The Internal Revenue Service and Treasury Department issued Notice 2026-62 and Revenue Ruling 2026-20 on September 28, targeting 351 ETF conversions that use exchange-traded funds as conduits to swap appreciated securities without an investment rationale. The ruling recharacterizes such arrangements as taxable exchanges when investors seed a new ETF with assets that do not fit the fund's stated strategy, the fund issues shares to an authorized participant for securities that do fit, and the fund quickly redeems those shares in kind using the original holdings.

The guidance carries no effective date, which law firm Ropes & Gray noted suggests the IRS views the ruling as existing law that can apply to completed transactions. The Treasury took no position on deals in which investors seed an ETF with assets consistent with the fund's investment thesis that the fund expects to keep. More than 100 ETFs have been seeded in-kind under Section 351 since 2021 and currently represent more than $40 billion in assets under management, according to a tracker maintained by Tax Alpha Insider.

Tim Steffen, managing director and director of advanced planning at Baird Private Wealth Management in Milwaukee, said the IRS is addressing the most aggressive uses of the strategy. Strategies designed solely for a tax benefit without an underlying investment thesis will draw the agency's attention, he said. "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."

Section 351 of the Internal Revenue Code generally allows investors to 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 percent of its value and the five largest make up no more than 50 percent.

Mohsen Ghazi, a partner at law firm Ashurst Perkins Coie, said the Treasury is not 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 said. "Advisors shouldn't assume a completed transaction is automatically invalid, 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."

Steffen said Baird has fielded a steady stream of questions about 351 exchanges over the past year from clients wanting to know more, but that inbound curiosity rarely develops into action 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." Questions that start with clients tend to come from less reputable sources that promote the benefits without talking about the details, he said.

The most common misconception involves a single concentrated holding, Steffen said. "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," he 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, and Baird is concerned about the funds themselves, which launch with no track record, he added. "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."