IRS targets 351 ETF conversions in new steerage on tax methods

The Internal Revenue Service has dominated {that a} well-liked exchange-traded fund maneuver, the so-called 351 conversion, is taxable in sure cases, whereas signaling the opportunity of extra steerage on ETF tax methods to come back.

In Notice 2026-62, launched Monday, the IRS and the Treasury Department recognized a number of funding fund methods that they mentioned could produce tax outcomes inconsistent with federal tax guidelines.

Alongside the discover, it handed down a companion proceeds ruling, Rev. Rul. 2026-20, which offers with 351 conversions immediately.

The guidance comes as 351 exchanges acquire traction amongst monetary advisors in search of subtle methods to assist purchasers with low-basis holdings obtain higher diversification.

What the ruling means for 351 exchanges

Section 351 of the tax code usually lets traders switch property to an organization in trade for its inventory with out recognizing a captial acquire, supplied they fulfill sure management and diversification exams. A portfolio often counts as diversified if no single issuer makes up greater than 25% of its worth and the 5 largest issuers make up not more than 50%.

The IRS mentioned the issue arises when that contribution is a component of a bigger plan. In the offers it described, traders would seed a brand new ETF with appreciated securities that do not match the fund’s funding thesis. The ETF then points shares to a licensed participant in trade for securities that match the thesis, or money earmarked to purchase such securities. Shortly afterward, it redeems these shares in sort, handing again the traders’ unique holdings. The traders find yourself proudly owning a materially totally different portfolio with out paying tax on their embedded features.

Rev. Rul. 2026-20 treats the ETF as a conduit in that association, recharacterizing the deal as a taxable trade between the contributing investor and the licensed participant. The discover additionally flags a partnership variation aimed toward traders whose holdings are too concentrated to go the diversification take a look at on their very own.

The companies left standard apply alone. The discover expresses no view on 351 transactions that seed a brand new ETF with property that match its technique and that the fund expects to maintain. It additionally doesn’t handle routine ETF creations and redemptions, a structural benefit that lawmakers have previously sought to eliminate through legislation.

Read extra: Why RIA firms are launching their own ETFs — and what it takes to win

Box spreads and tax-aware funds additionally flagged

The discover additionally covers a number of different methods:

• Box unfold ETFs, which mix choices to imitate short-term rates of interest with out producing present revenue;
• Funds that rotate between ETFs monitoring the identical index to keep away from dividend revenue;
• ETFs holding commodities or digital property that use in-kind redemptions to get across the 90% qualifying-income take a look at for regulated funding corporations; and
• Derivatives trades utilized by tax-aware funds to provide capital features alongside atypical losses, that are already going through strain as custodians tighten access to tax-aware long-short accounts.

The companies mentioned doable responses embrace laws, extra proceeds rulings, or labeling sure offers as listed transactions or transactions of curiosity. Any new steerage may apply retroactively. The IRS might also problem abusive methods on examination underneath current regulation.

“The Treasury Department and the IRS intend that any steerage to handle the transactions described on this discover will goal particular abusive transactions, will reduce compliance burdens, and can respect market expectations with respect to standard, long-established tax planning that’s in line with the intent of Congress,” the discover mentioned.

Read extra: 351 exchanges are gaining momentum, and most firms are underestimating the risk

Treasury warned in July

The motion follows warnings from Treasury management over the summer time. At a Wall Street Tax Association gathering in New York in July, senior officers mentioned some tax-aware merchandise could also be abusive, according to Reuters. 

The methods in officers’ sights on the time included 351 conversions, field unfold ETFs and funds that flip between ETFs to keep away from dividend revenue. They didn’t concern steerage on the time, saying they wished a dialogue with the market first.

Treasury Secretary Scott Bessent adopted up in a put up on X on July 22, saying “Tax guidelines ought to reward funding, not abusive monetary engineering.”

The scrutiny comes after speedy development within the 351 market. According to a tracker maintained by Tax Alpha Insider, greater than 100 ETFs have been seeded in-kind underneath part 351 since 2021, representing greater than $20 billion in launch AUM. 

In the Monday discover, the Treasury division and the IRS mentioned they have been requested feedback offering extra particulars on the kinds of transactions it flagged, in addition to comparable transactions, and ideas on the suitable remedy underneath federal revenue tax regulation. The deadline for written feedback is October 28.