What Advisors Are Asking About Section 351 ETF Exchanges

Section 351 ETF exchanges have moved from a niche institutional strategy to one that many advisors are now actively evaluating, and the questions submitted during a recent webinar presented with SS&C ALPS Advisors and VettaFi reflected that. They were detailed and practical. Advisors wanted to know which assets qualify, how the diversification tests work when several clients participate, what happens to tax lots, and how fees work.

That interest makes sense. For the right investor, typically one with a diversified taxable portfolio, large embedded gains, and a long time horizon, a Section 351 exchange can be an effective way to reposition into a professionally managed ETF without an immediate tax bill. Using it well takes a clear understanding of how the rules work in practice, which is what these questions were after. We grouped them by theme and answered each group together; the questions are paraphrased and combined.

This piece is meant to be read alongside our primer, Section 351 ETF Exchanges: How They Work and Who Qualifies, which covers the mechanics, eligibility rules, process, and alternatives. We don't repeat that material here. Where a question depends on it, we link to the relevant section and pick up from there.

The Treasury Department is also reviewing how some of these transactions are being used. This piece reflects publicly reported developments through September 2026, so check for anything newer before acting on it.

Nothing in this document constitutes tax, legal, or investment advice. It does not describe or relate to any specific fund, and it is not an offer of any security. The analysis of any specific investor's eligibility and suitability for a Section 351 exchange requires engagement with qualified tax counsel and financial advisors familiar with the investor's complete financial situation.

What Can Be Contributed

Can mutual funds be contributed, or only individual stocks and ETFs?

Mutual funds generally can't be contributed. It doesn't matter whether the client bought them or they transferred in from a previous advisor. The full list of eligible and ineligible assets, including how ETFs are looked through for the diversification tests, is in the "What Qualifies and What Doesn't" section of our primer.

Mutual fund questions came up more than any other eligibility topic. What the primer doesn't cover is what a client holding appreciated mutual funds might do instead. Some fund families offer an ETF share class of the same portfolio and let mutual fund shareholders convert into it. Vanguard has done this for years with many of its stock index funds, and the conversion is generally not a taxable event when completed at Vanguard. Since late 2025, the SEC has granted exemptive relief allowing a growing number of other managers to add ETF share classes to existing mutual funds. [1] Terms vary by fund and custodian.

Whether a position converted this way could later go into a Section 351 contribution is a question for tax counsel, particularly given how closely the Treasury is watching multi-step arrangements.

What about private company stock, shares from vested stock options, or positions held in a revocable trust or LLC?

Private company stock generally isn't eligible, because programs accept securities that are listed on a US exchange and can be transferred through the Depository Trust Company. Unvested and restricted equity is also excluded, as the primer notes.

Once option shares have vested, been exercised, and become freely tradable, they are ordinary listed stock. The diversification tests still apply, so if the employer's stock would make up more than 25% of the client's contribution, the contribution fails. For many executives that is the constraint that rules the strategy out. Company trading windows and insider restrictions can also limit when shares can move.

Trusts and LLCs are usually not the problem. The primer lists the entity types that generally can participate. For tax purposes, a revocable trust is typically treated as owned by its grantor, and a single-member LLC is typically disregarded, so in both cases the individual is effectively the contributor. What an entity can't do is change the diversification math. A single stock held in an LLC is still a single stock. Treasury officials have specifically questioned structures that route stock through an exchange fund before an ETF conversion, [2] and similar questions could be raised about arrangements that pool assets in an intermediate entity ahead of a contribution.

For concentrated positions that can't meet the tests, the alternatives compared in the primer, such as exchange funds and charitable vehicles, are usually the more relevant starting point. A gradual, tax-aware transition inside a separately managed account is another, which our separately managed account vs. ETF guide discusses.

How the Diversification Tests Work in Practice

Is the 25% limit applied per client or across all contributors, and if each contribution must already be diversified, how does a client's portfolio actually change?

The tests apply to each contributor separately. Treasury Regulation Section 1.351-1(c)(6) treats a transfer as not resulting in diversification if each transferor transfers a diversified portfolio. [3] So every client's contribution has to pass both the 25% and 50% tests on its own. A well-diversified contribution from one client does nothing for a concentrated contribution from another, and the makeup of the combined fund at launch doesn't change that. If a client has several accounts, such as individual, joint, and trust accounts, ask the program's tax counsel how they will be tested.

Contributions are then pooled. Several contributors typically seed one new ETF, and each receives shares in proportion to the market value of what they put in. From that point on, the client owns a share of the whole fund, not the individual securities.

That is why Section 351 doesn't diversify a concentrated position; the portfolio going in has to be diversified already. What changes is who manages the portfolio, and to what strategy. After launch, the fund is run according to its prospectus. Some 351-seeded ETFs track an index. For those, look at the index methodology and, once the fund has a history, its tracking difference and tracking error. A new index fund may start out holding something quite different from its index, since its first portfolio is whatever was contributed. Other 351-seeded ETFs are actively managed, and portfolio changes follow the investment process described in the prospectus.

How a fund moves from its contributed portfolio to its target holdings, and how fast, is exactly what Treasury officials raised in July 2026. [2] The regulations also look past the initial transfer: a transfer made as part of a plan to achieve diversification without recognizing gain can be treated as resulting in diversification. [3] Before recommending any 351-seeded fund, ask the sponsor how that transition will be handled and how tax counsel has evaluated it.

