The US tax code, with its myriad rules and regulations, can seem like a labyrinth designed to confound the average taxpayer and full of tax loopholes. However, hidden within its complex structure lies a powerful tool that allows the rich and connected to avoid capital gains taxes indefinitely: the Section 351 conversion.
Section 351 of the Internal Revenue Code permits individuals to transfer appreciated assets, like stocks or securities, to a corporation in exchange for shares of that corporation without triggering a taxable event. This mechanism is particularly relevant in the context of Exchange-Traded Funds (ETFs), where investors can “seed” the launch of a new ETF by contributing a diversified portfolio of assets in exchange for shares of the ETF. This process, known as a “351 exchange”, effectively transforms a portfolio of appreciated assets into ETF shares, all while deferring capital gains taxes.
Section 351 allows investors to exchange a portfolio of securities for shares in a new ETF. And if done correctly, the transaction can be tax-free.” – Wesley R. Gray, the CEO at Alpha Architect
The benefits of this strategy don’t stop at tax deferral. ETFs offer several advantages over traditional investment vehicles like Separately Managed Accounts (SMAs), including market access, tax efficiency, and transparency. Furthermore, converting to an ETF can provide operational and cost benefits and improved investment selection.
So, how does this benefit the wealthy?
- Indefinite Deferral: The ETF structure, coupled with the 351 exchange, allows investors to indefinitely defer capital gains taxes. As long as the shares of the ETF are held, the embedded gains remain untaxed.89 This benefit becomes even more pronounced when shares are held until death, as the step-up in basis rule under Section 1014 effectively eliminates any inherent gain.
- “Heartbeat” Trades: ETFs can further exploit this tax advantage through a complex maneuver known as “heartbeat trades”. These trades involve the creation and redemption of ETF shares in rapid succession, using custom baskets of securities, to effectively “wash out” realized gains without triggering a taxable event.
- Unequal Benefits: The tax benefits of Section 852(b)(6), which governs the taxation of ETFs, disproportionately favor high-income, high-net-worth investors. By facilitating the deferral or avoidance of taxes, these provisions enable wealthy investors to compound their gains at a faster rate, widening the income and wealth gap.
Concerns and Potential Solutions
The tax advantages offered by 351 conversions and ETFs have raised significant concerns. Critics argue that these provisions violate fundamental tax policy norms, costing the Treasury billions in lost revenue.
Several potential solutions have been proposed, including:
- Repealing Section 852(b)(6): This would eliminate the tax exemption for in-kind redemptions by ETFs, effectively closing the loophole that enables tax avoidance.17
- Converting ETFs to a Partnership Tax Regime: This would subject ETFs to the same tax treatment as partnerships, potentially mitigating the tax advantages they currently enjoy.18
- Implementing a Basis-Reduction Rule: This approach would reduce the basis of an ETF’s remaining portfolio securities by the amount of unrecognized gain on securities distributed in in-kind redemptions.
While the debate continues on the best approach to address the tax advantages enjoyed by ETFs, one thing is clear: the current system allows wealthy investors to exploit loopholes and avoid paying their fair share of taxes. Addressing these issues is crucial to ensure a fairer and more equitable tax system for all.
