Exchange Funds vs 351 ETFs: The Millionaire's Guide to Tax-Free Diversification

You're sitting on a stock that changed your life. Maybe it was your startup equity, or a lucky bet on Nvidia or Tesla. The problem? You’re also sitting on a massive tax bill if you try to sell. A concentrated stock position may have helped you build your wealth - but now it’s a risk you can’t afford, and you feel trapped.

This is where advanced tax strategies come into play - specifically Exchange Funds and 351 Conversion ETFs. These aren’t everyday tools. They’re sophisticated legal strategies used by ultra-high-net-worth individuals and family offices to diversify without triggering capital gains tax.

In this article, we’ll break down both strategies in depth, explore real-world use cases, and help you understand when each strategy makes sense. If you’ve got $5M, $25M, or even $100M of low-basis stock, this is the kind of chessboard you should be playing on.

Let’s say you hold $20 million in Nvidia stock with a $2 million basis. That’s an $18 million unrealized gain. Selling would likely cost you:

• Federal LTCG tax (20%) = $3.6 million
• NIIT (3.8%) = $684,000
• State tax (e.g., California ~13.3%) = $2.4 million

Total tax hit: over $6.6 million.

So you don’t sell. But you’re overexposed, under-diversified, and potentially one earnings call away from a disaster. You need a way out that doesn’t set fire to your gains.

Enter Exchange Funds and 351 ETFs.

An Exchange Fund is a pooled investment vehicle—usually structured as a limited partnership—where multiple investors contribute their concentrated stock holdings. Over time, they receive a diversified basket of stocks, without triggering a sale.

These funds are governed under Section 721 of the Internal Revenue Code and are typically offered by firms such as Goldman Sachs, Eaton Vance, or Morgan Stanley.

1. You contribute $5M–$10M+ of a single low-basis stock (e.g., Apple).
2. Others do the same with their stock.
3. You receive LP units in a diversified fund.
4. After 7 years, you can redeem your pro-rata share of the diversified basket.

• The initial contribution is non-taxable.
• The exchange after 7 years is also non-taxable, provided the structure follows IRS rules.
• You retain carryover basis in the stocks you receive - so tax is deferred, not erased.

• Management Fees: Typically 0.75%–1.25% annually
• Performance Fees: Some funds may charge a back-end or performance-based fee
• Opportunity Cost: Limited customization and 7-year lockup
• Administrative Costs: Built into the fund’s NAV; not always transparent

• Simple to implement through institutional platforms
• No need to create a new legal entity
• Built-in diversification

• 7-year lockup
• No control over fund holdings
• Illiquidity
• Mismatched strategies possible

A 351 Conversion ETF is a bespoke, publicly traded ETF created by contributing appreciated assets under Section 351 of the IRC, which allows tax-free transfers of property into a corporation. White-label firms, such as Tidal, Exchange Traded Concepts, or Alpha Architect, commonly structure these ETFs.

This strategy enables you to create an ETF, seed it with your low-basis stock, and utilize in-kind transactions to rebalance into a diversified portfolio—all without incurring capital gains tax.

• You or your advisor creates a new ETF (via a white-label platform).
• You contribute $25M+ of appreciated stock (e.g., Snowflake, Palantir).
• The ETF is launched with your holdings.
• Within days or weeks, the ETF rebalances via in-kind heartbeat trades into something like SPY or AGG.
• You now own diversified ETF shares—with no tax triggered.

• Initial contribution is non-taxable (Section 351).
• Rebalancing trades within the ETF are non-taxable (in-kind swaps).
• You now hold ETF shares with a carryover basis.
• Tax is deferred until the ETF is sold.

Let’s say Sarah holds $25M in Snowflake (basis $3M). She funds a custom ETF with the position. The ETF then swaps Snowflake for SPY and a few fixed income ETFs. Sarah now owns ETF shares worth $25M with a $3M basis—fully diversified, fully liquid, no tax paid.

