351 ETFs: Tax-Free “Diversification” Is Supposed to Hurt

Co-authored by Wes Gray, PhD (Alpha Architect) and Robert Elwood (Practus, LLP).

On July 21, 2026, at the Wall Street Tax Association (WSTA) tax-geek meeting, Treasury announced that it may put certain types of Section 351 transfers to ETFs on a list of transactions that may look “too good to be true.” Cue the media’s panic headlines.

Of course, the problem with media companies is that they have economic incentives to focus on clicks, but they don’t care about context. The point of this post is to help readers contextualize and understand the comments made by the Treasury officials so they can make their own assessment of the potential risks tied to “351 ETFs.” We’ll provide a summary of the past 60 years of debates on these topics, but we can start with the BLUF.

The bottom line up front: Congress’ intent is to ensure that tax-free “diversification” of a concentrated position is painful. Don’t break this rule.

Are there other hot button items discussed regarding 351 ETFs? Certainly. Contributing securities that don’t seem to align with the prospectus? High turnover post-closing? In-kind redemptions used to “cleanse” a portfolio? But are these high-risk areas besides tax-free diversification? The rulemaking history on this topic seems to suggest “no.” Over the past 60 years every update that Congress or Treasury have made has been focused on the same thing: making sure nobody turns a concentrated position into a diversified one without paying tax. The other items matter, but mainly as an evidence trail that could indicate shenanigans. They are how the IRS figures out that a contribution was “fake” diversified and part of a scheme to achieve tax-free diversification of a concentrated position. However, if your contributions are bone fide diversified and you’re following the spirit (and the letter) of the rules, our read is that you are probably less interesting to the IRS. Of course, Congress can always update the rules of the game, which means anything is possible.

Before we dive into the wildly entertaining topic of taxation, we’ll quickly cover some key rules involved in the recent Treasury discussion regarding 351 ETFs:

Section 351 is a roughly century-old rule that lets you transfer property to a corporation, take back its stock, and pay no tax today. An ETF is a corporation for tax purposes. So you can seed a new ETF with securities instead of cash and carry your old cost basis into the new shares.(1)

Section 852(b)(6), often referred to as the “ETF tax loophole,” is the other half of the story. When a fund transfers appreciated securities to a redeeming shareholder in kind, the fund recognizes no gain. That rule is the engine behind ETF tax efficiency generally, and it lets a manager reshape a portfolio without generating a distribution.(2)

For a 351 ETF, the two rules play together in the following way from a tax perspective: Sec. 351 allows one to move a diversified portfolio, tax-free, into a newly formed ETF, and once inside the ETF, ordinary-course portfolio changes can be made tax-efficiently via Sec. 852(b)(6). Investors love both concepts due to their potential tax deferral benefits, but there are numerous non-tax benefits to investing in an ETF as well: lower costs, lower admin, lower trading costs, more flexibility, more liquidity, greater transparency, better diversification, intra-day trading, and so forth. All of this is a good deal for investors, which explains the massive growth in ETFs as well as 351 ETFs.

But where can this go wrong?

Let’s repeat the most important item from the BLUF: tax-free diversification of concentrated positions. There is a long history that highlights lawmakers’ disdain when investors find clever ways to transition concentrated positions into diversified positions without paying tax. The rule only fires if the transfer itself diversifies your interest. That is the trigger, and it is the whole ballgame. When it fires, the contribution becomes a taxable exchange and the entire built-in gain is recognized in the year you contributed, which is the opposite of what you signed up for if you participate in a 351 ETF. Clever engineering doesn’t help, because since 1967 a plan to reach diversification through a chain of tax-free steps counts as diversification too.(3)

The BLUF was referenced in the discussion at WSTA, but was buried in the media reports. The moderator asked Kevin Salinger from Treasury whether the real worry with 351 ETFs was somebody with built-in gains getting diversified, as opposed to phantom income inside the fund. Salinger’s answer:(4)

I would say diversification is driving our concerns, and we’re not here to disrupt ordinary-course ETF market activity.

Consistent with 60 years of history on this topic, the government is still concerned with investors getting diversified without paying tax. We’ll start with a quick history lesson on why the government doesn’t like tax-free diversification and we’ll end with some examples and generic concepts that will help investors minimize risk when they consider contributing to a 351 ETF.

