Advisors Weigh Risks of 351 Conversions Amid IRS Guidance
Regulators are warning investors and advisors to follow the spirit, not the letter, of the law when recommending certain ETF-related conversions that are increasingly used in tax strategies, according to industry compliance experts.
Overall, advisors and investors who use 351 conversions to move portfolios of assets into an ETF as a diversification strategy (while continuing to manage the portfolio) may not be in the crosshairs of the Internal Revenue Service guidance enacted this week. But Rick Wedell, the president and CIO of RFG Advisory, said other advisors may need to consider whether it’s worth continuing to recommend the conversions.
“I think for certain players that were purely marketing this as a tax avoidance strategy, that sale becomes much harder, and they’re going to want to think about whether or not they want to go down that path,” Wedell said. “I think that it might have a little bit of a chilling effect on the industry. And, candidly, I think that’s what the IRS wants.”
351 conversions allow investors to transfer portfolio holdings into ETFs without paying capital gains taxes. According to Wedell, the conversion makes sense for managers running SMAs for multiple clients who opt to move a portfolio of assets into an ETF wrapper while continuing to manage it as a strategy.
While Wedell found it sensible that investors shouldn’t be penalized for taking those investments and rolling them into a new structure associated with the ETF, the IRS is targeting those investors who pull assets into one vehicle, complete the ETF transaction, and quickly sell the portfolio and buy something else (avoiding all taxes during the repositioning).
“I think what that requires is … whatever your contribution portfolio is and however you were managing that in the past, when you move it into the new ETF structure, you need to continue to do whatever it was that you were doing in the past with that portfolio,” he said.
The new guidance comes as Section 351 ETF conversions are gaining popularity among RIAs as a diversification option. While Wedell said the idea of the exchange as a tax-management vehicle wasn’t prevalent in the industry several years ago, he’d seen a large uptick in interest in the past 12 to 18 months. This year, RIAs ranging from Ritholtz Wealth Management to Dynasty-affiliated N10 Holdings have launched ETFs to mitigate concentration risk.
Earlier this year, treasury officials flagged that they were looking into 351 conversions, as well as other strategies, including box-spread ETFs, products that offset ordinary income, and funds avoiding dividend income by flipping between other ETFs.
‘A Legitimate Strategy’
In an interview with Wealth Management, Tim Steffen, director of advanced planning at Baird Private Wealth Management, said the new guidance wasn’t surprising in light of Treasury’s prior warnings. While he said it remained “a legitimate strategy” after the guidance, he would be hesitant to promote it as an RIA until the IRS detailed the guidance’s scope.
“We don’t know how far the IRS is going to push this ruling,” Steffen said. “Are they going to just completely try and shut these things down? That doesn’t seem like the case, but they’re definitely going after the most egregious abusers of it.”
Wedell said the IRS isn’t necessarily looking to penalize portfolio managers making decisions consistent with prior management strategies in the ETF and the pool of securities post-351 conversion (he surmised they were more interested in investors selling their portfolios quickly after the conversion). But the IRS doesn’t clarify how long advisors would have to wait before adjusting their portfolios to be deemed reasonable moves.
“The fact that they’re providing a guidance rule that is subject to interpretation means, ‘Hey, we see what you’re up to, and you should be aware—follow the spirit of the regulation, not the precise letter of the regulation,’” he said. “I think that the industry needs to keep that in mind. What was the regulation designed to allow?”
Steffen said other strategies could fill similar gaps for advisors wary of recommending 351 conversions in the immediate aftermath of the guidance, including opportunity zone funds and direct indexing.
But he stressed that RIAs who aren’t trying to “get too much” out of a transaction shouldn’t be too concerned.
“If you push the line too far, those are the kinds of transactions that get caught,” he said.
