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00:00This is basically about how wealthy families can create or convert their own personal stock holdings into ETFs in order
00:06to defer taxes.
00:08And I pause there because it's deferral, not dodging, right?
00:13It's deferral, at least in the first step.
00:16Whether they actually end up having to pay in the end of the day is another question.
00:19But basically, so many people just have these huge gains from the stock market in the last few years.
00:25And so it becomes a question, is there some way we could say, get out of an NVIDIA position that
00:31went really well and diversify into some other things?
00:34And this is the kind of opportunity that people are taking nowadays to do that, to be able to switch
00:40into exposure to other stocks without having to pay the tax that would normally entail if you were to just
00:48sell it.
00:48Without triggering a tax bill, essentially capital gains, BN crunched the numbers and you guys looked at the growth of
00:57this class of ETFs.
00:59How quickly are these growing?
01:00How much in capital gains, therefore, have been deferred by your estimation?
01:03Right.
01:04So most of the creation has just been in the last two years or so.
01:08And we counted up over $20 billion of sort of funds created and at least over $6 billion of gains
01:17that were deferred.
01:18So those are gains that rather than having to pay, those investors will be able to kind of keep holding
01:24those winnings, keep reinvesting them in the market and maybe pay them later on or never at all.
01:28Okay.
01:29So let's go over this.
01:30I think the word dodge also, I got hung up on this because, okay, so you bring your NVIDIA into
01:35this customized ETF.
01:36It gets diversified.
01:37A lot of people also just don't want to sit on one stock.
01:40It took over their whole portfolio.
01:41So they want to like vanguardize their portfolio.
01:43They move into this diversified ETF.
01:46And then let's say, you know, seven, eight years goes by.
01:49You sell.
01:50You still have the basis of which you bought NVIDIA.
01:52So you're still on the hook for the complete tax bill.
01:55The question is, should the government have had that money right when you wanted to get out of NVIDIA so
02:01it could like, I don't know, do something with it, pay somebody's Social Security.
02:05It's running out.
02:06TSA, among other things.
02:07I get it.
02:08But at the end, you still are on the hook.
02:10Or do you find they're able to wash that out somehow, which would be more of a dodge than a
02:16deferral?
02:16Well, so that would be a separate move.
02:18But there are, if you talk to estate planners, there are lots of ways to do that.
02:22Because ultimately, when you die, your heirs receive your assets with a step up in basis.
02:28And so, for instance, if you were to, once you converted this through 351, convert to, say, the S&P
02:35and just held it and left it to your heirs, then they would get the benefit of that without either
02:41you or them having to pay tax on the gain.
02:43So that's one way it can happen.
02:46But you're right.
02:46Sometimes people might, after a few years, they might end up having to pay.
02:50Okay, let's go after this ultra-rich thing, too.
02:53Because I get it.
02:54Like, the top 1% own half the stock market.
02:57So clearly, they are the ones who would be involved with most things stock-related.
03:01But there's still, like, 20, 25 million people who own ETFs.
03:04Some are middle class.
03:05And the argument that I might have to counter this is, hey, well, if you are in the middle class,
03:12upper middle class, and not top 1%,
03:14isn't this a way to get in on something that the really rich have been doing for ages with private
03:20banks?
03:21Yeah, that's an argument that people like Wes Gray and Alpha Architects have made,
03:25is this is kind of democratizing something that maybe these bespoke strategies were only available to the truly 0.01%.
03:33Now, there's an element of truth to that.
03:36But there's also, if you look at some of these deals that are subscriptions where multiple people put their money
03:41together in a 351,
03:42the minimum you can invest is a million.
03:45That's not your total wealth.
03:47That's just what you're putting in.
03:48And then you see individual families who are billionaires who are putting in hundreds of millions of dollars personally.
03:54That's the kind of transaction that's not available to most of us.
04:00All right.
04:00I want to bring in Brent Sullivan.
04:01He is editor of Tax Alpha Insider.
04:03And he was featured in Zach's Big Take, saying,
04:05high net worth folks and their advisors see this as a slam dunk.
