The Internal Revenue Service has ruled that a popular exchange-traded fund maneuver, the so-called 351 conversion, is taxable in certain instances, while signaling the possibility of more guidance on ETF tax strategies to come.
In Notice 2026-62, released Monday, the IRS and the Treasury Department identified several investment fund strategies that they said may produce tax results inconsistent with federal tax rules.
Alongside the notice, it handed down a companion revenue ruling, Rev. Rul. 2026-20, which deals with 351 conversions directly.
The guidance comes as 351 exchanges gain traction among financial advisors looking for sophisticated strategies to help clients with low-basis holdings achieve better diversification.
Section 351 of the tax code generally lets investors transfer property to a corporation in exchange for its stock without recognizing a captial gain, provided they satisfy certain control and diversification tests. A portfolio usually counts as diversified if no single issuer makes up more than 25% of its value and the five largest issuers make up no more than 50%.
The IRS said the problem arises when that contribution is part of a larger plan. In the deals it described, investors would seed a new ETF with appreciated securities that don't fit the fund's investment thesis. The ETF then issues shares to an authorized participant in exchange for securities that fit the thesis, or cash earmarked to buy such securities. Shortly afterward, it redeems those shares in kind, handing back the investors' original holdings. The investors end up owning a materially different portfolio without paying tax on their embedded gains.
Rev. Rul. 2026-20 treats the ETF as a conduit in that arrangement, recharacterizing the deal as a taxable exchange between the contributing investor and the authorized participant. The notice also flags a partnership variation aimed at investors whose holdings are too concentrated to pass the diversification test on their own.
The agencies left conventional practice alone. The notice expresses no view on 351 transactions that seed a new ETF with assets that match its strategy and that the fund expects to keep. It also does not address routine ETF creations and redemptions, a structural advantage that lawmakers have previously sought to eliminate through legislation.
The notice also covers several other strategies:
The agencies said possible responses include regulations, more revenue rulings, or labeling certain deals as listed transactions or transactions of interest. Any new guidance could apply retroactively. The IRS may also challenge abusive strategies on examination under existing law.
"The Treasury Department and the IRS intend that any guidance to address the transactions described in this notice will target specific abusive transactions, will minimize compliance burdens, and will respect market expectations with respect to conventional, long-established tax planning that is consistent with the intent of Congress," the notice said.
The action follows warnings from Treasury leadership over the summer. At a Wall Street Tax Association gathering in New York in July, senior officials said some tax-aware products may be abusive, according to Reuters.
The strategies in officials' sights at the time included 351 conversions, box spread ETFs and funds that flip between ETFs to avoid dividend income. They did not issue guidance at the time, saying they wanted a dialogue with the market first.
Treasury Secretary Scott Bessent followed up in a post on X on July 22, saying "Tax rules should reward investment, not abusive financial engineering."
The scrutiny comes after rapid growth in the 351 market. According to a tracker maintained by Tax Alpha Insider, more than 100 ETFs have been seeded in-kind under section 351 since 2021, representing more than $20 billion in launch AUM.
In the Monday notice, the Treasury department and the IRS said they were requested comments providing additional details on the types of transactions it flagged, as well as similar transactions, and thoughts on the appropriate treatment under federal income tax law. The deadline for written comments is October 28.
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