Treasury and IRS Warn Wealthy Investors That Some ETF Conversions Do Not Avoid Capital Gains Tax

The Treasury Department and the Internal Revenue Service have told wealthy investors and their advisers that certain ETF conversions meant to defer capital gains taxes do not work under current law, CNBC reported on Oct. 2. The warnings came this week.

They target investors as well as the financial, tax and investment advisers who arrange the deals.

Treasury Secretary Scott Bessent said in a post on X that the guidance shows Treasury is serious about cracking down on transactions designed to dodge taxes or exploit the federal tax code. He said the message on these conversions is that they fail under existing law.

How the Section 351 strategy works

An exchange-traded fund (ETF) is a basket of securities that trades like a single stock. ETFs are often valued for managing capital gains efficiently.

Section 351 of the tax code generally lets investors move property into a corporation in exchange for its stock without recognizing a capital gain, if certain conditions are met.

No single asset can exceed 25% of the portfolio's value, and the five largest holdings cannot exceed 50%, CNBC reported, citing Kitces.com. CNBC said that use of the provision remains generally accepted.

The contested version involves wealthy individuals who, through an intermediary, set up a new ETF seeded with highly appreciated stocks. The aim is to defer the tax on those gains.

What the guidance covers

The guidance has two parts, a companion IRS revenue ruling and a broader notice. CNBC explained that a revenue ruling is the agency's official interpretation of a specific set of facts, while a notice gives more general guidance for wider circumstances.

Deferral through a Section 351 exchange is still a legitimate strategy, CNBC reported, but the guidance adds qualifications. It targets cases in which an ETF serves as a conduit for passing securities along to avoid taxes.

Jeffrey Colon, a Fordham Law professor who focuses on tax law and policy, told CNBC that the IRS and Treasury are focused on strategies they consider abusive.

Comment period and possible stricter rules

A summary of the CNBC report by Pluang said the agencies are seeking comments on the new guidance. It added that they may impose stricter rules, especially on quick portfolio changes after an ETF is created.

The summary described the changes as significant for high-net-worth investors who use these structures.

Pluang's summary was published Oct. 2. Neither Treasury nor the IRS has set out in the material above what any stricter rules would contain.