WASHINGTON — A fast-growing tax strategy used by wealthy investors to move highly appreciated stock portfolios into exchange-traded funds without immediately paying capital-gains tax has come under direct attack from the U.S. Treasury Department and Internal Revenue Service.
The IRS has issued new guidance warning that certain transactions marketed as Section 351 ETF conversions may not qualify for tax-free treatment after all.
In one commonly discussed structure, an investor contributes appreciated stocks to a newly created ETF.
Instead of selling those shares and immediately triggering capital-gains tax, the investor receives shares of the ETF.
That can be perfectly legitimate when the requirements of Section 351 are satisfied.
But Treasury says some transactions have gone further.
The investor contributes one portfolio.
The ETF then rapidly moves those securities out through its creation-and-redemption machinery.
The investor is effectively left owning exposure to a materially different portfolio—without recognizing the capital gain that normally would have resulted from selling the original securities.
The IRS is now drawing a much harder line around that strategy.
And for wealthy investors sitting on millions of dollars in unrealized stock gains, the consequences could be substantial.
WHAT DID THE IRS ACTUALLY DO?
On September 28, Treasury and the IRS released two major documents:
Revenue Ruling 2026-20
and
Notice 2026-62.
The revenue ruling addresses one particular ETF transaction and concludes that it does not qualify for tax-free Section 351 treatment.
The broader notice identifies several investment-fund strategies that Treasury believes may produce tax results inconsistent with the purpose of federal tax law.
The message is essentially:
using an ETF does not automatically turn what is economically a sale or exchange into a tax-free transaction.
SECTION 351 ITSELF HAS NOT BEEN ELIMINATED
This distinction is critical.
Section 351 remains part of the U.S. tax code.
It generally allows property to be transferred to a corporation in exchange for stock without immediate recognition of gain when specific conditions are satisfied.
The idea is that the investor has not truly cashed out.
Instead, the form of ownership has changed while the investment continues.
That principle has existed for decades.
What Treasury is challenging is the use of Section 351 together with other ETF tax rules to produce what it views as an economically different result.
WHY INVESTORS LIKE SECTION 351 EXCHANGES
Consider an investor who bought technology stocks many years ago.
The original portfolio may have cost:
$2 million.
Today it may be worth:
$10 million.
That means the portfolio contains:
$8 million in unrealized gains.
Selling the stocks to diversify could trigger a huge federal capital-gains tax bill.
Instead, a qualifying Section 351 exchange could potentially allow the investor to contribute the securities to a new ETF in exchange for ETF shares without recognizing the gain immediately.
The investor becomes diversified through the fund while the tax basis effectively carries forward.
The tax generally is:
deferred, not erased.
That distinction matters.
THE STRATEGY SOLVES THE “GOLDEN HANDCUFFS” PROBLEM
Long-term investors can become trapped by successful investments.
A stock may have appreciated hundreds or thousands of percent.
That creates what advisers sometimes call a concentrated-stock problem.
Selling reduces investment risk.
But selling also creates tax.
So investors may hold an increasingly risky position simply because they do not want the tax bill.
Section 351 ETF conversions emerged as one possible solution.
Instead of selling hundreds of appreciated securities and purchasing an ETF, investors could contribute those securities directly into a newly created fund.
THE MARKET HAS GROWN RAPIDLY
What was once an obscure institutional technique has become increasingly popular in wealth management.
Industry estimates suggest more than 100 ETFs have been seeded using Section 351-style in-kind contributions in recent years, representing more than $20 billion in launch assets.
Another industry analysis cited data showing 77 U.S. ETFs had already launched with roughly $16.6 billion in seed assets from individual investors by mid-2026.
The exact totals depend on how transactions are counted.
But the direction is clear:
Section 351 ETF conversions have moved from a niche tax-planning technique into a meaningful part of the ETF market.
TREASURY BECAME WORRIED ABOUT WHAT HAPPENED AFTER THE ETF LAUNCHED
The key issue is not necessarily what the investor contributes.
It is what happens next.
Imagine an investor contributes a basket of appreciated stocks into a new ETF.
An authorized participant then contributes:
Cash
or
Different securities
to the fund.
Shortly afterward, the ETF redeems that authorized participant and hands over some or all of the original investor’s appreciated securities.
The ETF is now left holding a materially different portfolio.
The original investor still owns ETF shares.
But economically, the investor may have transformed an old portfolio into an entirely different investment without paying the capital-gains tax that would normally result from selling and reinvesting.
