Consider a Section 351 Exchange in Your Diversification Strategy
We’ve all heard the adage, “Don’t put all your eggs in one basket.” While this piece of wisdom applies to many aspects of life, one of the most applicable is investing. Even an investor who has historically remained diversified can find themselves in a position where one or two stocks have significantly outperformed the rest of their portfolio. Early investors who purchased a minimal number of shares in a hyper-growth company a decade or more ago may be finding themselves with a lot of eggs in one basket today. This risk, called concentration risk, is often difficult to mitigate because of one main issue — taxes.
Unless shares of highly appreciated stock are held in a retirement account, when sold the investor must pay capital gains tax on the difference between the purchase and sale price. The more the stock appreciates, the less likely the investor will want to sell it to diversify. On the other hand, as the stock appreciates it continually makes up a greater percentage of the investor’s net worth leading to higher concentration risk.
Historically, exchange funds have been a way for higher net worth investors to diversify this single stock risk into a broader portfolio of holdings, albeit with some drawbacks. High upfront fees, ongoing management fees of 1-2% annually, and a 7-year-plus lockup period can add further illiquidity and complexity to the situation. Investors are also limited to the diversification that the other investors within the fund bring by way of their stock contributions to the investment pool, which may or may not be sufficient.
A new method of diversifying such positions is emerging, however. Named after Section 351(a) of the Internal Revenue Code, a Section 351 Exchange allows investors to contribute highly appreciated stock to a newly formed ETF (exchange traded fund) which, by way of its tax treatment as an investment company, is allowed to sell the shares to reallocate to a fully diversified actively managed portfolio without triggering a taxable event. Of course, requirements at the fund level must be adhered to for the fund to qualify, such as each stock’s original percentage not exceeding 25% of the total seed value of the fund, among other guidelines. Even with these additional rules, 351 ETF Exchanges offer higher diversification at a significantly lower cost than exchange funds, with fees similar to other actively managed ETFs.
At the moment, minimums for contributions to such ETFs are in the $1million range; however this is expected to trend downward as advances in technology for record-keeping and administration of the funds improve.
To quote Benjamin Franklin, “Nothing is certain except death and taxes.” As such, it's important to note that this strategy does not eliminate capital gains tax due, it defers it. The cost basis of the original shares the investor contributed to the fund is carried forward and applied to shares in the new fund if/when sold. The reduction and/or elimination of concentration risk provided by this approach may make sense for many investors who have a position that now represents too big a percentage of their net worth who wish to diversify.
If you would like to learn more about whether this strategy could be prudent for your situation, reach out to your McKinley Carter advisory team to start the conversation.