In a recent episode of “Behind the Ticker,” Raymond Holst from Practus LLP discussed the intricacies of 351 exchanges and their relevance to the ETF industry. Holst, a tax attorney with over 20 years of experience, joined Practus in 2023, bringing extensive expertise in financial products and taxation. Practus, a fully virtual law firm with attorneys across the United States, specializes in ETF and mutual fund markets, offering tailored legal and tax solutions.

Holst explained that a 351 exchange refers to a provision in the Internal Revenue Code allowing for the transfer of property into a corporation in exchange for shares without triggering immediate tax recognition on built-in gains. This mechanism is particularly useful for asset managers looking to convert separately managed accounts (SMAs) or private funds into an ETF wrapper. The process enables investors to transfer diversified securities portfolios into an ETF while maintaining their original tax basis and avoiding taxable events.

Key requirements for a successful 351 exchange include maintaining at least 80% ownership in voting and value by transferors post-exchange and adhering to diversification rules. Holst elaborated on the 25/50 diversification test, which ensures that no single security exceeds 25% of the portfolio and the top five securities do not exceed 50%. These safeguards are essential to comply with tax regulations and ensure the exchange qualifies under the 351 provision.

Holst emphasized the importance of partnering with experienced professionals for 351 exchanges, noting the complex coordination required among custodians, fund administrators, and legal advisors. While the process is tax-efficient, it involves significant logistical work, particularly in transferring tax information and establishing proper valuations. Once completed, however, ETFs formed through 351 exchanges operate like any other ETF, offering investors liquidity, marginability, and tax advantages.

For asset managers considering launching an ETF using a 351 exchange, Holst highlighted the long-term benefits, including improved tax efficiency and operational flexibility.

Raymond Holst - Practus

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