Requirements & Regulations
Process Of 351 Tax Free Conversion
A 351 tax-free conversion, much like a 1031 exchange for real estate but for public securities, allows investors to transfer appreciated assets, such as stocks or securities, into a newly formed corporation, such as an ETF, without incurring immediate taxable events.
The newly formed entity inherits the cost basis and holding period of the transferred assets, preserving their tax characteristics. This process, often referred to as a “351 exchange,” allows investors to restructure portfolios without triggering immediate tax liabilities.
This mechanism is made possible by Section 351 of the U.S. Internal Revenue Code. For the transaction to be considered tax-free, certain conditions must be met, such as diversification compliance, where no single asset exceeds 25% of the portfolio, and control requirements, where original contributors retain at least 80% control of the ETF’s voting power and value post-conversion. Accurate record-keeping of the cost basis and holding periods for all contributed assets is also crucial for tax reporting purposes.
What Can Be Contributed?
Numerous nontax and tax advantages exist for utilizing an ETF structure, including transparency, liquidity, ease of trading, low cost, scalability, access to complex investments, a larger universe of possible investors, and tax-deductible advisory fees. A 351 tax-free conversion involves the tax-deferred transfer of appreciated assets into a newly formed corporation.
US equities and ADRs
US equities and ADRs, as long as they are liquid and align with the fund strategy
Foreign equities and GDRs
are eligible, provided the market allows for in-kind transfers.
US and foreign ETFs
US and foreign ETFs are allowed. The underlying assets within the ETF are subject to diversification rules, and foreign ETFs must be redeemable in-kind.
Closed-end funds
Closed-end funds are eligible if publicly traded and redeemable in-kind.
Fixed income ETFs
Fixed income ETFs are acceptable if aligned with the broader strategy, but a large portion used to launch an all-equity ETF would not be suitable.
Spot crypto within an ETF
Spot crypto within an ETF (like GBTC) is eligible if aligned with the fund strategy, but spot crypto cannot be held directly.
Commodity ETFs
Commodity ETFs (like GLD) are eligible in small portions if aligned with the fund strategy.
MLPs/Public Partnerships
MLPs/Public Partnerships are acceptable in small amounts if aligned with the fund strategy.
What CANNOT Be Contributed?
In addition to asset types, several other factors influence eligibility for a 351 tax free conversion:
Mutual funds
Mutual funds cannot be traded in-kind, rendering them unsuitable for a 351 transaction.
Private stocks/REITs
Private stocks/REITs and restricted stock units lack the required in-kind redeemability.
Hedge funds
Hedge funds, while potentially eligible, require a complete transfer of assets, alignment with the prospectus, and the unwinding of derivatives exposure and leverage.
Cash
Cash, although often part of a portfolio, is not considered in diversification calculations. For example, a portfolio containing 50% Nvidia stock and 50% cash does not meet the diversification requirement.
ETF Issuers
ETF Issuers and Asset Managers interested raising seed assets for your ETF ExchangiFi.com learn more here.
Investors & Advisors
For investors and advisors seeking tax-efficient portfolio diversification, a Section 351 exchange offers a powerful strategy to defer capital gains taxes while transitioning concentrated stock holdings into a new ETF.