Tax Strategies for IDEX Employees With Concentrated Stock Positions

For IDEX employees who have experienced significant market appreciation, the thought of rebalancing their portfolio can be daunting. The large embedded capital gains in their holdings often create a powerful disincentive to sell, leading to a 'tax-locked' portfolio. While an investor may have a well-diversified portfolio on the whole, a single, highly appreciated stock can still represent an uncomfortable level of risk. In these situations, the conventional wisdom of simply selling the position is often prohibitively expensive from a tax perspective. However, a little-known but powerful tool—the Section 351 exchange—may offer a strategic and tax-efficient solution.

Consider Michael, a successful professional with a total investment portfolio of $5 million. The majority of his assets are in a broadly diversified mix of mutual funds and exchange traded funds (ETFs). However, his portfolio also includes a single stock position valued at $500,000, which he acquired years ago for $100,000. While this single stock represents only 10% of his total portfolio, its low cost basis and unrealized gain of $400,000 make him hesitant to sell. A sale would trigger a tax bill of roughly $95,200, reducing the capital available for reinvestment and diversification. Michael's situation is common; he understands the importance of diversification, but the tax cost of achieving it feels punitive.

This is precisely the kind of scenario where a Section 351 exchange can provide a strategic advantage. This tax provision, as outlined in the Internal Revenue Code, allows for a tax-deferred transfer of property to a corporation in exchange for its stock, provided certain conditions are met. As Kevin Landis, a finanial advisor with Wealth Enhancement notes, 'A Section 351 exchange could help investors with appreciated assets achieve tax-efficient diversification.'

The core of the strategy is rooted in the tax code itself. IRC Section 351(a) states: “No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation.” The gain is not eliminated, but deferred, as the investor's original cost basis carries over to the new corporate shares. This is a critical distinction from a traditional sale.

For the exchange to be valid, two main requirements must be satisfied:

Diversification: The portfolio being transferred must be diversified according to the IRS's 25/50 test. This means no single holding can represent more than 25% of the total value, and the top five holdings cannot exceed 50%. Since Michael's $500,000 single stock position is only 10% of his total $5 million portfolio, his entire portfolio passes this test.

Control: The investor must have at least 80% control of the newly formed corporation immediately following the exchange. In practice, this is often achieved by multiple 'seeding' investors transferring assets at the same time to establish an ETF, or by an investor with a significant enough portfolio acting as the primary seeder of a new fund.

By working with an ETF sponsor that facilitates these exchanges, Michael can transfer his entire $5 million portfolio into a newly formed ETF. He would receive ETF shares in return, and his $400,000 unrealized gain would not be taxed. Within the ETF wrapper, the fund manager could then sell Michael's single stock and reinvest the proceeds into other securities to align with the fund's mandate. Due to the in-kind creation and redemption process of ETFs, this internal rebalancing does not trigger a taxable event for Michael. He has successfully diversified away from his single-stock risk and preserved the full $500,000 of market value.

Tyson Mavar, a Senior Vice President and Financial Advisor with Wealth Enhancement, emphasizes the importance of a holistic approach to these complex strategies. 'For clients with significant embedded gains, the goal is always to optimize after-tax returns,' Mavar says. 'A Section 351 exchange is a prime example of a strategy that, when executed correctly, can help preserve capital that may otherwise be lost to taxes, allowing it to continue working for the client over the long term.'

While the benefits are clear, it's important to acknowledge the limitations. The number of ETFs currently accepting such exchanges is limited, and these funds may have higher expense ratios than their more established counterparts. There's also the risk of an inadvertent tax treatment failure if the rules are not strictly followed. However, for an investor like Michael, the ability to defer a substantial tax bill and gain immediate diversification makes the strategy compelling. It is a powerful tool for advisors to help their clients escape the 'tax-locked' state and realign their portfolios with their long-term financial goals.

Key Resources:

IRC Section 351(a): https://www.law.cornell.edu/uscode/text/26/351

IRS Treasury Regulation 1.351-1(c)(5): This regulation details the diversification test, often referred to as the 25/50 test, which is crucial for the strategy to be valid.

Kitces.com: 'Using Section 351 Exchanges To Tax-Efficiently Reallocate Portfolios' by Ben Henry-Moreland (March 12, 2025). This article provides a comprehensive overview of the strategy's mechanics and use cases.

Cambria Tax Aware ETF (Ticker: TAX): As one of the first ETFs to publicly announce the use of Section 351 exchanges, its prospectus and fund information offer a real-world example of the strategy in practice.

Longview  Advantage ETF (Ticker: EBI): Another example of a new fund launched via Section 351, demonstrating the increasing adoption of this strategy by ETF sponsors.

Other ideas if you own a highly appreciated stock

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Articles you may find interesting:

- Donating highly appreciated stock to a public charity.

- Contributing appreciated stock to a Donor-Advised Fund (DAF).

- Gifting highly appreciated stock to a family member in a lower tax bracket.

- Upstream gifting of appreciated stock to an older family member for a step-up in basis.

- Using tax-loss harvesting to offset capital gains.

- Entering into a variable prepaid forward contract.

- Reinvesting capital gains into a Qualified Opportunity Fund (QOF).

- Holding the stock until death to receive a step-up in basis for heirs.