The Internal Revenue Service is warning about potential abuses of a longstanding rule that has helped investors defer capital-gains taxes. Investment advisors should take note.
The IRS recently issued guidance fleshing out its views of 351 exchanges, the mechanism in the tax code that allows investors to convert appreciated assets into exchange-traded funds or other pooled vehicles. It can be a smart strategy, both to defer taxes clients owe as well as to refresh their portfolio with a more diversified basket of equities.
But the IRS' latest guidance suggests that some investors, or advisors acting on their behalf, have been playing loose with the rules for 351 exchanges. The IRS is collecting comments from the public on 351 conversions that could inform new regulations in the area through Oct. 28.
The IRS has long expected 351 exchanges to facilitate the transfer of comparable assets, and the spirit of that rule hasn't changed, according to Rich Malinowski, co-CEO of Exchange Traded Concepts, a registered investment advisor firm specializing in ETFs.
"It remains a practical, legitimate tool for the right types of accounts and clients," Malinowski says. "What has changed is that the line between seeding an ETF and using an ETF as a pass-through for a tax-free portfolio swap is now much clearer."
The IRS guidance includes what it calls a revenue ruling, which addresses conversion transactions in which an investor offloads a portfolio of appreciated stocks to an ETF, which then converts those holdings through an in-kind contribution to a third-party. When the original investor received a portfolio of securities that is materially different from what was initially contributed to the ETF, the IRS is now saying that it will view that transaction as ineligible for tax-deferred treatment under the 351 framework.
"The investor has sold one portfolio for another, with the ETF acting only as a pass-through," Malinowski says. "So the investor is treated as having made a taxable exchange for the securities that get redeemed out."
The 351 framework has diversification requirements to prevent an investor from avoiding taxes on a portfolio that is highly concentrated in a single stock or a small basket of stocks. The new guidance amplified but didn't change those rules, affirming that the so-called 25-50 test, which holds that portfolios are considered diverse, and therefore eligible for a 351 exchange, if no more than 25% of the portfolio is concentrated in a single stock and no more than 50% of the portfolio is held in five or fewer stocks.
How the IRS will act on its ruling remains to be seen. Lawyers with the firm Debevoise and Plimpton noted in an analysis of the IRS guidance that the agency doesn't "clarify how different an ETF's resulting portfolio must be from the portfolio the investor initially transferred in order to be 'materially different.'"
The IRS guidance highlights other strategies that can be involved in 351 conversions without offering any new rules or prohibitions, only signaling that those issues are on the agency's radar. For advisors, that might warrant a measure of caution. Those include contributions of nondiversified funds to a partnership ahead of a 351 conversion, box-spread funds, which investors use to hold a variety of options on the same underlying asset, and record-date strategies that involve transactions among multiple ETFs with similar holdings aiming to defer capital gains.
Malinowski says he anticipates that advisors will shy away from seeding an ETF with a group of investors who aren't their clients and have no relationship to each other.
"Those arrangements almost always require substantially repositioning the contributed portfolio after launch, which is exactly the fact pattern the ruling targets," he says. "Unless that kind of seeding can be done without materially repositioning the portfolio, we don't expect it to survive as a practice."
He also recommends that advisors take a close look at whether the client's portfolio matches the fund's investing thesis. "If the plan depends on turning over much of what's contributed shortly after launch, that's a red flag," he says.
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