Exchange Funds vs. 351 ETFs: How Founder Families Diversify Without a Tax Bill

The founder's dilemma, restated for 2026

A founder family that still holds a large block of the company it built faces a particular kind of risk. Most of the household balance sheet rides on one issuer, one sector and one management team. The usual fix is diversification. But the shares often have a cost basis close to zero, so diversifying by selling means giving a large share of the position to the government on day one.

For decades that tension has supported a small, specialised industry. Private-bank exchange funds, charitable remainder trusts, systematic selling programmes and, more recently, direct-indexing overlays all promise some version of the same thing: less concentration, with the tax bill pushed into the future, spread out or partly offset.

Since late 2024 a newer structure has joined the list: the Section 351 ETF exchange, where investors seed a newly launched exchange-traded fund with appreciated securities in kind. Advisers have adopted it quickly. Then, on 28 September 2026, the Treasury Department and the IRS published Revenue Ruling 2026-20 and Notice 2026-62. Together they narrow the most aggressive version of the 351 ETF trade and put a partnership exchange-fund variant on notice. Comments are due on 28 October 2026.

This analysis covers how each route works mechanically, where the statutory limits sit, what the September guidance changed, and what all of this means for the RIAs, multi-family offices and alternatives managers that serve founder families. It describes mechanics and considerations. It is not tax, legal or investment advice, and every structure discussed here depends on facts that a qualified adviser has to review.

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Part I: The baseline. What an outright sale actually costs

Every deferral strategy has to be measured against simply selling, so the baseline comes first.

Federal capital gains rates. Under Section 1(h) of the Internal Revenue Code, long-term capital gain is taxed at 0, 15 or 20 percent, with the 20 percent rate applying at the top of the income scale. Section 1411 adds the 3.8 percent net investment income tax once modified adjusted gross income passes a threshold. The statute fixes that threshold at $250,000 for joint filers and $200,000 for most other individuals, and it contains no inflation-indexing provision. A founder selling a large block in a single year will usually sit at the top federal rate on most of the gain, plus whatever state tax applies.

The step-up alternative. Section 1014 gives property acquired from a decedent a basis equal to its fair market value at the date of death. This is why "deferral" means more to an older founder than to a younger one. A gain that is deferred until death may never be taxed as income at all. Every strategy below that defers gain rather than triggering it also keeps the step-up available.

The QSBS check comes first. Founder stock in a C corporation may qualify under Section 1202, which excludes some or all of the gain on qualified small business stock. The One Big Beautiful Bill Act (Pub. L. 119-21, approved 4 July 2025) changed the rules for stock acquired after that date. The exclusion is now 50 percent after three years, 75 percent after four years and 100 percent after five. The per-issuer cap rose from $10 million to $15 million for newly acquired stock, and is indexed for taxable years beginning after 2026. The aggregate gross-assets test rose from $50 million to $75 million. Stock acquired earlier keeps the older regime. For many founders the first question is how much of the position is QSBS and when each lot becomes eligible, not which exchange fund to use. Exchange funds and 351 ETFs carry over basis and holding periods, but whether contributed shares keep their Section 1202 character is a separate question for counsel.

Insiders cannot simply sell whenever they like. A founder who is still a director or officer usually sells through a Rule 10b5-1 trading plan. Under the SEC's 2022 amendments (Release 33-11138), directors and officers must wait through a cooling-off period of the later of 90 days after the plan is adopted or modified, or two business days after the issuer discloses that quarter's results, capped at 120 days. Other persons face a 30-day cooling-off period. These timing rules apply whether the founder sells outright or sells to fund a hedge or a gift programme, and they shape which strategies are practical.

So the starting point is clear. An outright sale buys immediate, complete diversification and liquidity at the full current tax cost. Every alternative trades some of that liquidity, control or simplicity for deferral.

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Part II: Exchange funds and Section 721

How the structure works

An exchange fund is a private limited partnership. Investors who each hold a different appreciated stock contribute those shares in exchange for partnership interests. In return for giving up the single-stock position, each partner gets a pro rata share of a pooled portfolio. If the structure is built correctly, nobody recognises gain at contribution.

The statutory engine is Section 721(a). It provides that no gain or loss is recognised by a partnership or any of its partners when property is contributed in exchange for a partnership interest.

