The 351 exchange continues to gain traction among asset managers as a strategic method for converting various investment vehicles, such as separately managed accounts (SMAs) into exchange traded funds (ETFs). This tax-deferred process can unlock benefits, including enhanced liquidity and transparency. However, it also demands meticulous navigation of regulatory, valuation, and operational challenges. This article explores the mechanics of the 351 exchange, its primary advantages, and the considerations for a successful transaction.

Defining the 351 Exchange

A 351 conversion involves transferring assets from an SMA to an ETF in return for ETF shares. This transaction is structured to allow for deferral of gain or loss on the transferred assets, provided specific IRS conditions are met. Mishandling this process can result in significant tax liabilities and operational disruptions. The complexities of valuation, regulatory compliance, and post-conversion administration require an experienced approach.

Key Elements of the Conversion

• SMA: a personalized investment account managed by a professional investment firm. The investor directly owns the securities within the account, which can include a diverse range of assets such as stocks, bonds, and other securities.
• ETF: a pooled investment vehicle that holds a collection of assets and is traded on stock exchanges. ETFs offer liquidity, diversification, and typically lower costs and can be more tax-efficient compared to individual asset management.

Requirements

To qualify for a Section 351 exchange, the assets transferred from the SMA to the ETF must meet IRS tax diversification requirements and satisfy specific control rules. An important aspect of this transaction is the control requirement, which means that the investor or group of investors must own at least 80% of the voting power and 80% of the total number of shares of the ETF immediately after the exchange. Fulfilling these requirements is essential to confirm the transaction qualifies for tax-deferral benefits.

Primary Advantages

A 351 exchange provides a mechanism for portfolio diversification by allowing appreciated securities to be transferred into an ETF structure. Because this transaction is treated as an exchange rather than a sale, the ETF manager can then diversify the portfolio by selling concentrated positions and acquiring new securities without triggering an immediate tax liability for initial investors. This process can also enhance liquidity, allowing for easier access to fund shares through public markets.

Tax Implications

A 351 in-kind exchange allows investors to transfer assets to an ETF without triggering a taxable event for the contributor. The unrealized gains are deferred until the ETF shares are sold. The cost basis and holding period from original assets carry over to the ETF shares, maintaining continuity for future tax calculations.

Conversion Overview

Converting an SMA to an ETF via a Section 351 exchange offers a structured approach to aligned portfolio management, allowing investors and asset managers to select vehicles that support client objectives. The process can also enable easier asset consolidation and facilitate ongoing adjustment to portfolio composition within a regulated, tax-conscious framework.

Key Steps in the Conversion Process

Several considerations are essential in converting an SMA to an ETF under a Section 351 exchange. These include accurately valuing all transferred assets, maintaining thorough transaction records and agreements, and adhering to relevant securities regulations. Each step supports the integrity and compliance of the conversion process.

Conversion Obstacles

Potential challenges in the conversion process may arise when SMAs include assets that are illiquid or difficult to price intraday in an ETF structure. Additionally, when multiple investors are involved, maintaining the necessary 80% control of the ETF immediately after the transaction can present obstacles that must be addressed.

Benefits of Converting to an ETF

ETFs provide advantages such as improved liquidity, enabling easier trading on public exchanges, and broader diversification across asset classes compared to many individually managed accounts. ETFs typically provide exposure to a broad range of assets, helping reduce risk by spreading investments across various sectors or asset classes. This approach can moderate the effects of underperformance in any single investment compared to more concentrated portfolios.

Cost efficiency is another consideration with ETFs, as these funds often have lower management fees compared to SMAs. Lower expenses can make them appealing to investors focused on reducing costs.

A key feature of most ETFs is the daily disclosure of portfolio holdings. This level of transparency supports informed oversight and can aid investors in monitoring their exposure and making portfolio decisions.

ETFs can be purchased through most brokerage accounts, offering investors a straightforward way to acquire fund shares alongside other investments. This streamlined purchasing process stands in contrast to SMAs, which may involve higher entry requirements and additional administrative steps.

ETFs support a variety of investment approaches, offering access to different sectors, themes, and global markets within a single fund structure. This flexibility allows portfolios to reflect a range of strategies or respond efficiently to changing market conditions.

How Ultimus Can Help

Converting an SMA to an ETF through a 351 exchange can improve liquidity, enhance diversification, and offer better tax efficiency. This approach provides a practical solution for adapting portfolio structures to evolving investment needs, but it requires careful planning and attention to regulatory details. Ultimus supports these complex, tax-sensitive asset transitions by addressing all operational, regulatory, and valuation considerations. Our collaborative approach, enhanced technology, and specialized guidance help manage each aspect of the conversion with precision and in alignment with client objectives. Connect with us to learn more: www.ultimusfundsolutions.com.

COD00001032 6/10/2026