• Single stocks (e.g., Snowflake, Nvidia)
• Other ETFs (e.g., SPY, AGG, sector ETFs)
• Fixed income ETFs
• Individual bonds (e.g., Treasuries, corporates, munis)

Using ETFs inside the 351 fund helps satisfy the IRS’s 25/50 diversification rule:

• 25% Rule: No single position can be more than 25% of the portfolio
• 50% Rule: The top 5 positions cannot collectively exceed 50% of the portfolio

ETFs and bond funds naturally spread exposure across dozens or hundreds of securities, helping the ETF pass this test and qualify for non-recognition under Section 351.

• ETF Formation/Legal Setup: $100K–$200K upfront
• White-label platform onboarding: $50K–$100K
• Annual Operating Expenses: $100K–$300K per year (compliance, audit, board, legal)
• Custom Fund Management: If outsourced, expect advisory fees
• Tax Compliance: Ongoing cost to track basis and file fund returns

• No lockup
• Full control and customization
• Transparent and liquid
• Diversification within days
• Flexibility in asset selection

• High setup and ongoing costs
• Requires careful tax and basis tracking
• Legal and operational complexity

• The ETF continues trading.
• You, as the original seeder, hold ETF shares that you can sell at any time (taxable event).
• Fund manager (or white-label platform) continues maintaining it.
• Other investors could theoretically buy into it, but often they don’t — it's not marketed.

This is the most common path for clients who want:

• Liquidity
• Ongoing tax deferral
• Custom index-like exposure

Once the strategic tax move is done (i.e., your appreciated stock has been exchanged for diversified assets), you may decide to:

• Liquidate the fund
• Redeem ETF shares in-kind
• Shut down the ETF shell

This could make sense if:

• The ETF has served its purpose (e.g., post-diversification)
• You want to reduce the costs of maintaining the ETF
• You’ve sold or donated your ETF shares elsewhere
• You don't want to deal with compliance and board governance long-term

Any liquidation or redemption must be carefully structured to avoid turning the transaction into a constructive sale or triggering gain. This is where a strong tax counsel and fund legal team are absolutely essential.

If you decide to shut down the fund:

• File termination paperwork with the SEC.
• Distribute assets to remaining shareholders (usually just you or your family office).
• Dissolve the legal entity.
• File a final return and issue final shareholder tax reports (cost basis, NAV at closure, etc.).

It’s not unlike shuttering a mutual fund or private fund. The key is that:

• You don’t trigger a deemed sale
• Basis tracking is preserved
• Any remaining assets are distributed in-kind (not cash) if you want to avoid recognition

Many clients hold the ETF for years, integrating it into their broader portfolio:

• Can be transferred to trusts
• Used for tax-loss harvesting pairs
• Or held until death for step-up in basis

But if you want to unwind it, you can — you just have to do it intentionally, not casually.

• You're contributing $5M–$10M and don’t want to deal with creating a new fund
• You're OK with a 7-year lockup
• You're looking for a passive, plug-and-play solution

• You have $25M+ in appreciated assets
• You want full control over the portfolio
• You need diversification quickly, not in 7 years
• You want liquidity and exit flexibility
• You’re a family office or highly sophisticated investor with tax counsel
• You're willing to absorb higher upfront and ongoing costs for greater flexibility

• Charitable giving
• Loss harvesting
• Lower-tax-bracket years

• CRUTs
• IDGTs
• Donor-Advised Funds
• Family partnerships

Wealthy investors aren’t dodging taxes. They’re deferring them—strategically, legally, and with precision.

If you’re sitting on a massive low-basis position, the game isn’t just about beating the market. It’s about utilizing the tax code in your favor. Whether you choose an Exchange Fund or a 351 ETF conversion, you’re playing a different game entirely and doing it with purpose.

At VIP Wealth Advisors, we don’t do boilerplate plans. We do battle-tested, bespoke strategy. If you’re ready to reposition your wealth without triggering a tax minefield, it’s time to talk.