How IRS Section 351 Can Offer a Massive Tax Advantage

Imagine you're sitting on millions of dollars in highly appreciated stock. It's a fantastic problem to have, right? Well, there's a catch: if you sell, you could owe hundreds of thousands of dollars in capital gains tax. This can make diversifying your portfolio feel like a prison, where every move triggers a "toll booth" of taxes.

But what if you could move that capital? Not just sell it, but repackage it, without triggering a tax bill? That's exactly what smart investors are doing with a little-known section of the tax code: Section 351 of the IRS code.

What is IRS Section 351?

Section 351 is a powerful provision that allows you to transfer "property" (which includes assets like stocks) into a corporation in exchange for stock in that corporation without paying tax at the time of the transfer. This means you can change the form of your investment without immediately triggering a capital gains event.

How It Works (and the Key Conditions)

The magic of Section 351 lies in its ability to facilitate a non-recognition event. However, you have to follow a couple of rules very closely:

• Stock Only: You must receive only stock in exchange for the property you contribute. Receiving other forms of property (like cash or non-stock assets) can jeopardize the tax-free nature of the transfer.

• Control Requirement: You, along with any other contributors, must collectively control at least 80% of the corporation immediately after the exchange. This ensures that the transfer is a genuine re-organization of assets rather than a disguised sale.

This strategy is often utilized to diversify large, concentrated stock positions into an ETF (Exchange Traded Fund) or a similar diversified structure. You contribute your appreciated stock to a newly formed corporation or ETF trust, and in return, you receive "creation units," which are essentially the building blocks of the ETF. If structured correctly under Section 351, you don't pay capital gains tax.

Just like that, you've gone from a concentrated, highly taxable portfolio to a diversified, marketable ETF structure without triggering a massive tax bill.

The Critical Limitation: The 25/50 Diversification Test

While Section 351 sounds like a dream for those with concentrated stock, there's a crucial hurdle known as the 25/50 diversification test that can severely limit its effectiveness, especially for individuals with a single, dominant appreciated asset.

Let's look at a real example: Imagine your total net worth is $4 million, but a significant $3 million (75%) of it is locked up in a highly appreciated employer stock. You desperately want to diversify to reduce risk, but you hate the idea of paying a six-figure tax bill to do so. In theory, Section 351 sounds perfect: transfer the stock to an ETF provider, receive ETF shares back, and you’re diversified and tax-free.

However, the 25/50 test applies to both the individual contributor and the entire group participating in the ETF creation:

• The 25% Rule: A maximum of 25% of the total contribution (both from the individual and in aggregate across all contributors) can be in a single security.

• The 50% Rule: A maximum of 50% of the total contribution can be held across the top five most concentrated positions.

Impact on Our Example: For our individual with $3 million in concentrated stock out of a $4 million net worth, this test severely limits what they can actually diversify. Even if they contribute all of their other $1 million in liquidity, they might only be able to contribute just over $300,000 of their highly appreciated company stock to the ETF. This means only about 10% of their concentrated holdings can be diversified using this method, and they've used up all their other liquid assets to do it.

While the strategy works, the 25/50 diversification test means it's generally most effective for individuals who are contributing a more balanced portfolio, rather than one overwhelmingly dominated by a single appreciated stock. It often means bringing in many other diverse contributors to meet the aggregate rules.

Pros and Cons of Utilizing Section 351

Like any complicated tax strategy, Section 351 comes with its own set of pros and cons:

Upsides:

• Tax-Free Diversification: The primary benefit is the ability to diversify a concentrated stock position into a broader, more liquid, and marketable structure without triggering an immediate capital gains tax event.

• Estate Planning Perk: Under current tax law, the ETF units passed to heirs may be eligible to receive a step-up in basis, potentially reducing future capital gains taxes for beneficiaries.

Downsides:

• Limited Effectiveness: As seen with the 25/50 diversification test, the strategy's real-world benefit can be significantly limited, especially for individuals with extreme concentration in a single asset.

• Complexity: This is a relatively advanced and nuanced tax strategy. It requires meticulous execution and careful adherence to IRS regulations.

• Professional Guidance: Due to its complexity and the potential for costly errors, it's essential to work with trusted and experienced tax and financial planning professionals who specialize in these types of transactions.

Is Section 351 Right For Your Portfolio?

Section 351 offers a fascinating planning opportunity for those with highly appreciated assets looking to diversify. However, its specific application and effectiveness depend heavily on your individual financial situation and asset composition. It's not a one-size-fits-all solution.

At Barrett FP LLC, we offer expert financial planning on an hourly basis, focused entirely on helping you achieve your goals.

Learn more about how we can help you navigate complex tax strategies and see if we're a good fit.