Tax Deferral Through ETF Fund Contributions via Partnership with Authorized Participants

This summary analyzes a strategy for high-net-worth U.S. investors to defer capital gains tax by contributing appreciated publicly traded equity securities into a partnership with an Authorized Participant (AP), who then engages in an in-kind creation transaction with an equity Exchange-Traded Fund (ETF).

The structure potentially leverages IRC §§ 721 and 351 to achieve tax deferral, but it also faces significant IRS scrutiny under multiple anti-abuse provisions. This memo explores the mechanics of the transaction, benefits and risks, and outlines practical strategies to mitigate those risks.

Transaction Mechanics

The transaction involves an investor forming a partnership with an Authorized Participant (AP). The investor contributes appreciated public equities to the partnership. The AP, through an agreement with the ETF sponsor, delivers the contributed equities in-kind to the ETF in exchange for ETF shares. The partnership may then hold or eventually distribute the ETF shares to the investor.

Key steps include:

(1) forming the partnership,

(2) transferring stock to the partnership,

(3) executing the ETF creation, and

(4) potential distribution or liquidation.

Legal Framework for APs and ETFs

Authorized Participants (APs) must be registered broker-dealers with agreements in place to transact with ETF sponsors. They must have NSCC and DTC access and be able to assemble custom creation/redemption baskets. ETFs are regulated investment companies (RICs) under Subchapter M and use in-kind creation/redemption to minimize tax exposure. IRC § 852(b)(6) allows ETFs to avoid recognition of gain on in-kind redemptions. ETFs must satisfy diversification and qualifying income requirements under IRC § 851.

Potential Tax Deferral Benefits (IRC §§ 721 and 351)

Under IRC § 721, contributions of property to a partnership in exchange for an interest are generally tax-deferred, unless the partnership is deemed an 'investment company' under IRC § 721(b). The in-kind transfer of stock to an ETF may be structured to defer gain if executed through the AP/partnership structure. IRC § 351 permits nonrecognition on contributions to a corporation, but § 351(e) disqualifies contributions to investment companies. Thus, § 721 is often the preferred path when a control requirement under § 351 cannot be met.

Key Tax Risks and Legal Analysis

There are several significant tax risks:- IRC § 721(b): Contributions to a partnership that results in diversification in an 'investment company' are taxable.

- IRC § 707(a)(2)(B): Disguised sale rules may apply if property is contributed and other property (ETF shares) is distributed within two years.

- Step Transaction Doctrine: The IRS may collapse the steps into a direct stock-for-ETF exchange and treat it as a taxable event.

- Substance-over-Form Doctrine: If the partnership is used merely as a conduit with no legitimate economic purpose, the IRS may recast the transaction.

- IRC §§ 704(c)(1)(B) and 737: These rules trigger gain recognition if contributed property is distributed to another partner or if a contributor receives other property within 7 years.

Mitigation Strategies and Structural Recommendations

To reduce audit risk and preserve tax deferral:

1. Hold ETF shares within the partnership for more than 2 years, preferably 7, to avoid disguised sale and 704/737 gain triggers.

2. Avoid prearranged plans or contractual obligations to distribute ETF shares.

3. Provide AP with a meaningful economic stake and business purpose.

4. Use a Series LLC to isolate each investor's transaction.

5. Include at least 20% non-security assets (e.g., real estate) to avoid 'investment company' classification.

6. Ensure the AP acts independently and complies with ETF sponsor requirements and SEC custom basket rules.

7. Consider obtaining a Private Letter Ruling (PLR) for certainty.

Conclusion and Practical Guidance

This structure can be a powerful tool for achieving tax-deferred diversification if executed correctly. However, the IRS is equipped with multiple anti-abuse doctrines to collapse the structure if not properly supported by business purpose, timing discipline, and documentation. Adhering to statutory safe harbors and planning for a multi-year holding period significantly strengthens the tax position. Counsel should review and customize partnership agreements, Series LLC tracking, and AP compensation mechanisms to align with these principles.

Following is an example of the step by step mechanics and summary, assuming a $1 billion contribution into the AP partnership.

Overview

An Authorized Participant (AP) can structure a transaction where a high-net-worth investor contributes appreciated publicly traded stock (valued at $1 billion total) into a partnership controlled by the AP. The partnership can then diversify the contributed assets—by exchanging the stock for ETF shares—while deferring capital gains recognition under IRC §721(a), avoiding the investment company trap under §721(b), and mitigating judicial anti-abuse risks such as the step-transaction doctrine, disguised sale rules, and substance-over-form arguments.

Mechanics of the Transaction

1. Formation of Partnership:

- A new partnership (or Series LLC) is formed between the Investor and the AP.

- The Investor contributes $1 billion of appreciated stock.

- The AP contributes nominal cash or a profits interest.

2. Avoiding Investment Company Status:

- Hold >20% of assets in direct non-security assets (e.g., real estate, commodities).

- Asset composition at formation must show clear non-security holding.

3. Timing and Execution:

- Initial holding of contributed stock for a reasonable period (e.g., 30-90 days).

- Later, the stock is exchanged through a custom ETF creation basket.

4. Holding and Distribution:

- Retain ETF shares for a minimum of 2 years to avoid disguised sale rules.

- Ideally, maintain holding for 7 years to fully comply with §§704(c)(1)(B) and 737.

Key Tax Risk Mitigations

- §721(b) Investment Company: Hold >20% non-security assets.

- Step Transaction Doctrine: No binding commitment to immediate diversification.

- Substance Over Form: Partnership must have real business operations.

- Disguised Sale: No distributions within 2 years.

- §704(c)(1)(B) and §737: 7-year minimum holding for safe distributions.

- SEC Basket Compliance: Follow Rule 6c-11 and custom basket protocols.

Additional Practical Considerations

- Draft a formal partnership agreement stating legitimate business purposes.

- Allocate small but real profits interest to the AP.

- Include real estate appraisals to support non-security asset valuation.

- Maintain ongoing operations and formalities to reinforce economic substance.

- Design an eventual exit path through a delayed buyout mechanism after safe harbor periods.

Conclusion

By carefully structuring the partnership, managing timing, holding proper asset types, and maintaining credible operational purposes, an AP can receive a $1 billion appreciated stock contribution, diversify into ETF shares, and allow the investor to achieve broad market exposure without triggering immediate capital gains. Correct execution is critical to defend against IRS scrutiny under statutory and judicial doctrines.