Financial advisors have two contradictory fiduciary duties. The first is to diversify and rebalance client portfolios, which means selling winners when they get too big. The second is to minimize taxes, which means not selling winners because they trigger capital gains taxes.
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For high net worth clients, the ultimate tax hack is to die, at which point heirs get a step-up in basis and the tax disappears. But since most clients prefer to stay alive, advisors need a way to diversify concentrated positions without handing over a chunk of the gains to the government.
One increasingly popular strategy, due to its simplicity, is a Section 351 ETF conversion. Under Section 351 of the tax code, contributing property to a corporation in exchange for stock is not a taxable event. Since an ETF is simply a corporation — a regulated investment company — that holds a basket of securities, investors contribute appreciated stocks to a newly created ETF in exchange for ETF shares of equivalent value. In doing so, they delay paying capital gains tax since the original cost basis remains.
There are some minimal requirements. Each investor needs to contribute a reasonably diverse basket — no single stock over 25% of the portfolio value — and the top five stocks can’t exceed 50% (the “25/50 rule”). The contributed stocks should align with the ETF’s approved strategy, but since there’s no actual guidance from the SEC or IRS on what that means, the answer depends on which lawyer you ask.
Finally, contributors must collectively own at least 80% of the fund, but since in a new ETF everyone owns 100%, that point is moot. Check those boxes, and your clients get diversification and risk management, and the IRS has to wait to get paid. Here are four ways wealth managers can use this strategy to benefit clients.
READ MORE: ETF inflows top $500B in first half of 2025 as advisors fuel boom
Re-indexing after direct indexing
In direct indexing, instead of buying an S&P 500 fund one buys most or all of those stocks individually, generally for tax-loss harvesting purposes. The problem is that after years of tax-loss harvesting, there are no more losers to sell and the portfolio no longer mirrors the S&P 500.
Rebalancing by selling the winners and rebuying the losers involves paying capital gains taxes. The Section 351 exchange offers a reset, or re-index, of a portfolio: Contribute the winning stocks to an ETF and the ETF deals with the rebalancing back into the index, giving clients that core equity index exposure once more.
READ MORE: New website aims to support emerging Section 351 ETF conversions
Solving the patient/lucky investor dilemma
Say a client worked at a company for 20 years, got paid in stock and/or participated in an employee stock purchase agreement and the stock went up 10,000%. They now have $10 million in one stock. If the client sells, they pay $2 million in capital gains taxes. However, if those shares are swapped into the ETF, the client pays $0 in taxes and gets to continue compounding from a higher base into retirement.
This same strategy would also work for a client who inherited legacy stock positions or made some lucky stock picks and sat on them for a long time. As long as there are other stocks to meet the basic diversification requirements to participate in a 351 exchange, those stocks can be exchanged for new ETF shares.
Dodging a pending forced taxable event
In this scenario, a client owns stock in a company a private equity firm is taking private for cash, probably at a premium to the share price. But the client will still owe taxes when the cash hits their account unless they swap the shares into an ETF. Now the ETF owns the shares, and the investor has shares in the ETF and delays paying that capital gains tax.
This is especially useful when an ETF is shutting down, which happens all the time in today’s crowded ETF market. Normally, when an ETF sponsor decides a fund isn’t economically viable anymore, they liquidate it, investors get cash and everyone pays capital gains tax. With a Section 351 exchange, investors can swap their shares in the ETF on the chopping block for shares in a new ETF, thereby avoiding the forced taxable liquidation.
Cleaning house
Advisors often inherit portfolios with dozens of overlapping funds, legacy stock positions, multiple custodians and maybe even old stock certificates. It’s operationally painful and expensive to manage. A 351 exchange allows the advisor to consolidate that mess into one diversified ETF.
True, a simpler portfolio with lower expenses might mean lower fees. But in practice, clients stick with advisors who fulfill their fiduciary duty by making their lives simpler and saving them on taxes. They leave advisors who keep their portfolios complicated to generate more fees.
Section 351 fits in nicely with an advisor’s value proposition. If a financial planner charges the usual 1% of assets, they can point out that Section 351 may save the client 20% of their assets in taxes — the equivalent of 20 years of fees. Everyone is happy, and the advisor may find opportunities to move those assets from brokerage accounts to the advised side.
Such strategies are yet another reminder that high-end investment management is mostly tax management. In an environment where everyone can get cheap market beta and outperformance is nearly impossible, stock picking takes a backseat to keeping the government away from a client’s capital gains.