Disclaimer up front. This piece is educational and general. It is not tax, legal, accounting, or investment advice, it was not written for anyone’s particular situation, and it cannot be relied upon by any person for any purpose, including avoiding penalties. Robert is a tax attorney and a co-founder of Practus, LLP, but he is writing here as a co-author and not as anyone’s lawyer. Nothing in this post is legal advice, reading it creates no attorney-client relationship, and the views are ours alone and not those of our firms, colleagues, or clients. Wes is neither a lawyer nor an accountant and holds no professional credentials in tax. We are simply interested in the subject and want to work through it in public to further our own knowledge, and hopefully yours. Nothing here is an offer, a solicitation, a recommendation, or an opinion on any specific fund, contributor, or transaction. Full disclosure on our interests: Wes’s firm operates an ETF platform that has worked on Section 351 seedings, and Robert and his firm have served as tax counsel on Section 351 transactions for that platform and other clients, so we both have a commercial stake in this subject. Read accordingly and take your own facts to your own advisors.

Also, special thanks to Brent Sullivan and Jack Vogel for comments and thoughts on the initial draft.

A very short history of the government hating tax-free diversification

1960. A Denver banker named William Berger reads Section 351 and realizes he can rally different appreciated stocks from his clients, pool them, hand out fund shares, and everybody walks out diversified. The kicker: not taxable! His Centennial Fund raises $25.8 million and the copycats pile in.

1966. Congress tells Berger to pound sand. They kill his idea. Section 351 no longer applies to transfers to an “investment company.”

1967. Treasury defines an investment company and what it means to have a “diversification of the transferors’ interests.” Two people each contributing solely IBM produces no diversification, so no tax. If one contributes IBM and the other contributes GE that produces diversification, so tax. Treasury also adds a sanity test: a plan to achieve diversification without tax, “however delayed,” is a path to getting busted. Berger’s idea is finished, though not instantly: funds already in registration had until June 30, 1967 to close.

1975–76. The concentrated money reappears with new tricks via partnerships and mutual fund mergers (Sec. 368). Congress creates new rules for partnerships and trusts and writes Section 368(a)(2)(F) to stop undiversified mutual funds from merging into diversified ones. Interestingly enough, Congress writes a definition of diversification: no more than 25% in one issuer, no more than 50% in your top five.

1996. Treasury notices its own inconsistency across 351 and 368: the same two portfolios can merge tax-free via 368, but the same transaction via 351 gets taxed. Treasury imports Congress’ 1976 diversification definition into 351. 351 is back in the game for diversified contributions.

1997. Congress reviews the regime and leaves it standing. Concentrated into diversified = pay tax. Shifting diversified into another diversified portfolio = we don’t really care.

2026. Treasury says tax-free diversification is driving its concerns.

Sixty years later and the memo regarding tax-free diversification hasn’t changed: society doesn’t like it! A quick graphic below maps out the timeline.(5)

If you want the full chronology with the statutes, the private letter rulings, and the reasons Congress gave at each step, it is in the footnotes and leans heavily on the work cited below.(6)

How does the government define diversification?

Ask several financial professionals what “diversification” means, and you’ll get different answers. For example, Warren Buffett might tell you ten well-researched stocks is a diversified portfolio, while Wes’s old advisor Eugene Fama would say you need every security in the global market portfolio to be diversified. Luckily, Treasury settled the debate and gave us a bright line. Your contribution is “diversified” if no single issuer is more than 25% of your portfolio and your five largest are not more than 50% of the total.(7)

An interesting but important side note is that the rules do not care whether you end up more diversified than you started. For example, if 100 investors each contribute 11 equal-weighted stocks (which hits the “diversified” definition), and assuming no overlap in anyone’s holdings, the pool that every contributor owns now holds 1,100 names. Clearly, everybody is way more diversified than they were prior to the contribution. But Congress/Treasury have reiterated that there is nothing wrong with this outcome. What concerns them is when non-diversified portfolios become diversified.(8)

Everything up until this point should be straightforward, but Congress has always been aware that investors like to play games. Since 1967, a Sec. 351 transfer that is “part of a plan to achieve diversification without recognition of gain” counts as diversification. In plain English: any scheme you cook up, we’ll look through, if the end game is that you took a concentrated position and turned it into a diversified position, tax-free.(9)

So, the job of a contributor in a 351 ETF is to clear the mechanical diversification tests and ensure there is no funny business behind the scenes. A judge will see through advanced financial engineering, and the IRS has plenty of tools to bust you.(10)

Diversified contribution? No problem, nothing to see here…or is there?