That is the structure Treasury is targeting.
THE IRS SAYS THE ETF CAN BE TREATED AS A CONDUIT
Revenue Ruling 2026-20 applies long-standing tax principles including:
Substance over form
and
The step-transaction doctrine.
These principles allow the IRS to look beyond the legal paperwork and evaluate what a series of transactions accomplishes economically.
If multiple steps were planned as parts of one transaction, tax authorities may treat them as one integrated event.
Under the fact pattern in the ruling, the IRS concludes that the ETF effectively acted as a conduit between the investor and the authorized participant.
The result is treated as a taxable exchange.
THAT MEANS SECTION 1001 CAN APPLY
Instead of receiving tax-free treatment under Section 351, the investor can be treated as having exchanged the appreciated securities under:
Internal Revenue Code Section 1001.
Section 1001 generally requires gain or loss to be recognized when property is sold or exchanged.
If appreciated securities are worth substantially more than their tax basis, that can create a large taxable gain.
For wealthy investors with highly appreciated portfolios, the difference between Section 351 treatment and Section 1001 treatment can amount to millions of dollars.
CAPITAL-GAINS TAX CAN REACH 20% FEDERALLY
Long-term capital gains are generally taxed at:
0%
15%
or
20%
depending on taxable income.
Higher-income investors can also potentially owe the:
3.8% Net Investment Income Tax.
State taxes may apply as well.
For an investor with millions of dollars in embedded gains, triggering recognition unexpectedly could therefore be extremely expensive.
That is why the IRS guidance has attracted immediate attention from:
Financial advisers
ETF issuers
Tax lawyers
and
Wealth managers.
A $10 MILLION PORTFOLIO SHOWS THE STAKES
Consider a simplified hypothetical example.
An investor owns securities worth:
$10 million
with a tax basis of:
$2 million.
The unrealized gain is:
$8 million.
At a 20% federal long-term capital-gains rate alone, recognizing the full gain could theoretically create:
$1.6 million
in federal capital-gains tax.
Add the 3.8% net investment income tax and potentially state taxes, and the total could rise substantially.
The exact liability depends on the investor’s circumstances.
But the example demonstrates why investors care so much about tax deferral.
LEGITIMATE “SEED AND HOLD” TRANSACTIONS ARE NOT THE MAIN TARGET
Treasury made an important distinction in Notice 2026-62.
The notice says it is not addressing ordinary situations where securities contributed to establish an ETF:
fit the fund’s investment thesis
and
are genuinely expected to remain in the ETF.
That is effectively a:
“seed and hold”
structure.
The investor contributes assets that the fund actually wants to own.
The ETF continues holding them unless normal investment circumstances later justify changes.
That is very different from a transaction designed from the beginning to remove the contributed securities shortly after the ETF launches.
THE IRS IS TARGETING “SEED AND SWAP”
Industry professionals have begun using another phrase for the structure attracting scrutiny:
“seed and swap.”
The investor seeds the ETF with highly appreciated securities.
Then a prearranged series of transactions swaps those assets out.
Economically, the investor has gone from:
Portfolio A
to
Portfolio B
without recognizing the tax normally associated with making that switch.
Treasury’s argument is that Section 351 was not designed to allow investors to disguise a portfolio sale in this way.
THERE IS NO SIMPLE HOLDING-PERIOD SAFE HARBOR
One of the biggest unanswered questions is timing.
The IRS has not said:
“Hold the securities for 30 days and you are safe.”
It has not established:
A 60-day rule
A six-month rule
or
A one-year rule.
Instead, the analysis depends heavily on facts and circumstances.
Did the ETF genuinely intend to own the contributed securities?
Or was there a prearranged plan to dispose of them almost immediately?
That makes documentation and investment purpose increasingly important.
INTENT MAY BECOME JUST AS IMPORTANT AS TIMING
Imagine two ETFs both sell contributed securities after three months.
In one case, market conditions changed dramatically.
The fund manager determined the holdings no longer fit the strategy.
In another case, everyone knew before launch that the holdings would be removed.
Those transactions may look similar on a calendar.
But economically and legally, they can be very different.
Treasury’s new guidance puts greater emphasis on:
Why the securities were contributed
and
What everyone expected to happen afterward.
AUTHORIZED PARTICIPANTS ARE CENTRAL TO HOW ETFs WORK
To understand the issue, it helps to understand the ETF structure.
Retail investors normally buy ETF shares on a stock exchange.
But large financial institutions called:
Authorized participants
interact directly with the ETF.