Eligibility, Fees, and Compensation

Are there income requirements or minimums?

Section 351 has no income or net worth requirement. Who can take part in a particular seeding, and at what size, is set by the fund's sponsor and the custodians involved. The primer explains the difference between a per-account minimum and the much larger aggregate amount needed to launch a fund. An individual contributor doesn't need to supply the aggregate amount alone.

Is a new ETF built for each investor, and how are fees and compensation handled?

Advisors sometimes assume a new ETF is built for each investor. It isn't. The structure pools many contributors into one fund, and the fund's sponsor organizes the launch, including registration, legal work, and the tax opinion.

Once the fund launches, the fee a client pays for owning it is the fund's expense ratio, which appears in the fee table of its prospectus, as with any other ETF. If a program charges contributors anything beyond that, it should be disclosed up front in the offering documents.

Fund issuers are generally not paid for the exchange itself. The fund's issuer and any sub-adviser earn the management fee disclosed in the prospectus, paid from fund assets. Because issuers benefit when assets are contributed to their funds, the client's own advisor and tax counsel should evaluate any opportunity independently.

After the Exchange

What happens to tax lots, and how long does a client have to hold the ETF shares?

Cost basis and holding period carry over from the contributed securities to the ETF shares, as the primer explains. How those shares appear on the client's statement is a different matter, and issuers don't all handle it the same way.

Some carry every contributed lot into the ETF as a separate lot. Contribute 10 lots and you get 10 lots back, each with the cost basis and acquisition date of the lot it replaced. Others collapse everything into two lots, one long-term and one short-term, each at an averaged cost.

The difference shows up years later, when the client sells. With lot-for-lot reporting, the client and advisor can still pick which lots to sell, just as they could before the contribution, and control how much gain is realized in a given year. Averaged lots remove most of that flexibility. Ask how a program reports lots before any assets move, and have tax counsel confirm the method.

On selling, there is no required holding period, and the shares trade freely once the fund lists. Intent still matters. Contributors typically represent in writing that they intend to hold the ETF as a long-term investment, and a quick sale could let the IRS argue that the contribution and the sale were steps in one taxable transaction. The primer's discussion of the step-transaction doctrine covers this in more detail. If a client expects to need liquidity, raise it with tax counsel before contributing. Because the holding period carries over, shares sold later will generally produce long-term gain where the original holdings were long-term.

Who provides the tax opinion, and what does it actually cover?

The opinion on whether the contribution met the requirements of Section 351 typically comes from tax counsel engaged for the fund or its sponsor, and is delivered when the transaction closes. It rests on factual representations from the fund and from each contributor, which is one more reason those representations need to be accurate.

An opinion is counsel's professional judgment. It is not a guarantee, and the IRS isn't bound by it. It is usually addressed to the fund. It also does not shield anyone from the strict-liability penalty for transactions found to lack economic substance. [4] Clients making large contributions may want their own tax advisor to read the opinion and the representations before signing.

Purpose and Regulation

A few advisors asked the bigger-picture questions: whether using Section 351 this way fits what the law intended, and where regulators stand. The short version is that the rules here are long-standing and specific.

Does using Section 351 to seed ETFs fit the purpose of the law, and is there a business purpose beyond the tax deferral?

Transfers of securities into investment companies are something the tax code addresses directly. Congress took up the question in 1966, when it restricted "swap funds" that let investors diversify concentrated stock positions without paying tax. [5] The rule it settled on, refined by Treasury regulations since, doesn't prohibit these transfers. It requires that each contributor's portfolio already be diversified under the 25% and 50% tests. [3] A contribution that meets that standard is doing what the rules contemplate.

The IRS can still disregard a transaction that complies on paper but has no substance beyond its tax result. That principle traces to the Supreme Court's 1935 decision in Gregory v. Helvering and is now written into the code as the economic substance doctrine, which looks for a real change in the taxpayer's economic position and a substantial non-tax purpose. [6] When Congress codified it, the Joint Committee on Taxation's explanation listed corporate organizations under Subchapter C among the routine transactions it was not meant to disturb. [7]

For an investor who fits the profile, the non-tax purpose is usually straightforward to articulate. The deferral matters, and most participants would say so. But the investor is also making a real investment decision, trading direct ownership of specific securities for a share of a professionally managed fund with its own strategy and risks. Common reasons include management better aligned with the investor's goals, consolidating holdings scattered across accounts, exchange-traded liquidity, and a single consolidated Form 1099.

Closing

For the investor it fits, a Section 351 exchange can address a problem that is otherwise hard to solve: moving a portfolio that has outgrown its original purpose into a professionally managed strategy without first paying tax on years of accumulated gains. The fit is specific. The portfolio has to be diversified already, the investor has to intend to hold for the long term, and the transaction has to be structured and documented with care, particularly while Treasury's review continues. Advisors who understand those conditions are well placed to identify the clients for whom this is a useful option, and to explain it to them clearly.

For the underlying framework, read our primer, Section 351 ETF Exchanges: How They Work and Who Qualifies. As with any tax strategy of this complexity, the decisions involved require qualified tax, legal, and financial guidance tailored to each individual's circumstances. This post is intended as educational context only.

Missed the webinar? The on-demand session with SS&C ALPS Advisors and VettaFi, How Section 351 Can Create Tax Advantages, is accepted for one hour of CE credit for CFP®, CIMA®, CPWA®, and other designations. Watch on demand →