This ETF Tax Loophole Is All the Rage Among Rich Americans

When the Merage family sold its company back in 2002, it was the fulfillment of an American Dream. Iranian-born Paul Merage came to the US as a teenager in the 1960s. He went to college, went to work, and went on to invent the Hot Pocket — the microwavable snack brand ultimately acquired by Nestle in a $2.6 billion deal. The family has since added a new step to the dream: Creating its own exchange-traded fund, and in the process deferring a hefty tax bill. The Merages supplied most of the seed assets for the MIG Core ETF (ticker MIGO), an investment product that launched in February with about $540 million of securities, according to a person familiar with the matter, who asked not to be identified as the information is private. The move allowed the family to offload appreciated shares without realizing capital gains, the person said. MIGO is what is known as a 351 conversion, a type of transaction that’s helping wealthy investors deal with years of market gains at the expense of government coffers – and attracting US Treasury Department attention as a result. They’re part of Wall Street’s booming tax alpha complex, which offers strategies that seek to beat the Internal Revenue Service as well as the market. A 351 sees an investor turn a portfolio of assets into an ETF, typically so they can rebalance winning holdings without paying an immediate tax bill – a handy maneuver for anyone who has found themselves with a concentrated position in one company or a few stocks. Technically it’s a deferral, since tax will still be owed when any shares in the ETF are eventually sold. But it keeps more money invested for longer, and investors can pursue several strategies that reduce or even eliminate what is owed. “The big benefit is taking a bunch of built-up gains in individual stocks and consolidating them into a diversified portfolio,” said Rory Riggs, a biotech investor whose firm Syntax Advisors helped create some of the first ETF conversions, including with his own assets. “It is about not having to realize those gains until you want to.” Conversions are not easy to spot in the sprawling and saturated ETF world, but they’re proliferating fast. A Bloomberg News analysis of filings to the US Securities and Exchange Commission has identified 105 ETFs created through 351 exchanges. Collectively they boasted $22.1 billion assets at launch and helped defer at least $6.5 billion in embedded capital gains, the filings show. More than half listed last year, as major asset managers including AllianceBernstein LP and American Century Investments began creating them for clients. 351 Conversions Are Booming MouseoverTap bubbles for more info Sources: Bloomberg, SEC Note: Last updated on July 16, 2026 As well as the Merage family and Riggs, private equity billionaire Richard Kayne is among those to use a conversion, the filings show. Dimensional Fund Advisors, the $1 trillion systematic giant, just joined the club alongside rival money manager Baillie Gifford. Neuberger Berman is laying the groundwork to do the same. Gabe Plotkin, owner of the Charlotte Hornets whose hedge fund was felled by a disastrous bet against GameStop Corp., plans an ETF primarily seeded with his own assets. In the majority of cases, such conversions are set up to quickly shed securities while avoiding realizing capital gains (though not always — Kayne’s fund, in particular, appears to use a different strategy). Read more ‘A Slam Dunk’ The sudden boom can be traced to a quadrupling of the S&P 500 over the past decade, largely driven by technology stocks. The rally has left many investors with huge gains, often concentrated in one name or a handful of companies. To diversify those positions without a big tax bill, they’re combining the famous efficiency of ETFs with Section 351 of the tax code, a century-old provision that lets Americans form new companies with existing assets. Say an investor’s portfolio includes shares of a company like Apple Inc. that they have held for the past 10 years. The stock has appreciated about tenfold in that time. If they want to trim their position for any reason, simply selling some of the shares would mean realizing a capital gain and facing a tax bill. Using section 351, they can convert the whole portfolio into an ETF, and once it is launched use flows in and out to gradually reduce their Apple holding. That can happen tax free because ETFs are underpinned by non-taxable “in-kind” transactions, where a special market maker swaps assets in and out. “High-net worth folks and their advisors see this as a slam dunk,” said Brent Sullivan, who runs the widely followed Tax Alpha Insider blog and recently wrote a paper on the legal issues arising from the phenomenon. “When you have a portfolio that