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The markets have been on fire, and you’re sitting on a group of concentrated stock positions with significant embedded gains.

You’re likely facing a difficult choice:

Sell the stocks and pay taxes now, or keep holding and live with the risk of a single stock (or stocks) dominating your net worth.

But what if there were other options?

Three potentially powerful strategies may help investors diversify concentrated positions while deferring or minimizing immediate capital gains taxes:

• Section 351 ETF exchanges (often used to seed new ETFs)
• Exchange funds (offered by firms like UseCache and traditional private banks)
• Long/short tax loss harvesting strategies (offered by firms like AQR or Quantinno using active trading to generate offsetting losses).⁽¹⁾

All three tools solve similar problems but operate under very different rules, costs, and liquidity profiles. And as we’ll explore, Section 351 exchanges come with specific diversification constraints, exchange funds require long lock-ups, and long/short tax loss harvesting works best with volatility and careful execution.

What Is a Section 351 Exchange?

Section 351 of the Internal Revenue Code, established in the Revenue Act of 1921, allows investors to contribute appreciated assets into a corporation in exchange for stock without triggering capital gains taxes.

Why Does Diversification Matter in Section 351?

When funding a corporation (such as an ETF) with investment securities via Section 351, the transaction must satisfy diversification requirements under IRC §368(a)(2)(F). These rules prevent taxpayers from avoiding taxes by stuffing a corporation with a single stock or narrow basket of securities.

(i.e., “I have $100 million in TSLA. Can I turn it into an ETF and swap into the S&P 500?”
Answer: No.)

Section 351 Diversification Rules (IRC §368(a)(2)(F))

• 50%/Top-Five Rule: The top five contributed securities cannot exceed 50% of the total portfolio’s value. (FYI, contributed ETFs are viewed on a look through basis)
• 25% Rule: No single security can dominate the portfolio (generally less than 25%), ensuring meaningful diversification.

Key Takeaway:

If your concentrated stock exceeds 25% of the total assets contributed, or your top five holdings are over 50% combined, a Section 351 transaction may not work unless you bring additional diversified assets.

What About RIC Diversification?

After the Section 351 transaction, if the corporation operates as an ETF (qualifying as a RIC), it must also meet RIC diversification requirements under IRC §851(b)(3).

RIC diversification is separate from the Section 351 requirements and applies after the ETF is operational, governing its ongoing tax treatment.

What Is an Exchange Fund?

Exchange funds, created under Section 721, allow investors to contribute appreciated stock into a partnership without triggering taxes. They gained popularity in the 1970s and remain a favored solution for ultra-concentrated positions.

Unlike Section 351 transactions, exchange funds do not have strict upfront diversification rules—making them ideal for extremely concentrated positions that can’t fit within the Section 351 framework.

For more background, refer to this great article with a captivating title:
“Am I the Only Person Paying Taxes? The Largest Tax Loophole for the Rich – Exchange Funds”.

What Is Long/Short Tax Loss Harvesting?

Long/short tax loss harvesting is a strategy that uses paired long and short positions to generate tax losses that can be used to tax-efficiently trim down a concentrated position.

How It Works:

1. Set up a market neutral strategy that goes long numerous stocks and short numerous stocks via an underlying alpha model.
2. Adjust the long/short portfolio to account for your underlying concentrated position’s exposure.
3. Actively manage the portfolio to realize losses on the long/short side as market volatility creates opportunities for tax-loss-harvesting.
4. Use the harvested losses to offset the gains that would be triggered when you sell down your concentrated stock.

Pros:

• No lock-up periods.
• Can work alongside other strategies.
• Harvests losses to offset gains from selling concentrated positions, improving after-tax outcomes.

Cons:

• Requires careful execution and monitoring.
• Works best in volatile markets.
• Does not eliminate the concentrated stock risk immediately—it’s a way to manage the tax impact of the gradual selling of a concentrated position.

For investors looking for more active, flexible strategies, long/short tax loss harvesting can be a valuable complement or standalone option.

Side-by-Side Comparison

Simple Rule Book

Illustrative Case Studies (not real, but illustrative)

Case Study 1: Section 351 for Moderate Concentration

Jane contributes $30 million in a portfolio of US stocks to a new $100 million US equity ETF funded via 351 contributions. Her largest security is under 25% of the total, and her top five securities stay below 50%, complying with §368(a)(2)(F).

Complies with Section 351 rules.
Gains liquidity, potential additional diversification, and extended tax deferral via the ETF structure.

Case Study 2: Exchange Fund for Extreme Concentration

John holds $30 million in a single stock. His position is too large for Section 351, so he joins an exchange fund partnership with a 7-year lock-up and access to a broader portfolio exposure via the partnership.

• Defers capital gains.
• Achieves some diversification.
• Sacrifices liquidity.

Case Study 3: Long/Short Tax Loss Harvesting for Flexible Tax Management

Emily holds $30 million in a concentrated stock. Rather than sell immediately, she uses her stock position to help collateralize a market neutral tax loss harvesting strategy. She captures 5-10 million in tax losses over two years, which she uses to offset gains as she gradually sells down her position.

• Actively manages taxes.
• Retains liquidity.
• Keeps flexibility without lock-ups.

Final Thoughts

Section 351 exchanges, exchange funds, and long/short tax loss harvesting are all viable tools for tax-efficient diversification. Each comes with its trade-offs related to liquidity, concentration limits, fees, and complexity. These tools do not need to be used in isolation, and can be considered at the same time, or mapped together (i.e., L/S TLH and then 351 into an ETF). But, of course, they all come with a lot of complexity and brain damage. Worst case, one can always just pay the taxes and move on in life.

Important Disclosure

The information contained in this article is for educational purposes only and should not be considered tax, legal, or investment advice. Tax laws are complex and subject to change, and the strategies discussed may not be appropriate for your specific situation. Before implementing any strategy—including a Section 351 transaction, exchange fund, or long/short tax loss harvesting—you should consult with qualified tax, legal, and financial professionals. Alpha Architect and ETF Architect do not provide tax or legal advice.