The IRS and Treasury Department have issued warnings regarding two exchange-traded fund strategies that could significantly reduce tax liability for wealthy investors. These individuals need to be prepared to support their reasons for using these strategies. Last week, federal tax authorities released a pair of documents on these strategies. The first was an income award related to certain ETF conversions under Section 351 of the Tax Code. Specifically, it is a strategy in which a wealthy investor with a portfolio of highly valued stocks uses these holdings to create a new ETF and then makes in-kind distributions of those assets without recognizing any capital gains. The second, a notice from the Treasury Department and the Internal Revenue Service, called for “novel investment fund strategies” designed to produce results that may be inconsistent with the proper application of tax rules. Featured strategies include those that use straddles to offset positions and generate capital gains or current losses. So-called non-dividend strategies, which aim to generate returns tied to an index without recognizing income, are also under scrutiny, according to an article by law firm Ropes & Gray. The tax authorities are seeking public opinion on these methods by October 28th. According to the IRS notice, any future guidance related to these tax-aware funds may apply prospectively only or retroactively. “Assess the situation and understand what it means,” said Damian Martin, partner in EY’s private tax and financial services organization. “Keep your eyes open, be aware and pay attention. This is a situation to be aware of.” Lawful use vs. questionable use Even though the Treasury Department and IRS are investigating these strategies, the question of whether they pass the smell test ultimately comes down to how they’re used, the investors’ objectives, and other factors, tax experts say. Cary Sinnett, a certified financial planner and director of personal financial planning at the American Institute of Certified Public Accountants, said Section 351, which is the basis for strategies to transfer appreciated assets into ETFs to reduce capital gains, is a long-standing provision of the federal tax code. “On the face of it, it’s a good idea. If you value stocks highly, your biggest risk is single stock exposure,” he said. “It’s worth putting this into an ETF that helps with diversification.” The problem is when investors are taking a series of steps that result in them having a diversified portfolio with no gain recognized, he said. “The IRS says you started with apples and ended up with oranges, but just because you go through an ETF doesn’t mean it’s tax-free,” Sinnett said. Questions the IRS might ask include how much sales the receiving ETF had and how quickly those sales occurred, said Jeffrey Levin, a certified public accountant and chief planning officer at Focus Partners in St. Louis. “The IRS is concerned that (these 351 conversions) could be used for subsequent expedited redemptions,” he said. “The lower the turnover of a 351 ETF since its inception, the less likely it is that the IRS will attack its trades.” Meanwhile, with a focus on “tax-aware” strategies, investors will need to consider their primary motivation for participating in these funds. In other words, even without the tax benefits, does the fund make sense for an investor’s situation? “A lot of this stuff is not new, but it comes down to how it’s framed. What’s the primary motivation? Is it tax alpha? Is it a function of the overall investment strategy?” Martin said. Avoid panic and consult a CPA. Investors in 351 conversions or “tax-conscious” funds shouldn’t necessarily walk away from their investments, but they should consider the following when speaking with their CPA: Be prepared to support your reasoning. Instead of making decisions based on tax savings, make sure these funds fit into your overall investment strategy. “Investors should expect more scrutiny when tax consequences are the primary reason,” Sinnett said. Organize your documents. The revenue determination for 351 conversions is an interpretation of current law and may be applied retroactively. This is different from the IRS, which asks for comment on “tax-conscious” uses of funds, and is more specific. “What are they getting back in exchange for (the increase in stock prices)? Is it significantly different from what they donated? If so, there needs to be a deeper conversation,” said Albert J. Campo, a certified public accountant at Campo Financial Group in New York. “Make sure your documentation is in order.” Work with your CPA to understand your risk appetite for tax savings. Investors are well aware of their risk tolerance in investing, and that also applies to taxes. “If we previously thought (351 conversions) was moderate, now we would say it’s moderate to aggressive,” Levine said. “If you don’t do these things badly, you’re at a little bit more risk.”
