Trapped By Taxes? How 351 Exchanges Let You Diversify Without Selling Your Stock (EP.225)

0:28We all need to make smart decisions with our money. Even on stage at conferences, it's 351 exchanges. And for good reason, because of all the different ways that you can manage a concentrated stock position, or a portfolio of individual stocks where maybe one isn't concentrated, but they all have giant capital gains. I don't think that there is a more compelling way to diversify without triggering immediate taxes. Now, I've done episodes in the past on diversifying out-of-concentrated positions and talked about exchange funds and option strategies, stage selling, charitable gifts, anything. But this has quickly become my favorite approach because it offers flexibility, transparency, and simplicity that none of these other strategies can match.

1:16So if you are someone who's accumulated company stock over a long career, inherited shares with big gains, or simply held on to a few winners for the past decade or so, this episode is for you. We will be covering what a 351 exchange is and why it's trending right now, how it works in practice, and what you should be asking the professionals helping you. Because this isn't something you can do on your own without a financial advisor. It's not something you can just click a few buttons in your brokerage account and have it done. It actually requires coordination between a financial professional and the ETF sponsor.

1:52So if you don't work with an advisor and you are interested, after listening to this episode, to learn how we are doing 351 exchanges with our clients, you can go to callwithpeter.com, schedule 30 minutes with me to learn more about becoming a client, or you can use the link at the top of the episode page. Now, here is how I like to explain a 351 exchange. At a high level, it's pretty simple because you're contributing appreciated securities into a newly created exchange-traded fund, or ETF. And so when you give a basket of securities, you receive back shares of that ETF. But I think to really understand how that works, maybe I should take a step back first.

2:33When I talk to clients about ETFs coming to market, it's not all that different than starting a small business. The asset manager has to go through the SEC, file the paperwork, line up operations, and most importantly, make sure there is enough investor demand before flipping the switch. And typically, these asset managers are going to gather capital commitments from institutions, from advisors, maybe from individual investors, but they're going to try to figure out ahead of launch whether the fund is viable and how they'll price it appropriately once trading begins. And so from the asset manager's perspective, the job is pretty simple.

3:10It's just collect assets. And if that's really your only job, you wouldn't really care whether the initial seed capital comes from cash or from securities as long as it brings money in the door and gets the fund off the ground. And that is where Section 351 of the tax code comes in because it gives investors a way to contribute securities instead of cash, which is a win-win because the asset managers get those assets to seed the fund, and the investor gets the ETF shares without having to sell anything and trigger a taxable gain. So instead of writing a check to fund an ETF, you're effectively rebalancing your existing stocks into the ETF itself.

3:51And the tax code allows this to be a non-recognition event, meaning you don't realize gains immediately. Your cost basis and holding period simply carry over to the ETF shares. Now, this applies to publicly traded stocks and ETFs. The tax code actually captures a lot of things, but in practice, anything that's like a private share or a mutual fund or an illiquid asset probably is not going to qualify because, yes, while asset managers are in the business of collecting assets, these funds that are coming to market do have objectives, and so they do want the assets to have a purpose within their fund.

4:30And so I like to tell clients this isn't a loophole. I mean, this is a legitimate IRS-recognized exchange of property. It's a way to reorganize how you own your investments, moving from concentrated holdings into a diversified ETF without paying taxes right now. And because you're in a fund structure, unlike some of the more complicated ways that I have in the past described on how to diversify out of a concentrated stock position, you don't really have any of those issues. There's no lockup. There's daily liquidity. You just get a 1099. And it's just like any other ETF you might go out and buy or sell on the marketplace.

5:09It's just one of these rare moments in finance where everybody wins, the investor and the asset manager. And I think the question that comes up the most often is, why now? Why is this happening now? And the short answer is that technology has finally caught up because this has been in the tax code for a long, long time. Even five years ago, this type of transaction would have been nearly impossible to execute at scale for the ETF sponsors who didn't have the operational systems to accept dozens of unique stock positions in kind. And same thing for the custodians who probably wouldn't have been able to process the transfers efficiently.

5:46And there's the compliance teams. They're left trying to stitch everything together manually, and it just wasn't possible. So I think now that the ETF ecosystem has matured, the custodians, the transfer agents, and the ETF issuers now are running on these integrated platforms designed for in-kind transactions. So they can do all the things necessary to make this 351 transaction happen. They can verify the positions instantly, match the cost basis data accurately, and handle complex security transfers with the same precision as cash trades. So it's really just a matter of the plumbing now works.