The limit is Section 721(b). Nonrecognition does not apply to gain on a transfer to a partnership that would be treated as an investment company under Section 351(e) if the partnership were incorporated. The investment-company definition therefore comes from the corporate rules. Under Treasury Regulation 1.351-1(c)(1), a transfer is to an investment company if it results in diversification of the transferors' interests and the transferee is a RIC, a REIT, or a corporation with more than 80 percent of its assets held for investment in readily marketable stocks or securities (or RIC or REIT interests). Section 351(e)(1)(B), as expanded in 1997, now treats a wide list of assets as "stock and securities", including money, foreign currency, derivatives, interests in REITs, RICs and publicly traded partnerships, and certain precious-metal interests. As Notice 2026-62 points out, the regulations under Section 351 have not been updated to reflect the 1997 changes.

Why every exchange fund holds real estate. The way out is to make sure the partnership is not an investment company. In practice, sponsors hold at least 20 percent of the fund's assets in property that is not "stock and securities" under the statute. Notice 2026-62 uses the same description: in the "partnership variation" it discusses, investors contribute to a partnership that invests at least 20 percent of the value of its assets in property that is not stock or securities, so that it would not be treated as an investment company if incorporated, and a footnote adds that such a partnership may be referred to as an "exchange fund". A Kitces analysis from April 2026 notes that the qualifying sleeve is typically real estate, held directly or through private pooled vehicles, but not exchange-traded REITs, which count as securities. The same analysis reports that most funds borrow at least 25 percent of the value of contributed securities to buy that real estate, so contributed stock does not have to be sold. That leaves total assets at about 125 percent of net asset value.

For an alternatives manager this detail matters a great deal. The qualifying-asset sleeve is a recurring, structural buyer of private real estate (and potentially other non-security assets), and it uses leverage to do so.

The history: a 1960s product, a 1976 fix

Exchange funds are not a recent idea. A Joint Committee on Internal Revenue Taxation staff pamphlet prepared for the House Ways and Means Committee on 6 April 1976, "Tax Treatment of Partnership Exchange Funds and Mergers of Investment Companies", describes how, in the early 1960s, investment managers publicly solicited holders of highly appreciated stock to pool their shares in newly formed corporations. Legislation in 1966 dealt with corporate swap funds. The pamphlet also records that in April 1975 the IRS issued a private ruling to one exchange fund organised as a limited partnership, and that the ruling prompted similar partnerships to form.

Congress responded in the Tax Reform Act of 1976 (Pub. L. 94-455, enacted 4 October 1976), which added Section 721(b). The amendment applies to transfers made after 17 February 1976. The modern exchange fund, with its pooled single stocks and its non-security sleeve, is the industry's answer to that rule.

The seven-year clock

The second constraint is time. Section 704(c)(1)(B) provides that if a partnership distributes contributed property to a partner other than the contributor within seven years of the contribution, the contributing partner recognises the built-in gain as if the property had been sold. Section 737 is the mirror image: a partner who contributed appreciated property and then receives a distribution of other property within seven years recognises gain up to the lesser of the excess distribution or the partner's net precontribution gain. The 1997 Taxpayer Relief Act (Pub. L. 105-34) lengthened the window from five to seven years for property contributed after 8 June 1997.

Taken together, the two rules explain the familiar exchange-fund life cycle:

• Years 0 to 7. The partner is effectively locked in. Funds that permit an early exit usually return the partner's own contributed shares, which Section 737(d)(1) exempts from the gain rule. That brings the concentration back. Kitces describes one modern sponsor that caps such early distributions at the lesser of the contributed shares' current value or the partner's pro rata share of net assets.
• After year 7. The partner can take a distribution of a diversified basket of securities from the pool. The basis in that basket is derived from the original low basis, so the gain is deferred, not eliminated.

A third rule completes the picture. Under Section 731(c), marketable securities distributed by a partnership are generally treated as money, which could make the in-kind exit taxable. Treasury Regulation 1.731-2(e) excludes distributions of marketable securities by an "investment partnership" to eligible partners, an exception that is central to how in-kind exits from investment partnerships are analysed.

