Tax authorities rolled out a revenue ruling alongside a broader notice that zero in on ETF setups they find problematic. In the scenario highlighted by the ruling, an investor contributed a portfolio to a brand new ETF, which then distributed those same securities soon after, leaving the investor with a "materially different" mix and no recognition of built-in gains on the original holdings.
The point, regulators say, is often to sidestep capital gains bills. Treasury Secretary Scott Bessent said on X earlier this week that the move "makes clear Treasury is serious about cracking down on transactions designed to dodge taxes or exploit our federal tax code." On a related IRS ruling covering Section 351 ETF conversions meant to avoid tax, he added, "Our message on these conversions is clear: they don't work under existing law."
A Bloomberg review last July found roughly $22 billion in ETFs had been launched for this purpose, potentially deferring up to $6.5 billion in gains, with activity ramping notably since 2024. In July, IRS and Treasury officials sat down with the Wall Street Tax Association to review deals attracting agency scrutiny, among them disputed Section 351 exchanges. The new notice takes up a wide swath of the tactics discussed.
Section 351 generally allows someone to contribute assets to a corporation and receive its shares without immediately recognizing a gain, as long as the structure clears certain hurdles. As summarized by Kitces.com, no single position can make up more than 25% of the portfolio, and the top five names together cannot exceed 50% of the portfolio's value. That framework remains broadly accepted.
"The IRS and Treasury are focused on tax strategies that they consider abusive practices," said Jeffrey Colon, a Fordham Law professor who specializes in tax. In the case that drew the ruling, "This is really about getting diversification without paying tax," Brian Gray, a tax partner at Gursey Schneider, said.
This is mostly the domain of the very affluent. John Pantekidis of TwinFocus in Boston, who holds the dual roles of managing partner and general counsel, estimates that setting up an ETF typically costs $200,000 to $300,000. Some providers suggest having at least $25 million of appreciated stock to make the math work, but Pantekidis sets the bar higher, saying it is not sensible for anyone contributing less than $100 million in stock.
There are legitimate uses. Joshua Norman, who serves as a principal in Cerity Partners' Bardstown, Kentucky office, noted situations like a donor wanting to gift ETF shares to someone who does not want individual stock positions. He also said moving separately managed accounts into an ETF wrapper can reduce ongoing tax friction for wealthy clients and improve after tax outcomes.
The notice itself carved out room for standard seeding: "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." And some see the door still open. "Non consensus view: Regulators opened the door this week for well designed 351s to hit the mainstream," wrote Mel Faber, founder of Cambria Funds.
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Regulators are tightening the conditions for transactions to qualify as tax deferred under this pathway. Timing is a big one. The notice indicates that when appreciated securities are contributed and actions occur "shortly after," the transactions raise red flags, yet it leaves the exact timeframe undefined. That ambiguity will linger until more detail arrives, Norman said.
Others expect facts and circumstances to drive the analysis for now. For his part, tax analyst Brent Sullivan, who operates the Tax Alpha Insider blog, wrote, "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." Ed Zollars, a tax partner at Thomas, Zollars & Lynch, cautioned that "Tax practitioners must understand these highlighted strategies to advise clients on emerging audit exposures."
Officials are taking feedback and asked for comments by October 28.
The notice also highlights other targets, such as shifting assets into partnerships as part of Section 351 conversions, and ETFs employing "box spread" option setups that can defer capital gains. Congress could weigh in too, potentially narrowing how ETFs benefit from distributing appreciated securities, said Colon.
Back in July, Bessent wrote on X, "Tax rules should reward investment, not abusive financial engineering," 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 pointed back to that warning in this week's post.
Do not expect regulators to dismantle the core ETF plumbing. "It's a multi-trillion-dollar industry," Pantekidis said, referring to the everyday create and redeem process that big ETFs rely on. But he expects more guardrails for smaller funds that form units and quickly diversify portfolios to harvest tax benefits.
If you are sitting on a concentrated, highly appreciated stock position, advisors are still using well worn alternatives. Gray pointed to exchange funds, private vehicles often set up as limited partnerships that pool concentrated positions into a diversified basket while deferring gains, with a typical seven year wait before redemption. He also mentioned charitable remainder trusts as another way to manage capital gains and losses.
In plain English: the tax playbook around bespoke ETF seeding is tightening, the timing rules are getting sharper, and high earners should assume more case by case review until clearer lines are drawn. That does not kill ETFs, but it does change the calculus on some of the flashier tax maneuvers.
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