The IRS's recent ruling on 351 ETF conversions may take aim at the most aggressive uses of the strategy, but properly structured deals remain viable for the right clients, according to Tim Steffen, managing director and director of advanced planning at Baird Private Wealth Management in Milwaukee.
It's been roughly two weeks since the Treasury Department and the Internal Revenue Service issued Notice 2026-62 and its companion revenue ruling, Rev. Rul. 2026-20. On September 28, the IRS targeted 351 ETF conversions in new guidance that also flagged box spread ETFs and other tax-aware fund strategies.
For Steffen, the move was not entirely unexpected.
"They've kind of alluded to this in some prior announcements that some of these strategies were things that they had their eye on," Steffen told InvestmentNews in a recent interview.
"In terms of [the 351 conversion strategy] in particular, they really are addressing some of the most egregious misuses of it or abuses of it," he added. Strategies designed solely for a tax benefit, "without an underlying investment thesis," will draw the agency's attention, he said.
Section 351 of the Internal Revenue Code generally lets investors transfer property to a corporation in exchange for its stock without recognizing a capital gain, provided they meet control and diversification tests. A portfolio typically counts as diversified if no single issuer makes up more than 25% of its value and the five largest make up no more than 50%.
Rev. Rul. 2026-20 addresses deals in which investors seed a new ETF with appreciated securities that don't fit the fund's strategy. The ETF issues shares to an authorized participant for securities that do fit, then quickly redeems those shares in kind using the investors' original holdings. In those cases, the IRS treats the ETF as a conduit and recharacterizes the arrangement as a taxable exchange.
The notice expresses no view on 351 deals that seed a new ETF with assets consistent with its investment thesis that the fund expects to keep. Law firm Ropes & Gray noted the ruling carries no effective date, suggesting the IRS sees it as existing law that can reach completed transactions.
The market at stake has grown quickly. More than 100 ETFs have been seeded in-kind under Section 351 since 2021, currently representing more than $40 billion in AUM, according to a tracker maintained by Tax Alpha Insider.
"[I think] if these things are done properly, they are still viable," Steffen said. "It's only the abusive ones that they're really going after. Now, where they draw that line remains to be seen."
Mohsen Ghazi, a partner at law firm Ashurst Perkins Coie, agrees that the Treasury isn't looking to kill the strategy altogether.
"It’s drawing a line between legitimate tax planning and strategies that sort of manufacture tax outcomes by combining rules Congress designed for different purposes,” Ghazi told InvestmentNews in an interview.
"Advisors shouldn’t assume a completed transaction is automatically invalid," he added, "but they should review how the transaction was structured – for these ETFs, whether the contributed securities were intended to remain in the ETF, and what tax analysis supported the transaction.”
As Steffen tells it, Baird has fielded a steady stream of questions about 351 exchanges over the past year from clients wanting to know more. That inbound curiosity rarely develops into action, he says, as people get educated.
"When people read the headlines of what these are, they get very interested," he said. "I think most of the initial wave of interest in these died off some once people better understood how it worked."
Advisors who call him have usually read careful coverage of the strategy, Steffen said. But questions that start with clients, he says, "tend to come from the less reputable sources. The people who promote the benefits without talking about the details. And that's where people are getting misled."
The most common misconception involves a single concentrated holding. "So often it's somebody who has stock in one company that has done really well, and they're thinking they can trade that stock for an ETF," Steffen said. "But ... it has to be a portfolio of stocks that have to be diversified."
The minimums needed to get into the strategies are usually larger than many clients will commit, he added. For its part, Baird is concerned about the funds themselves, which launch with no track record.
"These don't have any history behind them," Steffen said. "You don't have anything we can look to as to how they're going to be run."
Steffen added that many clients misread what the strategy actually does.
"This is simply a tax deferral technique. It's not a tax elimination technique," he said, describing it as a diversification tool that doesn't trigger taxes right away. "There's other good ways to do that [tax deferral]. This one isn't the one that works for most people."
Baird itself doesn't offer 351 products, and Steffen said every advisor or client he's walked through the brass tacks came away feeling it wasn't a fit, though he emphasized "[that] doesn't mean it can't happen. It just hasn't happened to me yet."
In the meantime, he expects sponsors touting 351 conversion strategies are currently in scramble mode as they work to show the IRS where legitimate deals sit on one hand, while at the same time reassuring prospective clients that "what they're coming after is not what they do."
The Treasury has opened a consultation period on the new guidance, with comments from concerned stakeholders due by October 28. While the outcome from that process remains to be seen, Ghazi sees several possible next steps for the Treasury Department to pursue.
"It could always issue regulations or additional rulings that clarify the substantive tax treatment, and they could designate certain strategies as transactions that you need to report to the IRS or challenge particular arrangements today under existing law," he said. "It could be prospective; it could be retroactive.”
As for advisors, Steffen offered a firm and direct message.
"If you're going to promote a product that has tax advantages, you need to understand the disadvantages too. How can these things go right and how can they go wrong?" he said. "The days of advisors saying, that's a tax question, I can't answer that, are gone."
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