One of the major selling points of ETF is its high tax efficiency when managing capital gains and losses. However, after recent communications between the United States Internal Revenue Service (IRS) and the Treasury Department, wealthy investors may need to reconsider certain ETF tax deferral strategies.
The focus of the dispute is on certain exchange arrangements under Article 351 of the Tax Law. In these arrangements, wealthy individuals use intermediaries to create new ETF with a basket of significantly appreciated stocks. The purpose is to defer capital gains tax – which remains a legal strategy – but according to new guidelines from the tax authorities, additional conditions have been imposed.
U.S. Treasury Secretary Scott Bosworth posted on X earlier this week that these guidelines "clearly indicate that the Treasury Department is taking a serious approach to transactions aimed at tax evasion or exploiting our federal tax laws."
He also stated regarding a IRS ruling that is related to the conversion of Article 351 ETF and is intended to avoid taxes: 'Our position on these conversions is very clear: under the current law, they are not feasible.'
This joint action covers situations that the tax authorities consider concerning, including ETF "merely being a channel for transferring securities," and attempts to evade taxes through such means. The ruling ( revenue ruling ) is an official interpretation made by IRS in response to specific factual circumstances, taking into account tax laws and regulations, and can be used to predict the manner of tax treatment. The notice ( notice ) is aimed at a broader range of situations and provides more general guidance.
Article 351 of the tax law generally allows investors to transfer property into a company in exchange for its shares under certain conditions, without the need to recognize capital gains. For example, according to Kitces.com, a single asset shall not exceed 25% of the portfolio value, and the combined value of the top five holdings shall not exceed 50% of the total value. This remains a commonly accepted practice.
Jeffrey Kolon, a law professor specializing in tax law and policy at Fordham University Law School, stated: “What IRS and the Treasury Department are concerned about are what they consider to be abusive tax strategies.”
The tax authorities believe that by improperly avoiding taxes, investors are actually undermining the original intent of these regulations.
For wealthy investors who have been using ETF as a tax shield, as well as their investment and tax advisors, the relevant environment is expected to change after the tax authorities issue new guidelines.
Why Have Tax Authorities Become More Vigilant?
The ruling regarding IRS involved the transfer of a basket of securities into a newly established ETF transaction. As part of the planned transaction, ETF allocated these invested securities shortly thereafter, and as a result, investors ended up holding a 'substantially different' portfolio, without recognizing any capital gains on the embedded earnings of the original securities.
Gursh Schnider ( Gursey Schneider ), a tax partner, and Brian Gray stated: "This is essentially achieving decentralization without paying taxes."
The tax authorities stated that this is indeed a problem, but it did not appear out of nowhere.
A Bloomberg analysis in July last year found that a total of $22 billion of ETF had been set up for this purpose, with deferred capital gains amounting to as much as $6.5 billion, and this activity has significantly accelerated since 2024.
Bessent once stated in a post on X on July 22: “Tax rules should reward investment, not abusive financial engineering.” He added that regulators “will not turn a blind eye to Wall Street’s misuse of tax loopholes, nor will they tolerate products designed to exploit our federal tax laws. If a tax promotion sounds too good to be true, it is likely fake, and investors should think twice.”
He cited this July warning in his post this week.
IRS and officials from the Ministry of Finance met with members of the Wall Street Tax Association in July to discuss types of transactions that the government is concerned about, including the suspicious Exchange 351.
This notice covers many of the strategies that are under discussion.
Who is using the 351 exchange? Mainly the wealthiest people.
Usually, only high-income individuals use Exchange 351.
Cost is one of the reasons. John Pantekidis, the managing partner and chief legal counsel of Boston TwinFocus, stated that the cost of creating an ETF could be as high as $200,000 to $300,000. Some institutions suggest that investors should have at least $25 million in appreciated stock to be considered for an ETF; however, Pantekidis sets a higher threshold, believing that it is not worthwhile for those holding less than $100 million in stock to do so.
This notice does not imply that all transactions under Article 351 are suspicious.
The notification states: "This notice does not cover, nor does it express any opinion on, the following transaction: In transaction number 351, assets were used to contribute capital to the newly established ETF, and these assets are consistent with the investment theme of ETF. Under the premise of no significant changes, it is anticipated and intended that ETF will hold these assets."
In fact, for high-net-worth individuals and families, there may be legitimate reasons for conducting a 351 exchange. Joshua Norman, who is in charge of the office in Bardstown, Kentucky, stated that, for example, wealthy individuals might wish to gift ETF shares to people who do not want to hold a single stock. Furthermore, converting a separately managed account into ETF can reduce the ongoing tax burden for affluent investors and increase their after-tax returns.
Some ETF experts believe that the wording in this notice may even lead to a wider adoption of this strategy. Mel Faber, the founder of the Cambria Funds management company, wrote: "Dissenting view: Regulators have opened the door for well-designed 351 transactions to enter the mainstream this week." Cambria Funds has previously outlined this strategy to investors.
ETF related issues still exist
Tax regulatory authorities are imposing additional restrictions to classify such transfers as deferred tax payments.
Norman stated, "The timing is also crucial."
Notifications from tax regulatory authorities clearly state that transactions that occur 'soon' after investing in appreciated securities will be subject to suspicion.
However, IRS did not further explain how long "soon" exactly refers to, which has led tax practitioners and legal professionals to anticipate that there will be more guidelines to follow.
Norman said that until tax regulatory agencies issue more guidelines, how soon "in the near future" actually is will remain a grey area.
Other tax experts also agree with this view.
Brent Sullivan, a tax analyst who operates a tax blog Tax Alpha Insider on X, wrote: "Regarding the Treasury Department's ruling to fund ETF under Section 351, I focus on three points to determine whether it constitutes aggressive planning: 1. Evidence of planning; 2. Rapid redemption after the funding; 3. A portfolio that is very different from the invested assets. This leaves many grey areas, and I believe that in the coming months/years we will see a large number of 'fact-based and situational' analyses."
IRS and the Ministry of Finance are soliciting opinions on this notice, with the deadline being October 28th.
One thing regulatory authorities will not do is to completely reject the idea of exchanging securities for shares, as the daily operations of all large ETF rely on tax-exempt subscription and redemption mechanisms. Pantekidis said, "This is a trillion-dollar industry."
However, he added that regulatory authorities are likely to impose additional safeguards for those small ETF entities that immediately diversify their portfolios after creating shares in order to gain tax advantages.
Other tax strategies may also come under scrutiny.
According to this notice, tax authorities are also paying closer attention to other strategies, including the transfer of assets to partnerships related to Article 351 conversions, as well as the use of the “box spread” strategy by ETF; the latter involves options and can help investors defer capital gains.
Ed Zolas, the tax partners of accounting firms Thomas, Zollars, and Lynch, wrote in a blog: "Tax practitioners must understand these strategies that are highlighted in order to provide advice to clients regarding newly emerging audit risks."
Congress may also get involved and make some modifications to the existing ETF regulations. For example, Cologne suggests that Congress could tighten the way in which ETF earns profits from distributing appreciated securities.
Gray suggests that investors looking to manage capital gains tax can consider exchange-traded funds (exchange fund). This is a type of private investment vehicle, typically structured as a limited partnership, that allows investors holding concentrated and appreciated stock positions to pool their shares into a diversified portfolio, while deferring capital gains tax. The downside is that participants need to hold onto their shares for seven years in order to redeem them.
He said that investors can also use charitable residual trusts to manage capital gains and losses.
