Invest2 publishers3 min readPublished
Treasury's 351 ETF crackdown turns on whether the converted portfolio stays the same
Treasury limited one Section 351 ETF conversion on Monday and called others potentially abusive, as more than 120 funds use the structure. Advisers who sold it as a tax play now face a harder pitch, judged on how the portfolio is run after the swap.
The Investor · Invest desk
What happened
- Treasury officials had called the conversions "too good to be true" at an industry event, but Monday's move was the first regulatory action taken against them.
- More than half of the funds using the structure launched within the past year, which works out to more than 60 new funds in twelve months.
- The guidance does not say how long a manager must wait after a conversion before a change to the portfolio counts as a reasonable move.
- Treasury will take public comment on the targeted transactions, and on others it says deserve similar treatment, until the end of October.
- Baird's Tim Steffen still calls the conversion a legitimate strategy but says he would hesitate to promote it until the IRS spells out the guidance's scope.
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Why it matters
- constraint With no safe period stated, a manager who rebalances a converted portfolio learns only after the fact whether the move was reasonable, so the cautious course is to change little.
- contradiction One account treats diversification as the protected use while Chou rules out diversification by planned disposal, and RIA funds built to cut concentration risk sit where those readings split.
- decision Advisers who pause new conversions until the scope is clear have to pick substitutes, and Steffen points them to opportunity zone funds and direct indexing.
- precedent Box-spread ETFs and funds that sidestep dividend income by flipping between ETFs were flagged alongside 351s earlier this year, so Monday's test gives Treasury a template for them.
Rick Wedell, president and chief investment officer of RFG Advisory, describes the guidance as a continuity test. He said the structure now requires that "whatever your contribution portfolio is and however you were managing that in the past, when you move it into the new ETF structure, you need to continue to do whatever it was that you were doing in the past with that portfolio" [9]. The case he expects the IRS to pursue is the investor who pools assets, completes the exchange, then quickly sells the portfolio and buys something else, paying no tax on the repositioning [10].
Section 351 lets appreciated assets move into a new vehicle without an immediate capital gains bill, provided the fund meets certain requirements [5]. Treasury's objection, in its statement, is to where some investors end up: they "purportedly avoid recognition of the built-in gains in their securities while effectively exchanging those securities for an indirect interest in an ETF with a materially different portfolio" [4].
Shang Chou, co-founder of the multi-family office Dishmi Capital, draws the line at intent. A "pre-planned idea to dispose of those assets" is "going to be a no-go going forward," he said [13]. Tim Steffen, director of advanced planning at Baird Private Wealth Management, does not expect the IRS to shut the structure down, but said "they're definitely going after the most egregious abusers of it" [18].
Wedell was blunt about advisers who sold the product on taxes [7]. "I think for certain players that were purely marketing this as a tax avoidance strategy, that sale becomes much harder, and they're going to want to think about whether or not they want to go down that path," he said [7]. I think the exposure runs wider than the marketing. WealthManagement's account places investors who convert for diversification, while continuing to manage the portfolio, mostly outside the IRS's sights [12]. Yet the RIA launches it cites this year, from Ritholtz Wealth Management and Dynasty-affiliated N10 Holdings, were built to mitigate concentration risk [16]. Turning one large position into many looks like the materially different portfolio Treasury described [4], and Chou's no-go covers diversification reached through planned disposal [13].
The counter-case is what Chou called "well-behaved 351s," funds whose contributed assets already fit the ETF's core strategy [14]. He set the MIG Core ETF, which took in assets from the Hot Pocket empire, against "ETF firms looking to launch S&P 500-tracking ETFs and willing to take in diversified baskets" [15]. If the Ritholtz and N10 funds accepted only contributions that matched their strategies, they sit on his safe side; the reporting does not describe how either fund handles contributions [16].
This view is wrong if the text Treasury issues after its comment period [6] treats a gradual sell-down of a contributed concentrated holding as ordinary management.
Wedell expects "a little bit of a chilling effect on the industry." He added: "And, candidly, I think that's what the IRS wants" [8].
What to watch
- Whether the text Treasury issues after the end-October comment close sets a period during which a converted portfolio must be run as before.
- Comment letters from sponsors of concentration-risk 351 ETFs, including the Ritholtz and N10 funds, describing how they handle contributed positions.
- Whether box-spread and dividend-flipping ETFs get their own notice under the same substance test.