is 50% unrealized capital gains, it starts to become a really attractive option.” Flow patterns for the MIGO fund suggest it has undertaken rebalances via in-kind redemptions five times, trimming stakes in companies including Western Digital Corp., Seagate Technology Holdings Plc and Micron Technology Inc. A spokesperson for the Merage family office declined to comment. How 351 Conversions Work Source: Bloomberg Ultimately, if the investor sells their ETF shares, they would still face a tax bill based on the original purchase price, or basis, of the seed securities — including the Apple stock. But in the meantime they have banked their profit and can keep the cash compounding for longer. They can also reduce the bill by delaying the sale of ETF shares until they have retired into a lower tax bracket, or avoid it entirely by passing the fund shares to their heirs upon death, triggering a basis reset. The widespread use of 351s was made possible by ETF rule changes in 2019, but it’s only in the past two years that the number of conversions has surged. Rising wealth manager awareness has contributed, while a wave of upstart fund issuers has emerged who are syndicating seed capital from different financial advisers. For instance, by tapping the clients of various advisers, Alpha Architect has launched three near-identical ETFs with combined assets of about $1.4 billion, according to data compiled by Bloomberg. Cambria Investment Management has launched five conversions with syndicated assets. Jason Marcus, the chief operating officer at Scharf Investments, sees a difference between his firm’s two 351 conversions in August and those by issuers who are broadly soliciting seed contributions. The latter are gathering assets that are not necessarily aligned with a fund’s principal investment strategy, which is “really not the spirit” of an exchange, he said. “We’re getting marketing notifications, ‘Oh, come to us, we’re launching a new product via 351,’” said Marcus. “That kind of dovetails into why there’s probably going to be more regulatory scrutiny.” Seeking Guidance The Treasury first signaled its interest in 351 conversions in the ETF market late last year, surprising an industry that might have thought such issues were off the radar under US President Donald Trump’s administration. In meetings with fund industry representatives, officials discussed various forms of guidance they could issue about the practice, including labeling the conversions “transactions of interest,” a designation for deals with tax-avoidance potential. Guidance has yet to be issued, and in a rare move the Investment Company Institute in May filed a comment letter to the Treasury seeking clarity around the practice. At an industry event this week, officials reiterated the department’s concerns about 351s and several other tax alpha strategies, but said it wants to consult with the market before deciding what action is appropriate. Kevin Salinger, now acting assistant secretary for tax policy, homed in on transactions that use an ETF’s in-kind redemption mechanism to dispose of “a substantial portion” of the contributed appreciated securities, which are then replaced with positions that fit in the fund’s strategy. The mechanism “was not designed to cleanse a portfolio contributed as part of a planned diversification transaction,” Salinger said. Spokespeople for the Treasury and IRS didn’t respond to requests for comment. The average 351 fund in Bloomberg’s list replaced about 51% of its portfolio within the first year, calculations show, compared with about 34% for mutual-fund-to-ETF conversions and 33% for actively managed ETFs that weren’t created by 351. Not all of these represented drastic rebalancing however, since some funds replaced direct stock holdings with ETFs containing the same securities. Based on underlying assets, 351 funds replaced about 36% of their portfolios within the first year, compared with about 28% for mutual-fund-to-ETF conversions and 30% for non-351 actively managed ETFs. “Historically where people get into trouble with any kind of tax-efficient trade is when they push the envelope too far,” said James Cofer, tax partner at Seward & Kissel LLP who has worked on 351 transactions. “If I contribute a diversified portfolio of securities and I immediately do an in-kind distribution of all of the portfolio’s assets, some people might argue that doesn’t have economic substance.” 