IRS guidance targets abusive 351 ETF conversions; Baird's Steffen says sound deals remain viable

The IRS is treating a specific ETF seeding-and-redemption sequence as a taxable exchange, while taking no position on funds seeded with assets that match their strategy, InvestmentNews reported. Tim Steffen, managing director and director of advanced planning at Baird Private Wealth Management in Milwaukee, reads the move as targeted rather than a ban.

Rev. Rul. 2026-20, issued Sept. 28 with companion Notice 2026-62, describes the targeted sequence. Investors seed a new ETF with appreciated securities that do not fit its strategy; the ETF issues shares to an authorized participant for securities that do; and then quickly redeems those shares in kind with the investors' original holdings.

Section 351 generally lets investors transfer property to a corporation in exchange for its stock without recognizing capital gain, provided they meet control and diversification tests. A portfolio generally counts as diversified when no single issuer makes up more than 25% of its value and the five largest holdings no more than 50%.

The notice expresses no view on Section 351 deals that seed a new ETF with assets consistent with its investment thesis and that the fund expects to keep. Strategies designed solely for a tax benefit, "without an underlying investment thesis," will draw the agency's attention, Steffen told InvestmentNews. He said the direction was not a surprise because the IRS had alluded in prior announcements to watching these strategies.

"I think 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."

More than 100 ETFs have been seeded in-kind under Section 351 since 2021, representing more than $40 billion in assets, according to Tax Alpha Insider. The guidance also flagged box spread ETFs and other tax-aware fund strategies, InvestmentNews reported.

Ropes & Gray noted the revenue ruling carries no effective date, a detail InvestmentNews characterized as suggesting the IRS sees its position as existing law that can reach completed transactions.

The agency is also moving on other tax-aware structures: it has said it plans guidance on trades used to harvest losses against ordinary income, naming currency bets and equity-swap-and-futures combinations while barring no trade, as this publication reported.

For advisors, the practical question is whether a client's concentrated, low-basis position is going into a fund that will actually hold it. A seeding whose assets match the fund's stated strategy and that the fund expects to keep is not addressed by the notice. A seeding assembled only for tax benefit is, under Steffen's reading, inside the guidance. The 25%/50% diversification test is the mechanical first check before the structure goes to the client's tax counsel.

Mohsen Ghazi, a partner at Ashurst Perkins Coie, agrees the Treasury is not looking to kill the structure, according to the same InvestmentNews report. The open question Steffen names is where the line falls, and until the IRS answers it, the diligence file—thesis, seeding assets, holding intent—is the part advisors can control.