Treasury's 351 ETF crackdown turns on whether the converted portfolio stays the same

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" ^[4]. 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 ^[5].

Section 351 lets appreciated assets move into a new vehicle without an immediate capital gains bill, provided the fund meets certain requirements ^[3]. 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" ^[12].

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 ^[7]. 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" ^[20].

Wedell was blunt about advisers who sold the product on taxes ^[14]. "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 ^[14]. 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 ^[6]. Yet the RIA launches it cites this year, from Ritholtz Wealth Management and Dynasty-affiliated N10 Holdings, were built to mitigate concentration risk ^[18]. Turning one large position into many looks like the materially different portfolio Treasury described ^[12], and Chou's no-go covers diversification reached through planned disposal ^[7].

The counter-case is what Chou called "well-behaved 351s," funds whose contributed assets already fit the ETF's core strategy ^[8]. 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" ^[17]. 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 ^[18].

This view is wrong if the text Treasury issues after its comment period ^[13] 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" ^[15].