Recent innovations in ETF structures are expanding tax-advantaged portfolio restructuring options for clients with concentrated positions in appreciated securities. The mechanism leverages Section 351 of the Internal Revenue Code to facilitate in-kind exchanges of diversified stock portfolios into specially designed ETFs, potentially deferring capital gains recognition while maintaining market exposure.
Operational Framework
The conversion process allows investors to contribute appreciated securities directly to qualifying ETFs in exchange for shares, structured as a tax-deferred transaction under Section 351. This differs from traditional portfolio rebalancing, which typically triggers immediate capital gains recognition. The contributed securities must align with the ETF's investment mandate and meet certain diversification requirements.
Key Market Developments
Cambria Investment Management, in collaboration with ETF Architect, launched the Cambria Tax Aware ETF (TAX) in December 2023, specifically designed to accommodate these conversions. The fund targets value and quality stocks with minimal dividend yields, addressing both capital gains deferral and ongoing tax efficiency through dividend minimization.
Client Qualification Parameters
The strategy is particularly relevant for clients holding:
- Concentrated positions with substantial unrealized gains
- Diversified portfolios requiring rebalancing
- Minimum investable assets between $200,000 and $1 million
- Securities aligned with the receiving ETF's investment mandate
Tax Treatment Analysis
1. Initial Conversion:
- No immediate capital gains recognition on qualifying contributions
- Carried-over basis in received ETF shares
- Holding period tacks from original securities
2. Ongoing Considerations:
- Deferred gains remain until ETF shares are sold
- Step-up in basis available upon death under current tax code
- Reduced dividend tax exposure through fund construction
Technical Requirements
To qualify for tax deferral under Section 351:
- Contributors must transfer property in exchange for ETF shares
- The transaction must be part of an overall qualifying exchange
- Portfolio components must meet fund diversification standards
- Contribution must align with fund's investment objectives
Compliance Considerations
While the strategy leverages established tax code provisions, practitioners should:
- Document qualification under Section 351 requirements
- Maintain detailed basis records for contributed securities
- Consider wash sale implications if clients maintain similar positions
- Monitor ongoing portfolio compliance with fund requirements
Implementation Strategy
Advisors should evaluate:
- Client's current portfolio composition against fund parameters
- Transaction costs versus tax deferral benefits
- Long-term investment alignment with ETF strategy
- Alternative tax management strategies (e.g., charitable trusts)
Risk Assessment
Key considerations include:
- Regulatory changes affecting Section 351 treatment
- Market liquidity of the receiving ETF
- Investment mandate drift affecting portfolio fit
- Future tax rate differential implications
This emerging application of established tax principles through ETF structures offers sophisticated tax deferral opportunities previously limited to ultra-high-net-worth investors through swap funds. While the strategy presents compelling tax advantages, practitioners should carefully evaluate client-specific circumstances and maintain thorough documentation of qualification requirements.
Christine Gervais is a licensed CPA, using her skills to help businesses grow and achieve their fullest potential. Christine has a Master’s degree in accounting from Southern New Hampshire University in addition to holding her CPA license for over a decade. Notably, Christine is a nationally recognized speaker providing education to other CPAs on how to best serve clients as well as instruction on a wide variety of topics for business owners on how to maximize success. Christine prides herself on the value she can bring to clients with her extensive tax knowledge and provides strategic, forward-thinking financial strategies to help clients grow. When not behind her desk, you can find Christine spending quality time with her daughter and stepson or tending to the family’s excessively loved farm animals.
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