The stock market has treated most people well over the past decade and a half, aside from a few rough patches like 2022. Large growth companies in particular have compounded at an incredible rate.
As great as that is, it creates a real problem for a specific group of investors: those who end up concentrated in a single stock or a small handful of companies. Maybe you invested years ago and rode the growth. Maybe you received the stock through your employer. Either way, you can end up stuck in a tough spot. You're nervous to rip the bandaid off and face a massive tax bill, but you're equally nervous about what happens if that stock drops.
This is where a strategy called a 351 exchange can come into play.
What Is a 351 Exchange
Section 351 of the tax code has been around for decades, but it's recently become more popular in the ETF and stock investing world.
Originally, it was created to incentivize people to invest in corporations. It allows you to transfer property in exchange for shares of a corporation and receive tax-deferred treatment, meaning it's a non-taxable event, as long as the group of people transferring assets ends up owning at least 80% of the resulting corporation.
More recently, this rule has found a new use case in the public markets. A 351 exchange can now allow you to swap individual securities for shares of a diversified ETF without triggering a taxable sale. You pool your shares together with other investors doing the same thing, and collectively that group owns more than 80% of the new ETF structured as a corporation.
How It Works
A few things need to be true for this to work:
- There needs to be a new ETF coming to market. Your shares, pooled with others', become part of the capital that funds it.
- Diversification rules apply. No single stock can make up more than 25% of the contributed portfolio, and no five stocks combined can make up more than 50%.
- The ETF sponsor has to approve the securities being transferred in. They also need to fit the ETF's stated objective. You can't transfer in a basket of small cap stocks for a fund that's supposed to be large cap focused.
- ETFs are viewed on a "look through" basis. If you transfer in an ETF rather than individual stocks, it isn't counted as one holding. The sponsor looks at the underlying holdings inside that ETF and breaks it down into its individual pieces.
Because of these rules, your starting portfolio can't already be fully concentrated in one name. But this strategy works well in a common scenario: a client holding 15 to 20 stocks concentrated in one sector, like tech, who wants to diversify into something broader, like a total US stock market ETF.
The Benefit: Tax Deferral, Not Tax Elimination
A 351 exchange doesn't make your tax bill disappear. What it does is let you avoid an immediate, forced decision to sell and pay capital gains all at once.
Compare two paths:
- Sell today. You pay capital gains tax now, and you reinvest whatever's left.
- Exchange into the ETF. You defer the tax, keep your full balance invested, and let a larger amount compound over time.
More often than not, the second path leads to a better long-term outcome. You also end up owning a more diversified fund that better matches the risk you're actually comfortable carrying, and you can strategically sell shares over time without jumping into a higher capital gains bracket all at once. Behaviorally, this takes a lot of the anxiety out of the decision. You're not forced to make a rash call out of fear.
How This Compares to Exchange Funds
If you've researched concentrated stock strategies before, you may have come across exchange funds, which serve a similar purpose but work differently.
Exchange funds are typically private placements, often requiring a long lock-up period, commonly seven years, before you can redeem your shares without penalty. A 351 exchange, by contrast, results in shares of a publicly traded ETF, which means daily liquidity and no lock-up requirement.
Exchange funds often require a minimum investment size that puts them out of reach for many investors. The ETF structure behind a 351 exchange tends to be more accessible.
Exchange funds also frequently hold a small allocation to real estate or other illiquid assets to satisfy partnership tax rules. A 351 exchange into an ETF doesn't carry that same requirement, so the underlying holdings are simpler and more transparent.
The Downsides to Know
This strategy isn't a perfect fix, and it's worth understanding the tradeoffs:
- Higher costs. The internal expense ratio of these ETFs is often higher than what you'd pay for a plain-vanilla, low-cost index fund.
- Not every concentrated position qualifies. The diversification rules mean this won't work for everyone, especially if your holdings are extremely concentrated in one name.
- It's a deferral, not a cure. You'll still owe capital gains tax eventually when you sell shares of the new ETF.
Wrapping It Up
A 351 exchange can be a powerful tool for investors sitting on a concentrated stock position who want to diversify without an immediate tax hit. It's not the right fit for every situation, and the details around diversification rules, costs, and timing matter quite a bit.
If you're sitting on a concentrated position and want to explore whether this strategy makes sense for you, reach out and we can talk through it.