6:25And when the plumbing works, ideas like the 351 exchange can finally move from theory to practice. And so after a really long bull market, there are more investors than ever who are sitting on large appreciated stock positions. Maybe some of it's through equity compensation. Maybe some of it's just picking some winners. Maybe some of it's inheritance. but ultimately, there's just been years where you're faced with the same two bad choices. The first being do nothing and hope your winners keep winning, and the second being to sell outright, triggering a large tax bill and start their wealth building over again.

7:02But this 351 exchange creates a third path, one that is rational in my opinion and very tax efficient. And it lets investors restructure their portfolios without surrendering a large portion of their gains to taxes, and it does so using technology that simply didn't exist before. So when I look at how we have done this at PlanCorp ourselves, it typically happens in five steps. First, we start with assessment where we review your holdings, your gains, your tax picture to see if a 351 even makes sense. And then we do the eligibility check. So you can't just trade in a ton of one stock and get back ETF shares.

7:44I maybe have oversimplified it, and that's probably what you're thinking. So if you have$100 ,000 in Apple stock, you can't trade that Apple just for ETFs. In fact, no single stock can be more than 25 % of your contribution, and then the top five stocks that you contribute have to be under 50%. Now, there are ways around this. So let's say you did have$100 ,000 of Apple stock, if that was only 25 % of your contribution and say you had another 75 % in a diversified ETF, then that counts. So really, you're just trying to figure out, can this work? Are you eligible? And if you aren't eligible, how can we move things around to make you eligible?

8:26So after those first two steps, then there's the sponsor coordination, where we identify an ETF launch that can accept your securities as seed capital. And this is the thing I tell the clients all the time. We never know the exact timing because these fund companies, we don't control when they launch funds and not everybody accepts securities from advisors. And even those that do don't necessarily accept them from all advisors. So once we have the assessment, the eligibility check, and we found a sponsor who is launching an ETF that we think is a good fit for you, Then comes for the exchange. So your stocks are transferred in kind and you receive the ETF shares.

9:05Your basis carries over. There are no gains recognized at the time of exchange. And then that last step is integration, where we're monitoring the new ETF position, rebalancing when appropriate, and planning future sales around your broader financial goals. To be clear, I feel like I've said this a few times, but this is a tax deferral. It's not a tax elimination. you still would owe taxes eventually if you went to sell shares of the ETF, but it allows you to defer that liability and stay invested in a far more diversified manner. So if you are thinking about exploring a 351 exchange, one of the most important steps is choosing an advisor who has actually done this before.

9:47These exchanges involve multiple moving parts, and not every advisor or firm has the experience to guide them well. So a few questions I came up with. If you have a financial advisor and you'd like them to do a 351 exchange, these are some of the things that I think you can ask. The first question is, how many 351 exchanges have you personally helped coordinate? It's clear, I think experience matters. You want someone who's worked directly with the fund sponsors and the custodians and not just read about the concept online now that it's getting more popular. The second is, can you walk me through your process from start to finish?

10:21And I kind of walked you through a quick version of our process. I feel like that would have been a reasonable response if you were asking your advisor with it. But the eligibility testing, the coordination with the ETF sponsor, the timing considerations, the post-trade integration, these are the sort of things that you want to hear outlined as the key steps. The third question that I wrote down here was, who handles the communication with the fund sponsor in my CPA? And let's be clear, successful exchanges require very tight coordination. We put together a tax packet for our clients after the transaction that has everything that they could possibly need.

10:58And we give a copy to their CPA and then we keep a copy online for us should it be needed. The fourth question I have is how do you evaluate whether a 351 exchange is actually the best fit? And this is really important because I mentioned that asset managers are in the business of collecting assets. And so just because you're allowed into a 351 exchange doesn't mean that that fund is something you would go out and buy with cash. That's sort of like a good benchmark is, would I buy this fund with cash? Because if I'm trading in a basket of individual stocks and getting back an ETF that has exposures that aren't very attractive or maybe it's too expensive, that's not necessarily something that you really want to do.

11:40The last question I have is, what does success look like 12 months later? And I think by asking these questions, it's going to tell you whether you're dealing with an advisor who has genuine 351 experience or if they're just hearing about it for the first time this year. So let me recap. If you are sitting on individual stock positions and you are feeling stuck between that do nothing or pay too much in taxes, I really do think a 351 exchange might be an elegant middle ground that you've been looking for. And at PlanCorp, we've been helping clients evaluate whether it fits in their situation, and we coordinate every step of the process.

12:17So if you'd like to explore this idea further, you can go to callwithpeter.com. You'll get a 30-minute phone call with me. You'll learn all about hiring PlanCorp. And I hope to hear from you all soon with your questions, with your comments, and most importantly, to help you get that financial house in order and keep it that way forever. Thanks for listening to the Long-Term Investor Podcast. To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan.

13:01This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.