Diversification and Concentration Limits in 351 Conversions

Diversification and Concentration Limits in 351 Conversions

Diversification and Concentration Limits in 351 Conversions

06/23/2025

A Section 351 conversion offers a tax-efficient strategy for transferring a portfolio of diversified stocks into an exchange-traded fund (ETF) without triggering immediate capital gains taxes. Under this provision, gains are deferred until shares of the ETF are eventually sold.

However, to qualify for this treatment, the IRS imposes specific diversification requirements. These rules are designed to ensure that the portfolio being contributed is not overly concentrated in any single stock or small group of stocks. Meeting these requirements is essential to maintain the tax-deferred status of the conversion and to align with the IRS’s intent of promoting broad-based investment structures.

There are two primary rules:

1. No Single Stock Over 25%

  • No individual stock or security can be more than 25% of the total value of the assets being contributed to the ETF.
    • Example: If the total value of the positions being contributed is valued at $1,000,000, you cannot contribute more than $250,000 of any one stock.

2. Top Five Holdings Must Be Under 50% Combined

  • The five largest positions together cannot make up more than 50% of your portfolio’s value.
    • Example: If the total value of the positions being contributed is $1,000,000, the combined value of your five largest positions must not exceed $500,000.

Diversification Rule Summary

RuleWhat It Means for You
Single position ≀ 25%No one stock can be more than 1/4 of total
Top 5 positions ≀ 50% combinedYour five largest must total half or less

Frequently Asked Questions

1. What if you have concentrated positions?

  • If you have a single large position (like company stock) that’s above these limits, you may only be able to include part of it in the ETF conversion.
  • The rest could remain outside the ETF, or you may choose to sell down the position separately (which could have tax consequences).

2. How are ETFs counted?

  • Shares of ETFs are “looked through” to their underlying holdings.
    • This means a holding in an S&P 500 ETF, for example, is already diversified and usually allowed.

3. Can mutual funds be contributed?

  • Unfortunately, mutual funds cannot be contributed, however some Vanguard equity mutual funds may be converted to an ETF at their custodian.  Please reach out to your advisor if you’d like to learn more.

4. Why do these limits exist?

  • The IRS rules are designed to ensure the tax-free conversion is only available for portfolios that are already reasonably diversified.
  • This prevents using the ETF just to diversify a highly concentrated position tax-free.

At NPF, We’ll Do the Math for You

If you decide to participate in an upcoming 351 conversion, NPF will review your holdings and let you know exactly which assets qualify and what—if any—adjustments need to be made before conversion. If you have a concentrated position, your advisor will help you explore options.

Questions?

If you’d like to talk to an advisor about participating in a Section 351 Conversion or have any other questions about ETFs, please contact us at etf@npfinvest.com. We’re here to help you understand and make the most of this opportunity!

General Risk Disclosure: Investing involves risk, including the loss of principal.

The information in this document is not complete and may be changed. The securities may not be sold until the registration statement filed with the Securities Exchange Commission is effective. This document is not an offer to sell these securities and is not soliciting an offer to buy these securities in any state where the offer is not permitted.

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