04:10Brent joins us now with more.
04:11Brent, I want to first start with the 351 part of the tax code.
04:15It's a specific part of the tax code.
04:17Just walk us through what does that Section 351 allow?
04:20What does it not allow to help us understand what's legal, what's not legal, or what might be questionably legal?
04:27Well, so the thing to understand is that Section 351 is a 100-year-old provision in the tax code,
04:33roughly.
04:33And what it allows is for folks to contribute appreciated securities into seeding a new corporation,
04:40in this case, an ETF.
04:42Now, Congress was pretty clear about what they're trying to achieve with this.
04:46They want to help bootstrap new businesses.
04:48They do not want to allow tax-free diversification.
04:52And so that's where we start to get into the difference between routine applications of Section 351 versus aggressive tax
05:00planning.
05:00And that's the change that Treasury was talking about at a big meeting last week in New York.
05:04How will this play out?
05:06In reality, if Treasury wants to do something, are they going to give guidance?
05:10And then will the ones already approved be okay, but new ones can't crop up?
05:15Like, how do you see this playing out?
05:17Well, there's three different layers to this.
05:18So we have to start with statute.
05:20So that's what the United States Congress and Senate and the president are all involved with.
05:24And as far as I can tell, there's really no momentum at that layer to make a change in the
05:29law.
05:29So now we have to move down a layer.
05:31We have to go into regulation.
05:32And so those are the rules that Treasury writes and that IRS enforces.
05:36So rules and the applications of the rules.
05:39And so it's possible that Treasury could look at how the market is actually using Section 351 and say,
05:46no, that's contrary to Congress's intent, which, again, namely was preventing tax-free diversification
05:51and really eliminating gains or avoiding gains indefinitely for portfolio rebalancing.
05:57And so they're going to look at these three different layers.
05:59And those are the different aspects that I can see that might be impacted or that might impact the ETF
06:04markets going forward.
06:06So the thing with these 351 conversions, these new ETFs, is that they're seeded with securities rather than cash.
06:12And that in and of itself is not against the law.
06:14And if you have a diversified portfolio, that seems to be okay.
06:17But if you have a bunch of stock because your friend founded NVIDIA and you got it and now you
06:23want to put that into an ETF,
06:25does that become a problem?
06:27Yeah, definitely. That's a problem.
06:29But the code is written such that certain diversification tests have to be met.
06:33And the details here are that essentially you can't have more than 25 percent of a single name going in
06:38to seed the new ETF.
06:40So that would already disallow non-recognition.
06:42In other words, you'd have to pay tax on that contribution anyway.
06:45But where this gets sort of in shenanigans territory is where we have folks doing things pre-contribution.
06:52So they'll borrow against maybe a concentrated position.
06:55They'll add some diversifying securities.
06:57And then they'll contribute that entire portfolio to meet the diversification tests on the way in.
07:03Now, that is not good.
07:05That is not what they were trying to achieve.
07:07And Brent, let me ask, given the Treasury's obvious interest in this right now, what are you seeing in the
07:13market?
07:13Are people still launching these 351s given the fact that there's some concern that the Treasury is going to take
07:19some action?
07:20Yeah, absolutely.
07:21I don't think that that train has slowed down.
07:23What I'm seeing, though, is that maybe a little more diligence around what is a routine transaction versus what is
07:29potentially aggressive tax planning.
07:31And I think we're really going to find out who's swimming naked here when IRS, like, does its investigations.
07:36We're going to find out who is using this to minimize transaction costs, to save investors, expense ratio, things like
07:44that, versus who is trying to achieve tax-free diversification.
07:48Brent, let me ask you this.
07:49Let's say somebody's listening to this and they're like, OK, it's actually pretty smart to try to, you know, limit
07:55your taxes.
07:56And it's all legal, but it's stretching the letter of the law.
07:59But I also like the government to have some tax money so it can pay for things.
08:04The people doing this, let's say you're a real rich person, you do one of these custom 351s, is their
08:10goal to sort of pass away, like when they pass away, to lose all of the tax basis?