Eligibility and minimums

Exchange funds are private placements. Historically they were bespoke products that investment banks and wirehouses built for ultra-high-net-worth clients. Many are limited to "qualified purchasers". Section 2(a)(51) of the Investment Company Act treats a natural person as a qualified purchaser if he or she owns at least $5 million in investments; a person acting for its own account or for other qualified purchasers qualifies if it owns and invests at least $25 million in investments on a discretionary basis. Sponsors do not consistently publish minimums. In one documented example of the newer, technology-led entrants, Kitces reported in April 2026 that Cache had a $100,000 minimum and launched new funds twice a month, while limiting one of its strategies (which Kitces identifies as Index Sync) to qualified purchasers.

What a family office is actually buying

Illustrative example. A hypothetical founder family holds public shares worth $40 million, nearly all of it gain. It contributes $10 million of those shares to an exchange fund and keeps the rest. After contribution, the family's look-through exposure to the founder company drops by roughly the amount contributed, less whatever proportion of the pool the founder stock itself makes up. In return the family accepts a seven-year lock, a leveraged real estate sleeve it did not choose, sponsor fees, and the risk that the pool's basket behaves differently from the index it is meant to resemble. At year seven it receives a diversified basket with a carried-over low basis. If the patriarch dies holding the interest, Section 1014 may step up the basis.

The structure works for a family that does not need the money for seven years, values the deferral, and accepts private-fund economics. It works less well for a family that may need liquidity, wants to direct where the capital goes, or objects to the leverage in the qualifying sleeve.

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Part III: Section 351 ETF exchanges

The mechanics

A Section 351 ETF exchange uses the corporate counterpart of Section 721. An ETF that is a RIC is a corporation for federal income tax purposes. Section 351(a) provides that no gain or loss is recognised when property is transferred to a corporation solely in exchange for its stock, if the transferors control the corporation immediately afterwards. "Control" comes from Section 368(c): at least 80 percent of the total combined voting power and at least 80 percent of the total number of shares of every other class. In a launch, the contributing investors as a group must therefore own at least 80 percent of the new ETF immediately after the exchange. That is why the technique is available only at a fund's inception (or in a fund the contributors effectively control).

The investment-company barrier is cleared differently. A new ETF is a RIC, so it is an investment company under Regulation 1.351-1(c)(1). The exchange still works because the regulation applies only where the transfer results in diversification of the transferors' interests. Regulation 1.351-1(c)(6)(i) provides that a transfer is not treated as diversifying if each transferor contributes a portfolio that is already diversified, meaning it meets the 25 and 50 percent tests of Section 368(a)(2)(F)(ii).

The 25/50 test. Under Section 368(a)(2)(F)(ii), a portfolio passes if no more than 25 percent of the value of its total assets is invested in the stock and securities of any one issuer, and no more than 50 percent is invested in the stock and securities of five or fewer issuers. Members of a controlled group count as one issuer. The statute also provides that a holder of RIC or REIT shares is treated as holding a proportionate share of the fund's assets, so ETFs and mutual funds in a contributed portfolio are looked through rather than treated as single positions. BNY's guidance notes that a portfolio made up entirely of single stocks needs at least 11 holdings to pass.

The result for the contributor. If the tests are met, the investor receives ETF shares with a carryover basis and holding period, and the gain is deferred until the shares are sold. The ETF can then manage its own portfolio. The in-kind redemption mechanism in Section 852(b)(6), under which a RIC does not recognise gain on property distributed to redeem its shares on a shareholder's demand, lets the ETF move low-basis lots out of the fund over time without distributing capital gains to the remaining holders.

Why it does not solve single-stock concentration

This is the point founder families most often miss. A 351 exchange cannot accept a single concentrated position on its own. If the founder stock is 60 percent of the contributed portfolio, the 25 percent test fails. A founder who also holds a large diversified book can contribute a portion that includes some founder stock, as long as the contributed portfolio as a whole passes. The founder stock cannot be more than 25 percent of that portfolio, and the five largest positions together cannot be more than 50 percent. In practice, a 351 exchange tidies up the diversified part of a wealthy family's balance sheet: legacy separately managed accounts, overlapping manager sleeves, decades of accumulated lots. It does not do much for the founder block itself.

