Section 351 of the Internal Revenue Code offers a powerful tax-deferral tool for investors seeking to diversify their portfolios without triggering immediate capital gains. This provision allows individuals to contribute appreciated assets to a corporation, often an Exchange-Traded Fund (ETF), in exchange for shares, deferring taxes on those gains. However, this tax-free exchange is contingent on meeting specific diversification requirements. One crucial aspect of these rules is the “look-through” treatment applied to ETFs, which can significantly impact an investor’s eligibility for a 351 exchange.
- The diversification requirements mandate that:
- No single asset can exceed 25% of the total portfolio value.
Assets exceeding 5% individual weighting cannot collectively represent more than 50% of the portfolio. This translates to a minimum of 12 securities for a compliant portfolio.
The “look-through” treatment for ETFs means that these diversification tests are applied not to the ETF itself, but to the underlying holdings within the ETF.4 This is crucial because ETFs, by their very nature, hold a basket of securities. For instance, if an investor contributes a portfolio with 10% allocated to the SPDR S&P 500 ETF (SPY), the diversification analysis considers the hundreds of individual securities held by SPY, not just SPY as a single holding.
This look-through provision offers a significant advantage for investors seeking to utilize 351 exchanges. By including ETFs in their contribution portfolios, they can benefit from the inherent diversification of the ETF’s holdings, making it easier to meet the IRS requirements.4 For example, an investor with a concentrated position in a single stock can leverage ETFs to diversify their portfolio rapidly, facilitating a tax-free exchange into a new ETF.
However, there are caveats to consider. The look-through analysis does not apply to cash and government bonds held within an ETF.25 These assets are excluded when determining the diversification of the contributed portfolio. This exclusion can complicate the diversification calculation, particularly for ETFs with significant cash or bond holdings.
Additionally, the IRS scrutinizes the alignment of the contributed assets with the investment strategy outlined in the ETF’s prospectus.67 While some flexibility exists, particularly for active ETFs, common sense dictates that the contributed securities should generally reflect the ETF’s stated objectives. This means a long-only US equity ETF, for example, should not receive foreign bonds in a 351 exchange.
In conclusion, the look-through treatment of ETFs within the 351 exchange diversification rules offers a valuable pathway for investors seeking to diversify their portfolios and defer capital gains. By understanding the nuances of these regulations, investors can strategically structure their contributions to maximize the benefits of this powerful tax-saving tool. However, it’s crucial to remember that careful planning, accurate record-keeping, and adherence to IRS guidelines are essential to ensure a successful and compliant 351 exchange.
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