Why the 351 Exchange Might Revolutionize Investing

If you asked the average investor about ETFs twenty years ago, there’s a good chance you would have received a blank stare. Fast forward to today, and most investors not only know what ETFs are, but likely own one. Low-cost, transparent, tax-efficient vehicles tend to grow into the mainstream, despite a historically lethargic industry’s best attempts to conceal them.

Today, the 351 ETF exchange seems to be gaining real traction and affording investors the opportunity to transition into the ETF structure to enjoy the potential benefits of ETFs. According to Brent Sullivan and Elliot Rozner in Managing Concentrated Public Stock Positions by Seeding an Exchange-Traded Fund, in just the first quarter of 2026, the amount of AUM seeded via 351 exchanges by individual investors is already over half of what was contributed in all of 2025. This trend is gaining some real traction!

A section 351 exchange allows investors to exchange property for shares of a new company. In the case of a new ETF, which are legally new companies that elect to be treated as a “RIC,” investors are able to exchange their appreciated holdings for shares of a new exchange-traded fund without immediately triggering capital gains, if rules and tests are met.

Still, many are wondering what the basis is for using a century-old tax rule and applying it to a modern investment wrapper. More importantly, if 351 exchanges cannot be used to diversify highly concentrated positions, why are they being used to seed ETFs? We think the answer is simple: investors are gravitating from sub-optimal investment delivery mechanisms and moving towards the generic benefits that often come with an ETF versus other vehicles: low-cost, transparency, and tax-efficiency. But that is our 40′ foot view on the matter. We brought in an expert to discuss further…

I invited Brent Sullivan, Chief Editor at Tax Alpha Insider, over to our YouTube channel to help unpack the modern-day applications of the 351 tax rules. If you want to watch our video, I encourage you to subscribe to our channel. But in this post, I’ll walk through my three main takeaways from our discussion, along with some warnings for investors considering seeding ETFs via a 351 exchange (and what tends to get them into trouble).

Let’s begin.

Diversification is Key

IRS law is one of the few areas where investors can technically check all the boxes and still fail to comply. The reality is the IRS doesn’t want you to just comply with their laws, they want you to comply with the spirit of the law. This is what is known as substance over form.

The 351 exchange was created to help investors seed businesses without triggering capital gains when they contributed property into a new business. But in 1960, something interesting happened. According to Brent, “Nearly 200 investors pooled various concentrated holdings and, in substance, traded single-name risk for a slice of a diversified portfolio.”¹ In essence they took their concentrated portfolio, performed some tax gymnastics, and diversified while neglecting the spirit behind the tax code. Congress did not like that. Eventually, they drew some lines around what portfolios could be contributed in a 351 exchange. Notably, there are two main rules that investors must adhere to if they wish to participate. These are what came to be known as the 25/50 rules:

1. The 25% rule states that the largest holding in a contributing portfolio must be less than 25% of the contributor’s portfolio.
   
2. The 50% rule states that the largerst five holdings must be less than 50% of the contributor’s portfolio.

By establishing these tests, the government highlighted that a 351 cannot be used to diversify a highly concentrated position⁽¹⁾, but also defined what diversification means in a concrete way so investors could have confidence what “diversification” means from an IRS perspective. In essence, investors who adhere to these diversification rules are considered diversified from an IRS perspective, and while finance geeks might opine that the IRS definition of diversification is incorrect or faulty, from a legal perspective, their opinions don’t matter.

Seems Straightforward. Are there Gray Zones?

While investors must comply with the 25/50 diversification rules to get tax-free treatment when contributing to a 351 ETF, there are certain areas where investors may run into trouble. In the paper, Brent discusses many of these tactics, including stuffing and sequential seeding.

With stuffing, investors with concentrated portfolios may go out and purchase assets just so they can pass the 25/50 test. In doing so, they may be running afoul of substance over form, and going around the intent of the diversification rules outlined in the law.

With sequential seeding, investors may begin with a concentrated holding, contribute just enough to a 351 exchange to pass the 25/50 rules, then use the remainder of the concentrated portfolio along with the newly seeded ETF to perform another 351 exchange, and so forth and so on, until the concentrated holding disappears. This is another area where, depending on facts and circumstances, the IRS might dig a bit deeper.

How to avoid gray areas? When contributing to a 351 exchange, investors need to ask themselves: Did I follow the intent of the laws? Or did I start with a concentrated portfolio and “do a bunch of shenanigans”² just to end up with a diversified portfolio? If so, enforcement may collapse all the steps and treat it as one large taxable event. However, if investors act in the spirit of the laws, the risk of an enforcement action is very low. Regardless, it is important for investors to document everything so they are prepared if enforcement decides to scrutinize their actions.

Education is Key

A 351 exchange may feel like a scary endeavor for individual investors and even advisers. Most are not even aware of the tax code, and some who are question how it can be applied to help seed ETFs. So while this 351 trend is picking up, there is still some skepticism preventing it from realizing its full potential. As believers in the power that education³ can play in adoption, this is something that will hopefully become more mainstream in years to come.

So we encourage investors to keep learning, to ask good, hard questions, and to examine the 351 exchange as a legitimate tool in their investing toolbox. In doing so, they may not only help their own situations, but also help broaden awareness around the utility of the 351 exchange.

1. Sullivan, Brent and Rozner, Elliot, Managing Concentrated Public Stock Positions by Seeding an Exchange-Traded Fund (March 31, 2026). pp 7. ↩︎
2. Brent’s words, not mine. ↩︎
3. After all, we exist to empower investors through education! ↩︎