The first launches

Section 351 itself dates to the 1954 Code. Using it to seed retail ETFs with individual investors' securities is much newer. A Kitces analysis published on 12 March 2025 lists three funds launched by then in this "publicly seeded" format: Stance's Sustainable Beta ETF (November 2024), Cambria's Tax Aware ETF (18 December 2024) and Longview's Advantage ETF (25 February 2025). It also notes that Cambria planned a second fund, the Cambria Endowment Style ETF. Cambria and ETF Architect announced the Tax Aware ETF (ticker TAX) launch in December 2024 with $27 million of seed assets contributed in kind. Kitces described the early sponsors as comparatively smaller ETF sponsors running active strategies, with funds that had little or no track record, and Cambria's launch was announced jointly with the ETF Architect platform. Kitces noted that the Stance and Cambria funds each charged 0.49 percent, compared with an average of about 0.15 percent for index equity ETFs.

The format then grew quickly:

• BNY reported that as of May 2026, 77 US ETFs had launched with approximately $16.6 billion in seed assets from individual investors, and that its own execution team had supported about $4 billion of Section 351 conversion activity over the previous two years.
• Alpha Architect, whose ETF Architect platform has hosted several of these launches, said that as of 15 April 2026 its tool had been used to complete more than 35 Section 351 exchanges, and that those ETFs had passed $1 billion in combined assets at launch.
• Larger managers have followed. The prospectus for the Oakmark U.S. Concentrated ETF (Harris Oakmark ETF Trust), as amended and restated on 25 June 2026, discloses that the fund may receive in-kind contributions at launch that are intended to qualify under Section 351, and lists a specific "Code Section 351 Tax Recharacterization Risk".

Sponsors set the access terms, not the IRS. One sponsor's primer (Stance Capital) says that some sponsors set per-account contribution minimums as low as $150,000 while others require $1 million or more, and that practitioners commonly treat about $50 million of eligible contributing assets as a practical minimum for a launch overall. Alpha Architect lists individuals, joint accounts, most trusts and S corporations as generally eligible. Partnerships and LLCs need review, and C corporations and non-US investors are excluded. Restricted and illiquid securities, derivatives and crypto are ineligible.

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Part IV: The September 2026 guidance

Rev. Rul. 2026-20: the "conversion" pattern

The fast growth brought a variant the IRS objected to. In what Notice 2026-62 calls a "Section 351 conversion transaction", investors contribute diversified but off-strategy portfolios to a new ETF. As part of the same plan, an authorized participant (AP) buys creation units with securities that fit the ETF's strategy (or with cash to buy them). Shortly afterwards the ETF redeems the AP's units in a transaction intended to qualify under Section 852(b)(6), paying with the securities the investors contributed. The ETF ends up holding a portfolio materially different from the one the investors transferred, and the investors expect to recognise none of the built-in gain while effectively swapping their securities for an interest in that different portfolio.

Rev. Rul. 2026-20 applies substance-over-form and step-transaction principles, citing among other authorities Court Holding, Minnesota Tea, Kuper and Rev. Rul. 71-336. It concludes that the ETF is "merely a conduit" in this arrangement. The investor is treated as having made a taxable exchange under Section 1001 with the AP of the contributed securities that the ETF uses to redeem the AP. The ruling says the result would be the same with multiple investors. It amplifies Rev. Rul. 71-336 and does not state a separate effective date.

Notice 2026-62: what is flagged, and what is not

The companion notice is broader. Its Section 2 describes several strategies that rely on "atypical usage" of Section 852(b)(6): the 351 conversion transaction, a partnership variation, box-spread funds, record-date strategies and RIC income-test avoidance. Its Section 3 covers "tax-aware" fund strategies that pair capital gains with ordinary losses.

Three points matter most for founder families and their advisers.

1. The exchange-fund-to-ETF combination is flagged directly. The notice describes a "partnership variation" offered to investors whose holdings are not diversified enough for a direct 351 exchange. The investors contribute concentrated stock to a partnership that keeps at least 20 percent of its assets in non-securities (an exchange fund, as a footnote explains), and the partnership then carries out a 351 conversion transaction. Treasury and the IRS say they "continue to consider other guidance" that would deny nonrecognition to those partnership contributions or recharacterise them. That is the route that would have let a founder with a single dominant position reach an ETF wrapper, and it is now the one most explicitly under review.