08:17Because that's the law, right?
08:19Or do you think they'll ever realize the gain eventually?
08:22Like, what percentage of these people will realize the gain eventually versus just you sort of die with it not
08:29realized?
08:30Well, it's hard to say, but I think something like a Treasury report came out and said something like 25
08:35% of the overall capital gains paid in a given year, something like 25% of that is mitigated or
08:43eliminated through step-up and basis.
08:44So it is a big chunk of the overall revenue in terms of capital gains that folks receive.
08:49But I think the planning opportunity here is really about timing.
08:53And so if somebody wants to defer the gains bill and then perhaps has losses from routine tax loss harvesting,
08:59then they can net that with the eventual gain that they might realize from this ETF.
09:03So it is not fully about estate planning and step-up and basis.
09:07It's also about interim timing that can be achieved, and that's just routine tax planning.
09:12So the ETF that, Zach, you profiled or you included in your story has the ticker MIGO, and it was
09:20seeded with about $540 million of securities.
09:23Eric, do other people trade these ETFs?
09:26I mean, MIGO is available on the Bloomberg Terminal.
09:28You can look it up.
09:29You can see how much assets it has now.
09:30But is this something that other people could trade if they wanted to?
09:34What did the flows look like?
09:35The flows obviously are custom because I really look at the volume.
09:40The volume is nonexistent.
09:41Okay.
09:42So it's just for that person and that family.
09:44Yeah.
09:44This isn't going to, like, sweep the nation as the big ticker everybody buys.
09:48AAUS, which is another one they use, that has a little more, but that's something that he uses constantly.
09:52So I think for ones that are custom, like MIGO, these are just for that purpose.
09:58Bespoke ETFs are not new here.
09:59They've been going on for a lot of years with ETFs.
10:01Typically, a bespoke ETF doesn't really ever make it.
10:04Like, it's usually just for this one person, like an anchor tenant.
10:06If it makes it, that's just bonus.
10:08So, Zach, I would just ask you, like, in your opinion, right, if you're looking at the industry and they're
10:16trying to be fiduciaries,
10:18and tax management is part of being a fiduciary, whether it's a separate account, direct indexing, or an ETF, doesn't
10:24it make sense to do all this?
10:25Oh, absolutely.
10:26I mean, you know, nobody's going to go around trying to pay more tax than they want to.
10:31I think, you know, some of the light we've tried to shine on some of these things is that, you
10:36know, these are coming pretty far afield from where, you know, Congress back in 1967, or 69, you know, two
10:45decades before the first ETF ever came into existence, really just wasn't anticipating.
10:50And at this point now, it has created this whole huge industry.
10:54So, it's worth policymakers thinking about what, you know, the unattended consequences of their actions.
10:59And ultimately, it'll be government that's going to have to decide if this is what, you know, they want to
11:04see.
11:04Brent, has the SEC ever objected to a filing of a 351 conversion?
11:11To my knowledge, that would be an interesting case, even though I do see them routinely get pulled down post
11:18-registration.
11:18And so, an ETF sponsor will propose an ETF, and then they'll say, oh, this actually is not viable, even
11:24though we've allowed or we've offered 351.
11:27They just don't see any market traction from it.
11:31Brent, this might be a little out of your purview, but one other thing is, like, I think ETFs probably
11:35pay a lot of taxes generally because, look, you saw, I don't know if you saw the beginning of the
11:40show, they're going to end up trading like $70 or $80 trillion worth of shares.
11:44That's a lot of capital gains probably triggered because all ETFs live outside of tax-exempt accounts.
11:51So, like, isn't there some maybe, like, karmic equality here because they already pay a ton of taxes because people
11:57trade them so much?
11:59Yeah, definitely.
12:00And it depends on the structure of the ETF itself also.
12:03If the ETF is holding fixed income securities, then, you know, I have not seen a 351 that is accepting,
12:08you know, anything that could be redeemed in kind outside of just broad equities at this point.
12:13So, yeah, it's possible.
12:15It depends.
12:16But it certainly matters.
12:18The asset class matters.
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