Treasury literally defines what it means to be diversified, so one might think there is no wiggle room on these rules. However, because 351 offers a tax-free exchange if you contribute diversified property, investors are heavily incentivized to spend a lot of brain power trying to look “diversified,” even if they really aren’t diversified behind the scenes. We call this “fake” diversification. The examples below will explain what we mean.

What the rules were built to allow

You already owned a diversified portfolio. No leverage. No recent changes. And you’ve owned it for 10 years. But now you’re tired of the complexity, the high advisor fees, the trading, the administration, and so forth. Time to look for a 351 ETF. Turns out a 351 ETF wants those securities because they fit its strategy. Post-launch, the 351 ETF’s rebalances are the manager’s ordinary-course decisions, made under its 1940 Act duties, and in-kind redemption gets used for the normal reasons any ETF uses in-kind redemptions.(11)

Where the facts get murkier

Your contribution cleared 25/50, but 80% of the portfolio is stuff the fund would never buy. Or maybe you made a bunch of recent transactions to ensure the contribution cleared 25/50. Or you contributed a diversified portfolio once, watched your ETF shares become a broad portfolio, and now want to use those shares plus another block of the same concentrated stock to seed the next fund, which is what Sullivan and Rozner call “sequential seeding.” All of these situations could make things a bit murkier and raise red flags, but it all depends on the facts and circumstances.

What 60 years of law was written to stop

Treasury described this territory publicly, and Sullivan and Rozner named it “stuffing,” so it is worth being able to recognize. To be clear about why it is here: this is the pattern 60 years of law was written to stop, not a playbook. You had $100 million in one stock and no other assets. Clearly you have a concentrated portfolio. But that won’t work for 351 since you need a diversified portfolio contribution! Solution? Borrow $300 million secured by the whole portfolio, buy a pile of random stocks/bonds so the concentrated position lands at exactly 25% of a $400 million portfolio and you are designated “diversified.” Next, contribute the whole thing into a 351 ETF tax-free (you were “diversified,” right?). Now that you are in the ETF structure, you can lean on in-kind redemption to transition the portfolio from your contributed junk into your heart’s desire. Finally, you sell some of the 351 ETF shares to repay the original loan that allowed you to look diversified in the first place. If it all goes according to plan you end up with a diversified $100 million and no tax paid. Congratulations, you seem to have accomplished what 60 years of lawmaker history says you cannot do: achieve tax-free diversification.(12)

Treasury addressed this territory directly from the stage at the WSTA event: Section 351 is not “a general device for exchanging one investment portfolio for another without tax,” and Section 852(b)(6) is “not designed to cleanse a portfolio contributed as part of a planned diversification transaction.” That is the stuffing pattern in Treasury’s own words. Our takeaway: do not defy the intent behind the rules.(13)

Where’s the rule against swapping out the portfolio after a 351?

We’ve focused on tax-free diversification so far because that is where lawmakers have aimed for 60 years, and Treasury already has the tools to go after shady deals with “engineered” diversified contributions. But Salinger did spend time chatting up section 852(b)(6) in the context of 351. A knee-jerk reaction follows:

Wait. I thought my concern was delivering a diversified contribution. And I contributed a legit diversified property into a 351 ETF, but now Salinger is saying that if the ETF manager turns over a bunch of the 351 ETF’s portfolio, they will blow up the deal?

We don’t think anyone would disagree that a large rebalance trade for a huge portion of a 351 ETF’s assets would be odd if it occurred soon after a deal closed. No disagreement there and that ETF is certainly waving a red flag to investigate further. But assuming all contributors were bona fide diversified contributors (i.e., nobody achieved tax-free diversification), what exactly is the legal risk with that large turnover trade?

We went looking for any rules or guidance that says a legit 351 ETF with genuinely diversified 351 contributors not trying to scam the system should get hammered because the fund later swaps out the portfolio. There isn’t one as far as we can tell, assuming all 351 contributors are bone fide diversified contributors. The 351 regulation tests the transfer, on the day of the transfer. In our read, that leaves a genuinely diversified contributor with little to worry about on this front (other than what we describe in the next paragraph). We could not find a rule tied to turnover, or one suggesting the ETF can’t sell your stuff post transaction. When Treasury rewrote these rules in 1996, post-transfer turnover didn’t come up once. Same story for section 852(b)(6).(14) No holding period. No anti-churn rule. No “unless the securities came in via 351.” We know there are various discussions in the context of Sec. 368 that speak to business continuity, so maybe those could be applied in the context of 351?(15) Anyway, we are not suggesting a 351 ETF portfolio manager blow out their entire portfolio immediately after launch, but this is an open question we’ve been wondering about, mainly because Salinger discussed it and there is no clear guidance on the topic.

