Asset managers may utilize Separately Managed Accounts (SMAs) to offer personalized portfolios for each of their clients’ accounts. While this approach allows them to customize portfolios to achieve the investor’s objectives, these accounts can become tax inefficient as unrealized gains grow in the accounts. Actively managed Exchange-Traded Funds (ETFs), however, can provide a more tax-efficient wrapper as they generally do not generate much in terms of capital gains, if at all. Managing an SMA strategy in an ETF wrapper as one portfolio can create better operational and administrative efficiencies, provide access to complex investment types such as derivatives, and can provide additional distribution capabilities. Converting like-strategy SMAs into an ETF could allow clients to defer gains while allowing the manager the future ability to take advantage of the tax efficiency that is inherent in ETFs.
When contemplating the conversion of SMAs to ETFs, Section 351 of the Internal Revenue Code plays a pivotal role in guiding the tax implications and procedural aspects of the transition. According to Section 351(a), no gain or loss is recognized when property is transferred to a corporation in exchange for stock, provided that the transferors, or “control group,” maintains control of the corporation immediately after the exchange. This principle ensures that the conversion process remains tax-neutral for the participants, as long as the control test—where the control group must own at least 80% of the corporation’s voting stock after the transfer —is satisfied.
In the context of transferring assets to an ETF, Section 351(e) further refines the tax treatment. This section stipulates that the transferor will not recognize any gain or loss on the transferred property. Instead, the transferor’s basis in the ETF shares received will be equal to their basis in the assets transferred, and the holding period of these shares will include the holding period of the transferred assets. Similarly, the ETF’s basis and holding period in the received assets will mirror that of the transferors. These provisions streamline the transition, maintaining continuity in tax attributes.
However, advisers must navigate additional considerations before the movement of any securities from the SMA to the newly formed ETF, including IRS and RIC diversification and procedural requirements. The IRS diversification test ensures that prior to transfer no more than 25% of any SMA’s portfolio value is invested in a single issuer and not more than 50% of the value of its total assets invested in securities of 5 or fewer issuers. SMAs participating in the conversion must individually meet the IRS diversification test on conversion date as this is crucial to avoiding potential tax issues. The ETF will also be required to pass RIC diversification testing on the combined portfolio’s total assets.
The conversion process itself demands meticulous planning: obtaining client approval, verifying the accuracy of investor information like cost basis, coordinating with custodians, and possibly securing a tax opinion. Each step involves significant coordination between the advisor, legal counsel, custodians and the administrator to ensure a smooth transition while adhering to regulatory requirements.
Registered investments advisers that manage SMAs may consider a conversion of SMAs to ETFs on a tax-deferred basis under Section 351 to provide a more tax-efficient strategic portfolio option for their existing clients while providing expanded distribution opportunities to facilitate growth. These tax benefits to current investors and better positioning the strategy for distribution growth are often worth the time and effort to go through a 351 conversion.
As a leading fund administrator of ETF assets, Ultimus has extensive experience in SMA to ETF conversions and would encourage you to leverage our deep ETF industry knowledge when considering your options in starting an ETF. We can handle the heavy lifting during the 351 process. To learn more about our comprehensive ETF solutions contact us today.
COD00000583 11/8/2024
