EP 247: How to Evaluate an ETF for a 351 Exchange: The Checklist to Get It Right

by Peter Lazaroff | Mar 11, 2026 | Podcast

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This is the third and final episode in my three-part series on ETFs. And I want to start by telling you why I did this series in the first place.

Plancorp is participating in a 351 exchange in the second quarter with a very large, well-known fund sponsor. In fact, I’m told we are the only RIA with access to this opportunity, so despite having participated in 351 exchanges before, we are pretty excited about this one.

If you aren’t familiar with a 351 exchange, don’t worry, I will tell you all about it, but the reason I started this ETF series was because our clients would frequently ask: How do you decide to do a 351 exchange with one fund versus another?

So that’s the goal of this episode. By the end, you’ll understand what a 351 exchange is, and how we think about evaluating a 351 exchange opportunity when the ETF is brand new.

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What Is A 351 Exchange (In Plain English)?

A 351 exchange refers to Section 351 of the Internal Revenue Code, which enables individuals to contribute property such as stocks or ETFs in a newly formed corporation, without recognizing capital gains or losses if they meet specific tests (discussed more in Episode 225).

Section 351 was established as part of the Internal Revenue Code of 1954, so this isn’t exactly a new thing, but technology advancements have accelerated the ability for fund sponsors to use them more broadly.

From an investor’s perspective, many investors hold positions in their portfolio that they would probably sell if it weren’t for the capital gains they would incur.

For some people, maybe it’s a concentrated stock position that represents an outsized portion of their portfolio and they would like to be better diversified. Other investors may not have a concentrated position, but are simply owners of individual stocks that have woken up to the data on why individual stocks are not ideal for long-term investment portfolios and are much riskier than they appear on the surface.

For owners of individual stocks that can meet the Internal Revenue Code guidelines, a 351 exchange lets you contribute those securities to seed the launch of a new ETF without triggering capital gains. So if you contribute $1 million of individual stocks, you get back $1 million of the new ETF and your cost basis carries into the ETF shares you receive.

But not only do individual stocks qualify for a 351 exchange, ETFs do as well. A typical use case is an investor who owns a mix of legacy ETFs that no longer align with their long-term investment plan, but the capital gains prevent them from making a change. Here the 351 exchange allows them to exchange their existing ETF shares–or some combination of individual stocks and ETFs–for shares of the new ETF while the cost basis remains in place.

In other words, the goal of a 351 exchange from the investor’s perspective is to solve a diversification and allocation problem without forcing a taxable sale today.

From the fund sponsor’s perspective, their goal is to collect assets. As we explained in the first episode of this series, Episode 245: How ETFs Come to Market, launching a new ETF requires the fund sponsor to gather capital commitments from institutions, advisors, or individual investors ahead of launch. They don’t really care whether the initial seed capital comes in the form of cash or securities — as long as it brings money in the door and gets the fund off the ground.

What Happens When An ETF Fails To Gather Assets

When an ETF doesn’t gather enough assets to offset its fixed costs, sponsors have two choices.

The first is to liquidate the entire portfolio and close the fund. This means ETF shareholders receive cash for their shares, but they also must recognize their capital gains (or losses). This is a doomsday scenario for most investors and something that fund sponsors tries to avoid by utilizing the second path.

The second path is merging the ETF into another fund. The benefit to the investor is that capital gains aren’t triggered, but the new exposure is often different from what you wanted to own in the first place. While many mergers are designed to be tax-efficient, the tax result ultimately depends on how it’s structured and what happens inside the funds during the transition.

So it’s important to think carefully when considering a newer ETF. Research (see here and here) shows that most ETFs that fail do so in the first three years.

As a result, it’s common for allocators to wait to even begin the due diligence process until there is three years of live history for a fund. Another common hurdle investment teams will consider is an AUM threshold, which can be as low as $100 million or as high as $1 billion depending on the strategy and fund sponsor.

But when you’re contributing securities to a new fund via a 351 exchange, you don’t have the benefit of waiting three years or for assets to accumulate, so that’s the process I want to share with you now.

How To Evaluate A 351 Exchange ETF

Most of the 351 opportunities we’ve evaluated in the past led to us passing, primarily due to concerns about the new ETF we’d be seeding with client assets.

When we evaluate a 351 exchange ETF with no track record, we’re underwriting three things: fit, support, and trading.

Fit is the easiest one to determine. Basically, would we want to own this ETF long-term even if there were no 351 exchange involved? If you don’t like the ETF as a long-term holding, the tax benefit doesn’t fix that.

In the current 351 exchange opportunity we are offering our clients, the fund we’re working with is providing a U.S. exposure that will look a lot like something we already allocate to today. So it is easy to see how the strategy matches our clients’ plans. The cost is in line with what we are targeting, too.

The same is true of past 351 exchanges we’ve participated in: the fund we are having clients utilize is aligned with something we would want to buy anyways and is offered at a reasonable cost.

Most of the opportunities we evaluate simply result in gaining an exposure to a fund that doesn’t fit with how we would want to invest our clients’ assets.

But for those opportunities that pass the “fit test,” the due diligence becomes about how confident we feel the fund sponsor can comply with the rules of a 351 exchange, how likely we feel the fund can survive, and how well the fund will trade.

Due Diligence Questions For A New ETF

So here are the questions I ask fund sponsors when we evaluate a 351 exchange opportunity:

1. Sponsor commitment

How long is the sponsor willing to support the ETF if assets are slow to arrive?
Do they have an internal runway or minimum viability period?
What are their closure or merger triggers?

2. Distribution plan

Who is the natural buyer after the seed?
What’s the credible path to adoption—models, platforms, home offices?
Who is responsible for executing that plan?

3. Capital markets support

Who are the lead market makers and capital markets contacts?
How many liquidity providers are lined up?
What should we realistically expect for spreads early on—and what conditions would widen them?

4. Portfolio fit at launch

Will the ETF be able to hold what we’re contributing without immediate forced selling?
Are there concentration limits or liquidity constraints?
Are clean-up trades required right away, and why?

5. Turnover and trading costs

What’s the expected turnover in the first 30–90 days, and why?
If there will be meaningful repositioning, how is that communicated?

6. Tax mechanics

Do we have a clear tax opinion or comfort that the exchange is intended to qualify?
What assumptions have to be true for that to hold?
What are the key pitfalls that could cause the intended result not to apply?

7. Risk allocation and operations

What representations are we making, and who bears the risk if something doesn’t go as planned?
Who is responsible for custody, administration, valuation, timelines, and cutoffs?
What’s the plan for reconciliation and basis reporting?

8. Contingency planning

If the ETF doesn’t scale, what happens to investors?
Is the expectation liquidation or merger?
What’s the timing and notice?

Bringing It Back To The Investor’s Perspective

When we look at 351 exchange opportunities at Plancorp, we start with the client’s plan.

And the holdings that show up are usually the same kinds of things, too. Sometimes it’s a handful of individual stocks that have grown into a concentrated risk. Sometimes it’s ETFs that were bought once upon a time for one reason or another, but today the only reason they’re still there is they carry meaningful gains. Sometimes it’s an SMA that did its job for years—harvested losses early on—but now it’s no longer generating losses, and it isn’t what we’d choose today.

A 351 exchange can be a tool for getting from “what you happen to own” to “what you want to own,” without forcing a big taxable event.

Now, not everyone qualifies. Not every holding can be contributed. And the reason we say no is just as important as the reason we say yes: if there isn’t a clear diversification benefit or a real rebalancing benefit, it’s not worth doing.

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