What is a 351 ETF Conversion?
A 351 ETF conversion allows investors to transfer assets into an ETF in exchange for shares without triggering a taxable event. This tax-related mechanism is specifically under U.S. tax law Section 351 of the Internal Revenue Code. Investors can contribute a portfolio of investments and, in return, receive a diversified ETF.
Why Convert SMAs to ETFs via Section 351?
Investors and advisors should understand why it makes sense to convert separately managed account (SMA) assets into an ETF through a 351 tax-free conversion. Section 351 allows investors to transfer assets like stocks or securities into a newly-formed ETF without immediately triggering taxable events.4 The cost basis and holding period of the transferred assets are inherited by the ETF, which preserves tax characteristics.4 The benefits of converting SMA holdings to an ETF through Section 351 include:
Tax Efficiency: Investors can defer capital gains taxes and preserve their original cost basis and holding periods for the assets.
Enhanced Liquidity: ETF shares trade on exchanges, allowing for greater liquidity than typically found in SMAs.
Operational Efficiency: ETFs streamline management, trading, and administration, reducing operational burdens.
How Does a 351 Conversion Work?
Individual investors contribute securities to a newly formed ETF in exchange for shares. Under Code Section 351(a), there is no recognized gain or loss if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in “control” (as defined in Section 368(c)) of the corporation. For example, individual SMA investors will contribute securities to a newly formed ETF in exchange for shares of the ETF.
What are the Tax Consequences of SMAs That Convert Into an ETF?
The ETF will have no taxable gain or loss because it will have a carryover basis and carryover holding period in the assets transferred. For instance, if the SMA contributions have a 0 basis in a portfolio of assets, the ETF will also have a 0 basis in the same assets. The investors will also have no taxable gain or loss on the transaction. They will have a carryover basis and carryover holding period in the ETF shares corresponding to the basis and holding period of the transferred assets.
What are Important Considerations for a 351 Conversion?
There are several logistical factors that need to be considered before a 351 conversion.1213 Making a plan to tackle these issues can help to ensure the process is smooth and allows for the success of the ETF after the conversion is complete.
Gaining Client Permission: Current investors need to give their permission for the conversion to happen before an SMA is converted to an ETF. This letter informs them of an impending action, which is the conversion, and gives them a specific time frame to respond if they object.12
Record keeping: Accurate record keeping of the SMA is necessary before converting it into an ETF. This means logging the cost basis and purchase date of every position in each client account.
Dealing with Custodians and Similar Parties: The in-kind transfers can be time-consuming for the advisor and custodians, depending on who acts as the present custodian for the securities transferred or if multiple custodians are involved. Lead time may be required.
Sufficient AUM: Before the conversion process starts, the advisor should consider whether the strategy has sufficient assets.
Alignment with Go-Forward Prospectus: The advisor, along with ETF Architect and tax counsel, will evaluate the proposed securities to be transferred against the draft prospectus for the ETF that will “receive” the securities.
What are the Diversification Requirements for a 351 Conversion?
For a transfer to satisfy the Section 351 requirements, each transferor’s portfolio must have its largest holding represent less than 25% of the total portfolio of that transferor.18 The ETF must meet IRS diversification standards to ensure no single asset exceeds 25% of the portfolio and that assets exceeding 5% collectively remain under 50%.19
Who Can Contribute to a 351 Conversion?
LP: An existing LP can easily be converted into an ETF.
Foundations and Tax-Exempts: These are almost always acceptable transferors.
Trusts: Similar to the situation with LPs, there is typically a way to accommodate trusts.
Corporations: Transfers from corporations can be more challenging.23 If property owned by a “C corporation” becomes the property of a RIC or REIT (the “converted property”) in a “conversion transaction,” then a so-called “built-in gains tax” will apply…unless the C corporation elects deemed sale treatment regarding the conversion transaction.23 Transfers from S corporations may be possible, but further analysis is required.
ERISA Accounts: ERISA assets cannot be transferred on an in-kind basis without a Department of Labor exemption.24
What Types of Assets Can be Contributed in a 351 Conversion?
US Equities/ADRs: Yes, ensure names align with the fund strategy and avoid illiquid and OTC securities.
Foreign Equities/GDRs: Yes, ensure names align with the fund strategy and ensure the market/country where local names are held allows in-kind transfers.25
Mutual Funds: No, mutual funds cannot be traded in-kind.
US ETFs: Yes, ETFs are treated as “look-through” for diversification purposes.25 For example, a 351 contribution with 10% SPY is really a 351 contribution with SPY’s holdings.
What are Common Mistakes to Avoid in a 351 Conversion?
It is important to plan and execute a 351 conversion carefully to avoid mistakes.26 Experienced tax counsel, securities counsel, and a meticulous team are needed.26 Here are common mistakes to avoid:
- Miscalculating positions.
- Neglecting risk disclosures.
- Lack of collaboration between the various parties involved.
- Not understanding foreign securities and other “challenging” assets.
- Failing to address affiliated transactions.
- Challenges associated with aggregating accounts.
- Issues with transferors that are not individuals.
- Misinterpreting the types of securities eligible for transfer.
- Unexpected fluctuations in asset values prior to conversion.
- Insufficient attention paid to the economic substance doctrine.
How Can I Learn More About 351 Conversions?
For additional information about 351 conversions, check out these links below.
