Top 10 Ways to Screw up a Tax-free Conversion from an SMA to ETF

Top 10 Ways to Screw up a Tax-free Conversion from an SMA to ETF If you’ve read about converting separately managed accounts or private investment funds into a new ETF using Section 351 of the Internal Revenue Code, you might think it’s an easy process. Think again. There are numerous ways to mishandle this intricate transaction. To execute it successfully, you need experienced tax counsel, securities counsel, and a meticulous team.Here are some common pitfalls in the tax-free conversion from SMA to ETF. Miscalculating positions. For a transfer to satisfy the Section 351 requirements, each transferor’s portfolio must have its largest holding represent less than 25% of the total portfolio of that transferor. Let’s say you have a potential transferor whose portfolio consists of $990,000 of Microsoft stock and $3M of an S&P 500 ETF. You might initially think to yourself, “great, the Microsoft stock is slightly less than 25%, and I can do a look through regarding the S&P 500 ETF, so I am home free.” Not so fast. Microsoft represents about 6% of the S&P 500, which means when you add the direct ownership of Microsoft ($990,000) to the indirect ownership of Microsoft (6% of $3M or $180,000) you now have $1,170,000 in Microsoft, which is slightly over 29% and means you just flunked the diversification requirements. Neglecting Risk Disclosures. Although a Section 351 conversion should be low-risk when planned and executed carefully, inherent risks still exist. Have you updated your registration statement to reflect these risks? Trying to Herd Cats with a Pitbull. A successful Section 351 transaction requires smooth collaboration among many parties, including custodians, all Registered Investment Advisors (RIAs), transferors, the ETF sponsor, advisors, tax counsel, securities counsel, the Authorized Participant (AP), ETF accounting teams, and others. Key steps involve timely delivery of securities or information. We prepare extensive PowerPoint presentations outlining all 17 steps and responsible parties, along with hosting weekly “all hands” calls to ensure alignment. Not Understanding Foreign Securities and other “Challenging” Assets. Weirdly, certain types of foreign securities and certain types of other assets can be included in a Section 351 transfer and certain ones cannot. Let’s just say that I am happy someone alerted me about a week before closing that Indian securities traded on the Indian stock exchange cannot be transferred in-kind. Failing to Address Affiliated Transactions. You will need to ascertain if one or more transferors is deemed to be affiliated persons. Section 17 of the Investment Company Act of 1940 prohibits certain transactions between affiliated persons and registered investment companies, such as ETFs. Among other things, you will need to make sure that the parties comply with Rule 17a-7. The Aggravation of Aggregating Accounts. Diversification tests often apply at the account level, but tax tests are assessed at the taxpayer level. For instance, if Mary has three accounts—her own, a marital account, and a trust account—you must aggregate these accounts and assess them at the “Mary” level, which can lead to interpretive challenges. The Inhumanity of Dealing with Transferors That Are Not Individuals. Any transferor that is an entity (e.g., an LLC, a trust, or a corporation) will require additional analysis. Often, but not always, there will be a way to accommodate such transferors, but there is important due diligence to do first. Evaluating Inbound Securities. Let’s say the new ETF will focus on large cap domestic equities. Could a transferor transfer stock of a Brazilian company to the new ETF? Answering that question entails a deep dive into both the tax law and the securities law. Fluctuations in Value. We did a Section 351 conversion for a wealth manager and its clients. The wealth manager had been clever enough to buy Google (Alphabet) about 20 years ago, and many of the clients had portfolios that were heavy on appreciated Google stock. A week or so before the closing, we evaluated each portfolio under the diversification tests. All were between 20% and 24.7% Google stock. We thought we were in good shape. But then, that week, Google appreciated dramatically in value, pushing many of the portfolios above the 25% limit. We scrambled around and changed the composition of some transfers so that we satisfied the 25% test, but it took some concerted effort and a conscientious and thorough team. Economic Substance. Judge Learned Hand, who served on the United States Court of Appeals for the Second Circuit, stated in 1934 in the famous case Helvering v. Gregory that: “Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.” However, it is important to note that despite this viewpoint, the taxpayer lost the case. That’s right, despite the language supporting the taxpayer, once Judge Hand reviewed the entire transaction, he disagreed that the transaction met the intent of the law and ruled against the taxpayer. Hand concluded that a business transaction must have economic substance and must not be merely an attempt to reduce tax. It is probably beyond the scope of this short blog post to cover a vast topic like the economic substance doctrine, but suffice it to say that nearly every Section 351 transaction (and often related transactions) presents an issue dealing with the economic substance doctrine. This is an area where one needs experienced tax counsel. ***There are many other potential traps. Ensure you engage a knowledgeable team to navigate these complexities, such as the professionals at ETF Architect.By Robert Elwood, the co-founder of Practus, LLPRelated Posts Top 10 Ways to Screw up a Tax-free Conversion from an SMA to ETF January 14, 2025 We want to launch an ETF. Should I be the ETF Advisor or Sub-Advisor? December 26, 2024 Lowering Costs by Taking EDGAR filing duties in-house September 9, 2023 We are Lowering ETF White Label Costs and Investing Back into the Business May 16, 2023

We want to launch an ETF. Should I be the ETF Advisor or Sub-Advisor?