They can create large blocks of ETF shares by delivering:
Securities
or
Cash
to the fund.
They can also redeem large blocks of ETF shares and receive securities from the fund.
This creation-and-redemption mechanism helps keep an ETF’s trading price close to its underlying net asset value.
It is also one reason ETFs can be extremely tax efficient.
SECTION 852(b)(6) IS THE OTHER IMPORTANT TAX RULE
ETF tax efficiency is partly supported by another provision:
Section 852(b)(6).
Under qualifying circumstances, an ETF can distribute appreciated securities in redemption of shares without recognizing capital gain at the fund level.
That is a major structural advantage.
Instead of selling appreciated securities for cash and creating taxable gains inside the fund, an ETF can sometimes deliver securities directly to an authorized participant.
The Treasury notice makes clear that ordinary ETF redemptions are not being broadly attacked.
The problem arises when Section 852(b)(6) is intentionally combined with Section 351 to manufacture a tax outcome Treasury believes neither rule was designed to produce.
TWO LEGAL RULES CAN BE VALID INDIVIDUALLY BUT PROBLEMATIC TOGETHER
This is the heart of Treasury’s argument.
Section 351 can legitimately allow tax-free property contributions.
Section 852(b)(6) can legitimately allow tax-efficient ETF redemptions.
But combining those rules in a prearranged sequence does not necessarily mean the entire transaction is protected.
Tax law frequently evaluates the overall economic substance of a strategy.
That is why the IRS is using doctrines that allow several formally separate steps to be collapsed into one transaction.
TREASURY IS LOOKING BEYOND SECTION 351
Notice 2026-62 is broader than one ETF conversion technique.
Treasury says it is examining several “tax-aware” investment-fund strategies involving financial products.
The notice raises questions about arrangements using:
ETF creation and redemption transactions
Exchange-fund structures
Options
Box spreads
Loss-generation strategies
and other financial instruments.
Some structures may be addressed through future guidance.
Others could potentially be challenged under existing tax law.
BOX-SPREAD STRATEGIES ARE ALSO GETTING ATTENTION
A box spread generally combines options positions designed to produce a largely predetermined economic payoff.
Sophisticated investors can sometimes use these structures as financing tools.
Treasury is concerned about certain arrangements where the tax characterization of the options may create:
Ordinary losses
Deferred gains
or other results that diverge from the transaction’s economic substance.
Notice 2026-62 requests industry information about these and similar structures.
That suggests Treasury’s broader target is not simply ETFs.
It is sophisticated financial engineering designed primarily around tax outcomes.
TREASURY SECRETARY SCOTT BESSENT HAS BEEN WARNING THE INDUSTRY
The new guidance did not come out of nowhere.
Treasury officials had already expressed concern about aggressive tax-aware investment strategies earlier in 2026.
Treasury Secretary Scott Bessent publicly argued that tax rules should encourage investment rather than what he described as abusive financial engineering.
Industry lawyers and ETF professionals therefore knew additional scrutiny was likely.
Revenue Ruling 2026-20 turns that warning into an actual IRS position.
THIS IS NOT A NEW TAX PASSED BY CONGRESS
Another important distinction:
Congress did not pass a new capital-gains tax.
The capital-gains rates themselves have not suddenly changed because of this announcement.
Instead, Treasury and the IRS are explaining how they believe existing tax law already applies to certain transactions.
That matters because taxpayers cannot necessarily argue that a transaction is protected simply because it happened before some future regulation is finalized.
The IRS may contend that the transaction was already taxable under existing law.
THE RULING CAN HAVE IMMEDIATE CONSEQUENCES
Revenue rulings represent the IRS’s interpretation of how federal tax law applies to a particular set of facts.
They do not have precisely the same legal status as Treasury regulations.
But taxpayers and advisers pay close attention because IRS examiners can rely on published guidance when reviewing transactions with substantially similar facts.
That makes Revenue Ruling 2026-20 important now—not merely sometime in the future.
THE NOTICE COULD LEAD TO EVEN TOUGHER RULES
Notice 2026-62 goes further.
Treasury says it is considering additional actions including:
Regulations
Revenue rulings
Notices
and potentially other forms of published guidance.
The government could also designate certain structures as:
Listed transactions
or
Transactions of interest.
Those designations can create significant disclosure and reporting requirements for investors and advisers.
They can also increase audit risk.
SOME FUTURE GUIDANCE COULD APPLY RETROACTIVELY
This point will concern the tax-planning industry.