2. Conventional exchange funds and strategy-consistent seeding are expressly left unaddressed, for now. The notice states that it does not address other transactions involving exchange funds and is not intended to express a view on them, and it expresses no view on a 351 transaction that seeds a new ETF with assets consistent with its investment thesis that are intended and expected to be retained absent a substantial change in circumstances. Except as it discusses, it also does not address ETFs' regular in-kind creation and redemption transactions. On tax-loss harvesting, the notice acknowledges that "certain long-standing, well-established techniques" may be used to reduce federal income taxes in a manner consistent with the intent of Congress. Its example is an investor holding an index's underlying securities who sells loss positions at year-end and keeps the gains.

3. Retroactivity is on the table. The notice warns that any further guidance "could apply prospectively only or retroactively" to transactions that have already happened, and cites Section 7805(b). It also raises the possibility of identifying transactions as listed transactions or transactions of interest, but does not do so. Written comments are requested by 28 October 2026 under docket IRS-2026-1255 on regulations.gov.

The practical effect is to split the 351 market in two. A launch where contributors' holdings already resemble what the ETF intends to hold, and where the fund keeps them, sits in the space the notice leaves alone. A launch that depends on swapping contributed stock out through an AP soon after inception is now the fact pattern of a published revenue ruling. For founder families, the route that seemed to promise "concentrated stock in, diversified ETF out" was the partnership variation, and that is precisely what the notice targets.

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Part V: The other routes

Charitable remainder trusts

A charitable remainder trust (CRT) is the established route for philanthropic founder families. Under Section 664, the trust pays an annuity (CRAT) or a fixed percentage of its value (CRUT) of not less than 5 percent and not more than 50 percent each year, for one or more lives or a term of up to 20 years. The value of the charitable remainder must be at least 10 percent of the property's initial net fair market value. Section 664(c)(1) exempts the trust from income tax, so it can sell the contributed founder stock and reinvest the proceeds in a diversified portfolio without paying tax at the trust level. If the trust has unrelated business taxable income, Section 664(c)(2) imposes an excise tax equal to that income.

The gain does not disappear. Section 664(b) taxes distributions to the non-charitable beneficiary in tiers: ordinary income first, then capital gain, then other income, then corpus. The founder's gain therefore flows out over the payment stream. The trade-off is permanent: the remainder goes to charity, so the family gives up part of the principal in exchange for immediate diversification inside the trust, spread-out recognition and an income tax deduction tied to the value of the charitable remainder, subject to the Section 170 percentage limits. Of all the routes, the CRT gives the most complete diversification of the founder block itself. The cost is the irrevocable gift.

Direct indexing and tax-loss harvesting

Direct indexing means holding the individual constituents of an index in a separately managed account instead of a fund. Because each position is owned directly, the manager can sell positions that are down to realise losses and buy similar but not substantially identical exposure, so the portfolio stays close to the index while losses accumulate. Section 1091 disallows a loss if substantially identical stock is bought within 30 days before or after the sale, and that rule governs how replacements are chosen. Section 1211(b) allows an individual's capital losses to offset capital gains in full, plus up to $3,000 a year of ordinary income.

For a founder family, direct indexing is a funding source, not a diversification wrapper. The harvested losses offset gains realised by gradually selling the founder block, often through a Rule 10b5-1 plan. The concentrated stock is still sold and taxed. Direct indexing only reduces the net cost of each sale. Its effectiveness depends on new cash being added and on market volatility, and tends to fall as the portfolio's own basis drifts lower. Notice 2026-62 is relevant here as well: it cites year-end loss harvesting in a directly held index portfolio as an example of a long-standing, well-established technique, while describing as of particular interest multi-position "tax-aware" strategies that seek to generate capital gain and ordinary loss in similar amounts.

Comparing the routes

Many family offices combine several of these routes rather than choosing one: a CRT for the philanthropic share, a staged 10b5-1 sale with a loss-harvesting overlay for the liquid share, an exchange fund for a tranche the family can lock up for seven years, and a strategy-consistent 351 exchange to consolidate legacy diversified accounts. QSBS planning should come before any of these, because a gain that is excluded needs no deferral.

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Part VI: The intelligence implication

For RIAs and multi-family offices

The September guidance raises the level of diligence that advisers need on any concentrated-stock programme. Three practical consequences follow.

