if it’s all done correctly, this isn’t going away, and I know that every large asset manager is looking into this and just waiting for some clarity on it,” Bucklin said. “When the Treasury comes out and says, ‘Here are the rules of the road. Here’s what you can and can’t do,’ and clears up these gray areas, their legal counsel will … know what to tell them to do, and the floodgates are going to open on this 351.”

However, Pratt said existing rules, such as those involving 25% and 50% limits within portfolios, are “clearly specified,” so the landscape is adequately clear. If regulations and laws end up changing, he questioned whether those would be retroactive or only apply going forward.

Urbanski, meanwhile, sees 351 exchanges as part of a shift away from separately managed accounts and toward ETFs. 

“351 exchanges are the future, only because it’s the only way to move the industry from where … all that capital currently is, which is mostly in [separately managed accounts], into that structure that’s more tax efficient,” he said.