351 Funds Traded More Aggressively After Launch Source: Bloomberg While there are restrictions around seeding an ETF with just a few concentrated bets, some funds stand out for the size of the winning positions they have managed to exit. For instance, the Twin Oak Active Opportunities ETF (TSPX) quickly dumped its two biggest holdings after it began trading in February last year. About $200 million of stock in the software companies Snowflake Inc. and Datadog Inc. was replaced mostly with a plain-vanilla S&P 500 portfolio. Filings suggest the shares in the two tech stocks were initially acquired at close to zero basis — a sign the ETF’s seed contributors were probably the companies’ early investors. A spokesperson for the Twin Oak ETF Company declined to comment. As it stands, the tax code leaves plenty of leeway for ETF managers to decide how soon and how aggressively they trade after launch. Amy Snyder, tax principal at professional services firm EY, says she tells clients seed securities for conversions have to align with the ETF’s objectives, and they shouldn’t go into the deal intending to get rid of the assets. “That’s not to say you can never dispose of any security in your ETF,” she said. “If you have to potentially dispose of securities at some point down the road, you should have good investment reasons for doing that.” Different Playbook Not all 351s follow the standard playbook of avoiding capital gains by selling long-held positions. Take the Simplify Propel Opportunities ETF, seeded by Kayne, the private-equity billionaire. The ticker, SURI, is a family in-joke: it’s the same portmanteau of Kayne’s and his wife’s first names that they previously used for a 208-foot yacht. Kayne made the bulk of his fortune, estimated by Forbes at $1.3 billion, at Kayne Anderson Capital Advisors LP, a pioneering oil and gas investor that also manages real estate, credit and infrastructure funds. More recently, he helped set up Los Angeles-based Propel Bio Partners, which manages a private fund to invest in life-sciences companies. SURI started trading in 2023 as the ETF version of Propel’s strategy. Kayne contributed about $109 million of stocks via a 351 conversion, including biotech stocks of the kind Propel holds, SEC filings show. But Kayne’s contribution also included $24 million of securities issued by an oil pipeline company, Plains All American. It’s likely that contributing those securities — dubbed publicly traded partnership units — to an ETF alongside other stocks reduced the amount of tax Kayne had to pay on cash distributions. Despite its stated focus on health care stocks, SURI’s largest single exposure remains to Plains. Kayne declined to comment. Testing the Limits Large money managers are increasingly joining the rush to use 351 conversions. Bloomberg’s list includes not only products formed with contributions from individuals or groups of investors, but also some seeded by hedge funds and other private investment pools. In December, AllianceBernstein launched a broad market ETF called the AB US Equity ETF (XCHG) with about $660 million worth of securities. About three months after launch, the fund consolidated its portfolio, trimming holdings of some ETFs and single stocks. “We looked at clients that had concentrated legacy positions in their portfolios — so not always so good from a diversification perspective, but also something that they might have different reasons for wanting to get out of,” said Noel Archard, global head of product solutions and marketing. “Getting a group of those together with alike securities to go into an ETF to provide them with diversification and an estate planning tool to us made sense.” Last month Dimensional launched the now-$1.2 billion Dimensional US Large Cap Core Equity Market ETF (DFAL) via a 351 deal, while Baillie Gifford debuted the $196 million Baillie Gifford International Alpha ETF (BGIA). In a recent filing Neuberger Berman flagged the potential for seeding new ETFs with in-kind contributions. With the use of 351s spreading, Sullivan has suggested some firms are testing the limits of the practice. A recent paper he wrote alongside Elliot Rozner, a freelance researcher, highlighted “stuffing,” where investors use borrowed money to alter a portfolio so it passes diversification rules, and “sequential seeding,” where multiple funds are used to diversify a concentrated position. Even if a conversion formally complies with the rules, the IRS will scrutinize anything that looks like “tax-free diversification in disguise,” the pair wrote. Riggs, the 351 pioneer, doesn’t expect that rising government scrutiny would curtail the practice. He spent four decades in pharmaceutical royalty investing, and by the late 2010s had accumulated large unrealized gains. Diversifying would have triggered a substantial tax bill, so starting in 2019 his firm Syntax launched four ETFs via 351 conversions instead. “There’s no reason to stop,” said Riggs. “They fill a hole. The hole is people have these marked up assets and would like to somehow be able to diversify them, right? And so it’s tax-free, and we all do it in different ways, but this is a clean one that works.”