Documentation of intent now matters more than structure. The line drawn by Notice 2026-62 is between assets consistent with an ETF's thesis that the fund intends and expects to keep, and assets planned for redemption through an AP. Advisers who brought clients into 351 launches over the past two years will want to know which side of that line each launch falls on. They will also want to know what the sponsor's documents say about post-launch turnover, because the notice keeps retroactivity open.

The single-stock problem is back where it started. For a founder whose wealth is mostly one stock, the 2025-2026 idea of an ETF exit has narrowed again to the older menu: an exchange fund with a seven-year lock, a CRT, or a taxable sale funded in part by harvested losses. The partnership-to-ETF bridge is the part of the market the notice flags most clearly.

Sponsor selection is a fiduciary question. Whether a 351 launch will hold up now depends heavily on the sponsor's process: portfolio vetting against the 25/50 test, the investment thesis, and redemption practice in the months after launch. ETF launches show up in fund filings on EDGAR, and the advisers involved file Form ADV. Wealthmetrica's RIA directory and the family office directory draw on those Form ADV disclosures. Our data methodology explains how firm-level fields, including private-fund and alternatives-readiness signals, are derived.

For alternatives managers

Exchange funds are a structural buyer of private real assets. Each exchange fund has to keep at least 20 percent of its assets in property that is not a security, and Kitces describes that sleeve as typically leveraged real estate. Private real estate managers that can supply a qualifying, financeable sleeve on the timetable sponsors need are serving a real and recurring demand. That demand does not depend on 351 ETFs, and the notice expressly states that it does not address other transactions involving exchange funds.

The 351 wave has favoured liquid, tax-aware equity strategies. The early 351 launches documented above were equity ETFs, and the format itself is promoted chiefly for its tax efficiency. Alternatives managers whose strategies cannot sit inside a RIC, or that rely on assets the 351 process excludes (restricted securities, derivatives and crypto were all ineligible at one major platform), will not find a seeding channel here. Managers that can offer a liquid, 40 Act version of an alternatives sleeve may.

Founder families need sequencing, not just products. An office managing a recent liquidity event is likely to work through QSBS, insider trading windows, charitable intent and the seven-year exchange-fund decision at the same time. Distribution teams that understand this order of decisions, and know which advisers in a region actually run concentrated-stock programmes, will reach those families more effectively than teams marketing a single product. The September 2026 guidance makes the sequence more complicated, and makes advisers who understand it more valuable to founder families.

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Key sources

• Internal Revenue Code Sections 1(h), 351, 368(a)(2)(F) and 368(c), 664, 704(c)(1)(B), 721, 731, 737, 852(b)(6), 1014, 1091, 1202, 1211(b), 1411 (US Code via Cornell LII)
• Treasury Regulations 1.351-1(c) and 1.731-2 (Cornell LII)
• Rev. Rul. 2026-20 and Notice 2026-62, IRS, 28 September 2026 (irs.gov)
• Joint Committee on Internal Revenue Taxation staff, "Tax Treatment of Partnership Exchange Funds and Mergers of Investment Companies" (JCS-6-76), 6 April 1976 (govinfo.gov)
• Investment Company Act of 1940, Section 2(a)(51) (15 U.S.C. 80a-2)
• SEC, Rule 10b5-1 amendments fact sheet, Release 33-11138 (2022)
• Kitces.com, "Using Section 351 Exchanges To Tax-Efficiently Reallocate Portfolios" (March 2025) and "Using Exchange Funds To Diversify Concentrated Securities" (April 2026)
• BNY, "Section 351 Conversions: Unlocking Value in ETFs" (June 2026)
• Alpha Architect, 351 Education Center (2026); Stance Capital, Section 351 ETF exchange primer (2026)
• Harris Oakmark ETF Trust, Oakmark U.S. Concentrated ETF prospectus, Form 497 (as amended 25 June 2026, SEC EDGAR)
• Business Wire, Cambria and ETF Architect launch announcement for the Cambria Tax Aware ETF (December 2024)

Wealthmetrica provides intelligence on investment advisers, family offices and the people who run them. This analysis draws on public regulatory filings, statutes and published research; it is not legal, tax, or investment advice.