All that said, what was Salinger likely talking about? Read his comments closely and every section 852(b)(6) sentence is tethered to the contribution: a portfolio “contributed as part of a planned diversification transaction,” redemptions used to shed “a substantial portion” of what came in. In-kind redemptions alone don’t seem to be the issue. It’s combining them with other steps to reach a result Congress didn’t intend. Our translation: the redemptions are evidence that the contribution was fake-diversified. In-kind redemptions are the back half of the stuffing story, not a freestanding sin. Maybe we’re missing something and if a more sophisticated reader has input on this topic, feel free to share and we’ll add it as a footnote on this blog. We still think the biggest issue is tax-free diversification.

Closing thoughts

Under the current laws, truly moving from concentrated to diversified must come with pain. That is how the system is designed. If you are concentrated and you want out, you can pay the tax, you can accept the frictions of an exchange fund, you can look into long/short market neutral tax-loss harvesting,(16) or you can hedge (watch out for straddle rules!) and borrow. Pick your pain.

But what you cannot do is use a 351 to engineer a concentrated-to-diversified path with no pain.

A “fake” diversified portfolio is the thing Salinger kept circling back to: it looks “too good to be true.” Does your contribution use massive leverage, off-balance-sheet shenanigans, 10 LLC entities based in the Caymans, and multiple meetings with 5 different law firms that won’t write a tax opinion on your proposed idea? If any of these sound familiar, 351 ETFs probably aren’t for you.

So, what should you take to your own tax counsel? A few questions worth asking, on your own facts. Does what I am contributing clear 25/50 on its own, without anything I bought or borrowed to get it there? Does the fund actually want these securities? Can I explain why I am shifting my portfolio into a 351 ETF, in terms that have nothing to do with taxes? Those are the questions I would want answered before signing anything, and they are questions for your advisors, not for a blog post.

Sources and further reading

None of the history is original research. It rests on people who mapped this territory first.

• Jeffrey M. Colón, “The Black Hole of Capital Gains: ETF Swap Funds” (Nov. 2025). The most complete recent survey of § 351(e), § 852(b)(6), and the seeding debate, and the source for much of the chronology in the footnotes. Also “Unplugging Heartbeat Trades” (2023) and “The Great ETF Tax Swindle” (2017).
• David J. Herzig, “Am I the Only Person Paying Taxes?” 2009 Mich. St. L. Rev. 503. Our source for the Berger history, the 80/20 structure, the exchange-fund frictions, and the Neal episode.
• Marvin A. Chirelstein, “Tax Pooling and Tax Postponement,” 75 Yale L.J. 183 (1965). The original critique, and the source of “an accident of skillful planning.”
• Brent Sullivan and Elliot Rozner, “Managing Concentrated Public Stock Positions by Seeding an Exchange-Traded Fund” (Journal of Wealth Management, 2026). The “stuffing” and “sequential seeding” taxonomy is theirs, and it is the best practitioner treatment available. Brent also prepared the WSTA transcript every government quote here comes from, at Tax Alpha Insider. The full record is his work, not ours.
• Primary sources: Treas. Reg. § 1.351-1(c); CO-19-95 (Aug. 10, 1995); T.D. 8663 (eff. May 2, 1996); T.D. 6942 (1967); I.R.C. § 368(a)(2)(F); Pub. L. 89-809 § 203 (1966); Pub. L. 94-455 § 2131 (1976); Pub. L. 105-34 § 1002 (1997).
• Also on the July seminar: Bloomberg (Mider, Lee, Tsekova) and the K&L Gates alert. Panelists: Jay Freedman (KPMG, moderator), Jeffrey D. Hochberg (Sullivan & Cromwell), Vadim Novik (Fried Frank), Kevin Salinger and Erika W. Nijenhuis (Treasury). Wes’s colleague Jose Ordonez covered these patterns in his conversation with Brent, and for how § 351 compares with other routes on cost and lockups, see our earlier post. The 1976 legislative-history quotation comes via NYU’s Tax Law Center.

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was originally published at Alpha Architect. Please read the Alpha Architect disclosures at your convenience.