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Section 351 ETF Conversions: Exchanging Appreciated Stock for ETF Shares

A Section 351 exchange moves a diversified basket of appreciated securities into a newly launched ETF for its shares, deferring capital gains tax, though September 2026 IRS guidance treats some versions as taxable.

Section 351 ETF Conversions: Exchanging Appreciated Stock for ETF Shares

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What is a Section 351 ETF conversion?

  • It is a transfer of appreciated securities to a newly launching ETF in exchange for ETF shares, without recognizing gain at the time of the exchange.
  • The contributed portfolio must already be diversified under the 25/50 test, so a single stock cannot be exchanged on its own.
  • Cost basis and holding period carry over to the ETF shares, so the tax is deferred, not forgiven.
  • The technique works only at a fund's launch, when contributors together control at least 80% of the new fund.
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Full Guide

What is a Section 351 ETF conversion?

  • It is a transfer of appreciated securities to a newly launching ETF in exchange for ETF shares, without recognizing gain at the time of the exchange.
  • The contributed portfolio must already be diversified under the 25/50 test, so a single stock cannot be exchanged on its own.
  • Cost basis and holding period carry over to the ETF shares, so the tax is deferred, not forgiven.
  • The technique works only at a fund's launch, when contributors together control at least 80% of the new fund.

What did the IRS change in September 2026?

  • Rev. Rul. 2026-20 treats a "conversion" as a taxable sale when, under the same plan, the new ETF hands your contributed securities to an authorized participant (a market maker) and ends up with a materially different portfolio.
  • A 351 contribution can still defer gain where the ETF keeps assets that fit its strategy; Notice 2026-62 expresses no view on that kind of seeding.
  • Treasury and the IRS say further guidance could apply retroactively and could identify these transactions as listed transactions, which carry IRS reporting requirements.
  • If you have already completed a 351 exchange, review it with your CPA.

The mechanics of tax deferral

  • Under IRC §351, no gain is recognized when property is transferred to a corporation that the transferors control immediately afterward.
  • An ETF organized as a regulated investment company is a corporation for this purpose, so contributors receive shares instead of a tax bill.
  • Selling the ETF shares later triggers the deferred gain, while heirs may receive a step-up in basis at death under current law.
  • Once operating, an ETF can use in-kind redemptions to manage its holdings, but Rev. Rul. 2026-20 treats a planned redemption of your contributed securities shortly after launch as part of a taxable exchange.

What is the 25/50 diversification test?

  • Transfers to an investment company are taxable if they diversify the transferor, unless the contributed portfolio is already diversified.
  • No single issuer may exceed 25% of the value of the contributed portfolio.
  • The five largest issuers combined may not exceed 50% of the contributed portfolio's value.
  • The test is measured on each contributor's basket on the day of the exchange.

Can a concentrated position be moved through a 351 exchange?

  • A concentrated holding can make up to about a quarter of the contributed basket, with other securities filling the rest.
  • Investors with several low-basis positions, such as long-tenured employees with company stock plus legacy holdings, may find the basket easier to assemble.
  • Larger concentrations may take several exchanges or complementary techniques, since the 25% cap applies to each contribution.

How do 351 conversions compare with exchange funds?

  • Exchange funds are partnerships that can accept a single stock, if the sponsor accepts it, but typically require about seven years before a diversified basket can be distributed tax-deferred.
  • A 351 conversion delivers ETF shares that trade daily with no lockup, though selling them realizes the deferred gain.
  • ETFs offer daily holdings transparency, while exchange funds typically limit access to qualified purchasers ($5M+ in investments), with some funds open to accredited investors.
  • The eligibility trade-off runs both ways: exchange funds take one stock but restrict liquidity; 351 exchanges require a diversified basket up front.

Risks and practical considerations

  • Ask any sponsor whether the ETF intends to keep the contributed securities, and get a tax opinion that addresses Rev. Rul. 2026-20.
  • After the exchange, returns follow the ETF's strategy, which may differ meaningfully from the contributed securities, and losses are possible.
  • The move is effectively one-way: exiting means selling ETF shares and recognizing the deferred gain.
  • Sponsor minimums, transferability of the securities, state taxes, and fees all require case-by-case review with a tax professional.

Key takeaways

  • Section 351 lets appreciated securities move into a newly launched ETF without immediate capital gains tax, when the ETF keeps them.
  • Since Rev. Rul. 2026-20, "seed-and-swap" conversions, where the ETF trades away your securities soon after launch, are taxable.
  • The 25/50 test means a concentrated stock can anchor, but not make up, the contributed portfolio.
  • Compared with exchange funds, 351 conversions trade a multi-year lockup for a diversified-basket requirement.
  • Confirm eligibility and tax treatment with a CPA or tax attorney; Rubric does not prepare tax returns or give legal advice.
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