A Section 351 seeding needs a diversified portfolio going in: no position over 25%. Someone whose wealth is one stock fails that test on the first line. An exchange fund needs the opposite: many investors, each with one concentrated position, pooling them into a partnership so that each walks out owning a piece of all of them.
How it works
Contribute the stock to the partnership and receive partnership units. No gain is recognized on the contribution. The fund holds everyone’s stock plus, by law, at least 20% in assets that are not marketable securities, which in practice means real estate. After seven years you can redeem in kind, taking a basket of the other contributors’ stocks with your original low basis carried over. Redeem earlier and the deferred gain comes due.
What you get
- Diversification today with no tax today.
- Carryover basis, so the estate step-up still applies if you never sell.
- Minimums from $100,000 at the newest entrant to $500,000 or $1 million at the traditional sponsors.
What you pay
- 0.40% to 0.95% a year, plus a placement fee of up to 1.5% at some sponsors.
- Seven years locked up.
- A fifth of the fund in real estate you did not choose, held to satisfy the tax test.
- Whatever the pooled portfolio returns, not what the index returns.
The break-even
The deferred tax is worth something every year it stays deferred. A fee plus a portfolio that trails the market eats that value. One widely cited estimate puts the break-even at about 2% a year: if the exchange fund underperforms a plain index by that much over the seven years, the tax benefit is gone.
Section 351 or an exchange fund
The two routes solve different shapes of the same problem.
| Section 351 seeding | Exchange fund | |
|---|---|---|
| What goes in | A diversified portfolio (no position over 25%) | One concentrated position |
| What comes out | ETF shares, tradable daily | Partnership units, locked for seven years |
| Fee | The ETF’s expense ratio, 0.2% to 0.6% | 0.4% to 0.95% plus placement |
| Legal footing | No ruling; step-transaction risk | Long-established statute |