The notice indicates Treasury is considering actions that could potentially apply to transactions completed before final guidance is issued, depending on the legal authority involved.
That does not mean every historical Section 351 transaction will suddenly become taxable.
But investors who entered aggressive structures may no longer be able to assume that past completion eliminates future scrutiny.
OCTOBER 28 IS THE NEXT IMPORTANT DATE
Treasury and the IRS are asking the public and financial industry to submit comments by:
October 28, 2026.
They want information about:
How these transactions work
How widely they are used
Why investors use them
How they should be taxed
and
What future rules should look like.
ETF issuers, banks, tax lawyers and asset managers are expected to follow that process closely.
The final regulatory approach could have major consequences for the tax-aware investment industry.
THE ETF INDUSTRY SAYS THE STRATEGY IS NOT DEAD
Industry specialists caution against interpreting the guidance as the end of Section 351 ETF conversions.
Properly structured transactions remain possible.
An investor can still potentially contribute a diversified portfolio to an ETF when:
Section 351 requirements are satisfied
and
the ETF genuinely intends to own the contributed assets.
The new guidance mainly reduces the ability to use the ETF as a temporary vehicle for rapidly changing the portfolio without tax.
That is an important distinction.
THIS COULD CHANGE HOW ADVISERS MARKET THE STRATEGY
Before the IRS action, some advisers promoted Section 351 exchanges largely around their tax advantages.
The new environment could force a different sales pitch.
Advisers may need to focus first on:
Investment strategy
Portfolio construction
Risk
Fees
and
Economic rationale.
Tax benefits then become secondary.
That may be exactly what Treasury wants.
If the only compelling reason to enter a complex transaction is avoiding tax, the government is more likely to question whether the structure has genuine economic substance.
CONCENTRATED STOCK HOLDERS STILL HAVE OTHER OPTIONS
Investors with huge unrealized gains are not without alternatives.
Depending on individual circumstances, wealth advisers may consider:
Gradual diversification
Tax-loss harvesting
Charitable giving
Donor-advised funds
Exchange funds
or other portfolio-management strategies.
Each carries different:
Costs
Risks
Tax consequences
and
Restrictions.
There is no universal solution.
And sophisticated transactions involving millions of dollars in unrealized gains generally require individualized tax and legal advice.
TAX DEFERRAL IS NOT THE SAME AS TAX AVOIDANCE
This distinction runs throughout the debate.
The U.S. tax code deliberately allows many forms of tax deferral.
Retirement accounts are an obvious example.
Section 351 itself was written to allow certain business reorganizations and property contributions without immediate recognition of gain.
Deferring tax through a transaction Congress intended to protect is legitimate.
The dispute begins when sophisticated structuring uses several rules together to create a result regulators believe Congress never intended.
That is precisely what Treasury says it is trying to prevent.
ETFs WILL REMAIN TAX-EFFICIENT
The new guidance does not remove the basic tax advantages of ETFs.
ETF investors can still benefit from features including:
In-kind creation and redemption
Relatively low portfolio turnover
and
The ability to avoid some fund-level capital-gains distributions.
Treasury explicitly says its notice is not intended as a broad attack on ordinary ETF creation and redemption transactions.
The ETF structure itself remains intact.
The focus is on transactions designed specifically to transform appreciated portfolios without meaningful economic continuity.
THE BIGGER STORY: WALL STREET FOUND A POWERFUL TAX TOOL — NOW THE IRS IS DEFINING WHERE THE LINE IS
Section 351 ETF conversions grew rapidly because they solved a genuine problem.
Investors with highly appreciated portfolios wanted diversification.
Selling meant paying tax immediately.
A properly structured Section 351 exchange offered another path:
transfer the securities,
receive ETF shares,
and defer the gain.
But sophisticated financial engineering pushed the strategy further.
Some transactions appeared to use an ETF as a temporary bridge:
put appreciated stocks in, move those stocks back out, and leave the investor holding something entirely different without recognizing the gain.
Treasury is now saying that can cross the line.
The message from Revenue Ruling 2026-20 is therefore not that every Section 351 ETF transaction is dead.
It is that the government intends to judge these structures by their economic substance, not simply their paperwork.
For investors and advisers, that creates a much tougher question than whether a transaction technically checks every box:
Was the ETF genuinely created to hold the contributed portfolio — or was it created mainly to make a taxable sale look like a tax-free exchange?
That distinction could determine whether some wealthy investors successfully defer millions of dollars in gains—or receive a very expensive tax bill from the IRS.
