Treasury Sec. Bessent, IRS crack down on ETF strategy the wealthy are using to avoid capital gains taxes

One of the selling points of ETFs is that they can be highly tax-efficient for managing capital gains and losses, but wealthy investors may have to rethink certain ETF tax-deferral strategies following recent communications from the Internal Revenue Service and U.S. Treasury.

At issue are certain use cases of Section 351 exchanges, in which wealthy individuals, through an intermediary, create new ETFs with a basket of highly appreciated stocks. The intent is to defer capital gains taxes — which remains a legitimate strategy, but with additional qualifications, according to new guidance from tax authorities.

Treasury Secretary Scott Bessent said in an X post earlier this week that the guidance, "makes clear Treasury is serious about cracking down on transactions designed to dodge taxes or exploit our federal tax code."

He added of a companion IRS revenue ruling related to Section 351 ETF conversions designed to avoid tax, "Our message on these conversions is clear: they don't work under existing law."

The combined effort covers instances that tax authorities find troubling, including when an ETF is "merely a conduit" for transferring securities in an attempt to avoid taxes. A revenue ruling is an official interpretation of a specific set of facts by the IRS, in relation to the tax code and regulations, useful for anticipating tax treatment by the agency. A notice, meanwhile, sets out more general guidance for broader circumstances.

Section 351 of the tax code generally lets investors transfer property to a corporation in exchange for its stock without recognizing a capital gain, under certain conditions. For example, no one asset can exceed 25% of the portfolio's value, and the top five holdings cannot exceed 50% of the overall value, according to Kitces.com. This is still generally accepted practice.

"The IRS and Treasury are focused on tax strategies that they consider abusive practices," said Jeffrey Colon, professor of law at Fordham Law, who focuses on tax law and policy.

According to tax authorities, by inappropriately avoiding gains, investors are subverting the intention of the rules.

For wealthy investors, as well as their investment and tax advisors, who have turned to ETFs as a tax shield, the landscape is expected to change in the wake of the new guidance from tax authorities.

Why the tax authorities are raising eyebrows

The IRS's revenue ruling related to a transfer of a portfolio of securities to a newly formed ETF. As part of the planned transactions, the ETF distributed the contributed securities soon after, and the investor ended up with a "materially different" portfolio, without recognizing any built-in gains in the original securities.

"This is really about getting diversification without paying tax," said Brian Gray, tax partner at Gursey Schneider.

Tax authorities said this is a problem, but the issue did not come out of nowhere.

A Bloomberg analysis from last July found that a total of $22 billion in ETFs had been created for this purpose, deferring as much as $6.5 billion in capital gains, with the activity accelerating significantly since 2024.

"Tax rules should reward investment, not abusive financial engineering," Bessent had said in a July 22 post on X, adding that regulators "will not turn a blind eye to abusive Wall Street tax dodges or tolerate products designed to exploit our federal tax code. If a tax pitch sounds too good to be true, then it probably is and investors should think twice."

He referenced that July warning in his post this week.

Officials from the IRS and Treasury had met in July with members of the Wall Street Tax Association to discuss the kinds of transactions the government has taken an interest in, including questionable Section 351 exchanges.

The notice addresses many of the strategies discussed.

**Who uses 351 exchanges? It's mostly the very rich **

Generally, only higher-income individuals are using Section 351 exchanges.

Fees are one reason. It can cost $200,000-$300,000 to create an ETF, said John Pantekidis, managing partner and general counsel at TwinFocus in Boston. Some firms suggest investors should have at least $25 million of appreciated stocks to include in the ETF for it to be a viable option, but Pantekidis sets the bar even higher, saying it doesn't make sense for anyone with less than $100 million of stocks to include.

The notice does not imply all Section 351 transactions are suspect.

"This notice does not address, and expresses no view regarding, transactions in which a Section 351 transaction is used to seed a newly established ETF with assets that are consistent with the ETF's investment thesis and that are intended and expected to be retained by the ETF absent a substantial change in circumstances," the notice reads.

Indeed, there can be valid reasons for high-net-worth individuals and families to do a Section 351 exchange, said Joshua Norman, principal in the Bardstown, Kentucky, office of Cerity Partners. For example, a wealthy person might want to gift shares of an ETF to another individual who doesn't want individual shares of stock. Also, converting separately managed accounts into ETFs can lessen the ongoing tax burden for wealthy individuals, enhancing after-tax returns.

Some ETF experts took the position that this language in the notice might lead to even more use of the strategy. "Non consensus view: Regulators opened the door this week for well designed 351s to hit the mainstream," wrote Mel Faber, founder of ETF manager Cambria Funds, which has provided an overview of the strategy to investors.

ETF questions remain

Tax regulators are placing additional restrictions in order for the transfer to be considered tax-deferred.

"The timing behind it is also key," Norman said.

The notice from tax regulators makes it clear that transactions that occur "shortly after" appreciated securities are contributed are suspect.

But the IRS did not elaborate on what this means, and that has left tax practitioners and legal professionals to expect further guidance.

How long "shortly thereafter" is will remain a gray area until tax regulators release additional guidance, Norman said.

Other tax experts agreed with this view.

"Regarding Treasury's Rev. Rul. on §351 for seeding ETFs, I'm looking at 3 things as evidence of aggressive planning... 1) evidence of a plan 2) quick redemption following seed 3) a very different portfolio from the contribution. This leaves a lot of gray area and I think we'll see many 'facts and circumstances' analyses in the coming months/years," Brent Sullivan, a tax analyst who runs Tax Alpha Insider, a blog devoted to taxes and portfolio strategies, wrote on X.

The IRS and Treasury are requesting comments on the notice by October 28.

One thing regulators are not going to do is kill the idea of exchanging securities for shares, because all the big ETFs rely on redeeming and creating units that aren't taxable as part of their daily operations. "It's a multi-trillion-dollar industry," Pantekidis said.

However, they will probably provide more guardrails for smaller ETFs that are creating units and immediately diversifying portfolios for tax advantages, he added.

Additional tax strategies could be targeted

Tax authorities are also looking more closely at additional strategies, according to the notice. These include transfers to partnerships in connection with Section 351 conversions and ETFs that use "box spread" strategies, which involve options and allow investors to defer capital gains.

"Tax practitioners must understand these highlighted strategies to advise clients on emerging audit exposures," Ed Zollars, tax partner at accounting firm Thomas, Zollars & Lynch, wrote in a blog.

Congress could also decide to step in to make some changes to existing ETF regulations. For example, they could narrow how ETFs benefit by distributing appreciated securities, said Colon.

Gray suggests investors looking to manage capital gains taxes consider an exchange fund instead. It's a private investment vehicle, typically structured as a limited partnership, that allows investors with concentrated, appreciated stock positions to pool their shares into a diversified portfolio, while deferring capital gains taxes. One disadvantage is the seven-year holding period for participants to redeem their units.

Investors can also use a charitable remainder trust to manage capital gains and losses, he said.