One of the selling points of ETFs is their tax efficiency in managing capital gains and losses, but recent announcements from the Internal Revenue Service and the U.S. Department of the Treasury may cause wealthy investors to reconsider their tax deferral strategies for certain ETFs.
At issue is a specific use case for Section 351 exchanges, where wealthy individuals use a basket of highly valued stocks to create a new ETF through an intermediary. The purpose is to defer capital gains taxes, and new guidance from tax authorities says this remains a legitimate strategy, but with additional conditions.
Treasury Secretary Scott Bessent told XPost earlier this week that the guidance “makes clear that the Treasury Department is serious about cracking down on transactions designed to evade taxes or abuse federal tax law.”
“Our message regarding these conversions is clear: They do not work under current law,” he added of an IRS revenue ruling related to Section 351 ETF conversions for tax avoidance purposes.
The joint effort covers cases that are problematic for tax authorities, such as when ETFs are “mere conduits” for transferring securities to avoid taxes. A revenue ruling is an official interpretation by the IRS of a particular set of facts related to tax laws and regulations and helps predict tax treatment by the IRS. The Notice, on the other hand, provides more general guidance for a broader range of situations.
Section 351 of the Tax Code generally allows investors to transfer assets to a corporation in exchange for stock without recognizing capital gains under certain conditions. For example, according to Kitces.com, no asset can exceed 25% of the portfolio’s value, and the top five holdings cannot exceed 50% of the total value. This is still generally accepted practice.
“The IRS and Treasury are focused on tax strategies that are considered fraudulent,” said Jeffrey Colon, a tax law and policy professor at Fordham Law School.
Tax authorities say investors are subverting the intent of the rules by improperly avoiding profits.
For wealthy investors and their investment and tax advisers who have turned to ETFs as a tax shield, the situation is expected to change following new guidance from tax authorities.
Why tax authorities frown
The IRS’s revenue determination related to the transfer of a portfolio of securities to a newly created ETF. As part of the planned transaction, the ETF distributed its equity securities immediately thereafter, but investors ended up with a “significantly different” portfolio without recognizing the gains embedded in the original securities.
“This is really about diversification without paying taxes,” said Brian Gray, a tax partner at Garthy Schneider.
Tax authorities say this is a problem, but the problem did not come out of nowhere.
A Bloomberg analysis last July found that a total of $22 billion in ETFs have been created for this purpose, with up to $6.5 billion of capital gains deferred, and that activity has accelerated significantly from 2024 onwards.
“The tax system should reward investment, not fraudulent financial engineering,” Bessent said in a July 22 post on X, adding that regulators “will not turn a blind eye to fraudulent tax avoidance on Wall Street or condone products designed to exploit the federal tax code. If the tax sales pitch sounds too good to be true, it probably is, and investors should think twice.”
He mentioned the July warning in a post this week.
IRS and Treasury officials met with members of the Wall Street Tax Association in July to discuss the types of transactions the government is interested in, including questionable Section 351 transactions.
This notice refers to many of the strategies discussed.
Who uses 351 exchanges? It’s mostly the super wealthy
Generally, only high-income earners use Section 351 exchanges.
Fees are also one of the reasons. Creating an ETF can cost between $200,000 and $300,000, said John Panthekidis, managing partner and general counsel at TwinFocus in Boston. While some companies have suggested that investors need to own at least $25 million in rising stocks to be included in an ETF for it to be a viable option, Panthekidis set the bar even higher, saying it doesn’t make sense for people with less than $100 million in stocks to include it.
This notice does not imply that all Section 351 transactions are suspicious.
“This notice does not address, and does not express a view regarding, transactions in which Section 351 transactions are used to seed a newly established ETF with assets that are consistent with the ETF’s investment theory and that are intended and expected to be retained by the ETF unless circumstances change materially,” the notice reads.
In fact, there may be legitimate reasons for high-net-worth individuals and their families to undertake a Section 351 exchange, says Joshua Norman, president of Ceriti Partners’ firm in Bardstown, Kentucky. For example, a wealthy person may wish to gift shares of an ETF to another individual who does not want individual shares. Converting separately managed accounts to ETFs also reduces the ongoing tax burden for wealthy individuals and increases after-tax returns.
Some ETF experts took the position that this language in the notice could lead to further use of the strategy. “Disagreement view: Regulators this week opened the door for well-designed 351s to become mainstream,” said Mel Faber, founder of ETF management firm Cambria Funds, which provides investors with an overview of the strategy.
Questions about ETFs remain
Tax authorities have placed additional restrictions so that the transfer is considered tax deferred.
“The timing after that is also important,” Norman said.
A notice from the tax authorities makes it clear that transactions that take place “immediately” after appreciation securities are contributed are suspicious.
But the IRS hasn’t elaborated on what this means, so tax and legal experts are hoping for more guidance.
Norman said how long “soon thereafter” is a gray area until tax authorities issue further guidance.
Other tax experts agreed with this view.
“Regarding Treasury regulations regarding §351 for seed ETFs, I look at three things as evidence of aggressive planning… 1) Evidence of planning 2) Rapid post-seed redemptions 3) A significantly different portfolio than contributions. This leaves a lot of gray area and I think there will be a lot of ‘facts and circumstances’ analysis in the coming months/years,” said Brent Sullivan, a tax analyst who runs Tax Alpha Insider. A blog dedicated to taxes and portfolio strategies written by X.
The IRS and Treasury Department are seeking comments on the notice by October 28th.
One thing regulators won’t do is kill the idea of converting securities into stocks. All major ETFs rely on redemptions and the creation of tax-free units as part of their day-to-day operations. “This is a multi-trillion dollar industry,” Pantekidis said.
But it would provide more guardrails for smaller ETFs that create units and immediately diversify their portfolios for tax benefits, he added.
Additional tax strategies may be targeted
The tax authorities are also considering additional strategies in more detail, the notice said. These include transfers to partnerships related to Section 351 conversions and ETFs that include options and use “box spread” strategies that allow investors to defer capital gains.
“Tax professionals need to understand these highlighted strategies to advise clients on new audit exposures,” Ed Zollers, tax partner at accounting firm Thomas Zollers & Lynch, said in a blog post.
Congress may decide to make some changes to existing ETF regulations. For example, an ETF can narrow the scope of its benefits by distributing higher-value securities, Colon said.
Gray suggests investors looking to manage capital gains taxes consider exchange-traded funds instead. It is a private investment vehicle, usually structured as a limited partnership, that allows investors with concentrated and appreciated stock positions to pool their stocks into a diversified portfolio while deferring capital gains taxes. One drawback is the seven-year holding period for participants to redeem their units.
He said investors can also use charitable remainder trusts to manage capital gains and losses.