We want to launch an ETF. Should I be the ETF Advisor or Sub-Advisor? “To advise or sub-advise…that is the question.” William Shakespeare, outsourced compliance consultant, circa 1978. Choosing an ETF white-label partner can be daunting, and the consequences of screwing it up can be stressful and expensive. First, while white-label relationships are not “till death do us part”, it can be difficult and expensive to get “divorced” (a $100k+ proxy is often needed – though if your firm gets acquired, the buyer usually pays for the proxy).  Second, you are buying into a package of complex services, each with its own nuance (trust platform, compliance, trading, custody, fund administration, technology, etc.). Finally, because of the steep learning curve, you are at a disadvantage with your negotiating counterparty (i.e., the ETF white-label firm). Our solution to these problems is to invest heavily in providing educational materials and maintaining transparency as one of our core beliefs. You can see our library of education materials here. Today’s topic is one we regularly get asked by professionals looking to launch an ETF.“What are the costs and benefits of being an advisor to an ETF versus being a sub-advisor to an ETF?”Naturally, being an “Advisor” simply sounds better! The generic logic is that it is never good to play second fiddle to anyone! Of course, just because something sounds better doesn’t mean it is actually a rational decision. One needs to understand the costs and benefits of being an advisor vs. a sub-advisor. What are the different legal requirements? What are the risks? What are the costs? And so forth.Here is the bottom line: Higher Risks – An Advisor takes on substantially more work and more tail risk than a typical Sub-Advisor. Higher Costs – Operating an Advisor is more expensive because they need more people, more process, and more tech to manage their risks. No Better “Control” – From a practical and legal standpoint, there are no differences in “control”. No Better Branding – For retail investors, there is virtually no difference. Harder Sell – For institutional investors, it’s harder to pass due diligence and open doors without scale, an operational track record, and established relationships. We hope this piece will help dispel some of the myths we hear in our industry and ensure that you, the white-label consumer, are fully informed and can ask the right questions. Boards are fiduciaries to ETF shareholders. Advisors or Sub-Advisors do not control them. ETFs (each a “Fund” and collectively “Funds”) are governed by the Investment Company Act of 1940[1] (the “40 Act”). The Fund is governed by a Board of Trustees (a “Board”), and the Board is controlled by the Fund’s shareholders, much like how a public operating company works. Of course, running a Fund via thousands of individual shareholders is impossible. Enter the 40 Act. The 40 Act creates a framework whereby shareholders elect a Board and delegate responsibility for oversight of their Fund to the Board. These trustees are held to a fiduciary standard to represent the Fund’s best interests, and if they do not exercise reasonable care in conducting their oversight of the Fund, they can be held personally liable (i.e., not a smart role for slackers).Boards can be comprised of “interested” and “independent” trustees. Whereas an independent trustee has no financial connection to the Funds, their advisor or a sub-advisor, an interested trustee can be affiliated. Typically, an interested trustee represents the firm that is paying for the costs of the Trust complex as a whole. This can be an executive from a large bank, an employee of the administrator, an Advisor employee, etc. In our situation, Wes serves as an interested trustee to our EA Series Trust, and he is deemed an “interested” trustee because he owns equity in ETF Architect, which serves as the Advisor to the Trust. Generally speaking, an interested trustee brings real-time knowledge and feedback from the entities supporting the Trust directly and helps connect the Board to the on-the-ground activities of the Fund. In contrast, Independent Trustees are expected to bring a level of objectivity to Fund matters because of their lack of any financial affiliation with the parties involved. In our case, we have 3 independent trustees: Mike Pagano and Daniel Dorn (both finance PhDs and tenured finance professors) and Emeka Oguh (a Harvard MBA, CEO, and serial entrepreneur). Team Bios. Be sure to evaluate a white label’s trust and understand who the independent and interested trustees are.Interested Trustees, despite being on a Board, have diminished powers compared to their Independent Trustee counterparts. That’s because some of the most important items on which the Board votes (like your advisory or sub-advisory agreement) are required by the 40 Act to be approved by a majority of the Independent Trustees in addition to the overall Board. Interested Trustees may also be excluded from certain “Executive Sessions” of the Independent Trustees, a private, independent trustee-only forum to discuss Trust business. Independent Trustees often retain their own counsel (who they select), insurance, and other supporting infrastructure as they see fit to ensure they can effectively carry out their fiduciary obligations. In short, interested trustees can provide input and feedback as board members, but the key decisions pertaining to ETF governance largely reside solely with the Independent Trustees.For a white-label trust, the Trustees are part of the package and have already been vetted and elected by the Trust’s previous shareholders. That’s a huge benefit because it means they have a proven history of ETF board experience and a track record of factors you can review (e.g., how they like to engage, areas of interest, and pain points). What you see is what you get. If you have your heart set on nominating Trustees to a Board as a new (or established) ETF issuer, you should be prepared to launch your own Trust (and enjoy the cost and operational complexities thereof).The bottom line is that nominating trustees to a board drives extra costs and complexity. Most importantly, don’t expect to establish a “controlled” board because the 40