Section 351: A 100-Year-Old Tax Rule for the Wealthy

For high-net-worth individuals, navigating the complexities of tax law can be a daunting task. A little-known provision in the Internal Revenue Code, Section 351, has been around for nearly a century, allowing wealthy investors to turn a concentrated stock portfolio into a private exchange-traded fund (ETF) and potentially put off capital gains indefinitely.

How Section 351 Works

Section 351 allows a taxpayer to contribute property to a corporation in exchange for that corporation's stock without recognizing gain at the moment of transfer. This means that when a wealthy investor contributes appreciated securities to a newly formed ETF, the exchange is treated as a nonrecognition event, and no capital gain hits Schedule D on the way in. The tax is deferred, and the basis carries over to the ETF shares, inheriting each investor's original cost basis and the built-in gain.

When the ETF shares are sold later, the gain reappears, but if the investor holds onto the shares until death, current law gives heirs a stepped-up basis, allowing the deferred gain to vanish entirely. This strategy is often referred to as the "buy, borrow, die" playbook, but with a diversified equity portfolio.

Restrictions and Requirements

While Section 351 offers a tax-efficient way for wealthy investors to manage their concentrated stock portfolios, there are three key restrictions that effectively reserve this strategy for family offices and founders:

  • 25/50 Diversification Test: The fund cannot look like a single-stock trust, with no single position above 25% of the fund and the top five positions capped at 50%.
  • Minimums: Sponsors typically require contributions of $1 million and up per client, plus legal and structuring costs.
  • Control: The IRS requires that the contributors, taken as a group, control at least 80% of the new corporation immediately after the exchange.

These restrictions mean that the typical customer for this service is a top-percentile investor, with IRS Statistics of Income data showing that the top 1% of filers reported 22.4% of adjusted gross income and 40.4% of federal income tax in 2022.

Regulatory Scrutiny and Alternatives

Regulators are watching, and some launches have paired the Section 351 seed with tax-aware long/short strategies that manufacture losses to layer on top of the deferral. However, the plain-vanilla exchange remains squarely inside the code.

For those who don't qualify for Section 351, there are alternative strategies available to any brokerage account holder. These include:

  • Using ETFs, not mutual funds, in taxable accounts to sweep out embedded gains.
  • Harvesting losses every year to offset realized gains without limit, plus $3,000 against ordinary income.
  • Minding the 0% long-term capital gains bracket for married retirees with taxable income under roughly $96,700.
  • Planning around step-up by not selling the most appreciated lot late in life if heirs will inherit it.

Conclusion

Section 351 is a powerful tool for wealthy investors to manage their concentrated stock portfolios and potentially put off capital gains indefinitely. However, it's essential to understand the restrictions and requirements that come with this strategy and to explore alternative options that may be available to a wider range of investors. As always, it's crucial to consult with a fiduciary CPA before making any significant financial decisions.