Bessent and IRS Say ETF Conversions Used to Avoid Capital Gains Taxes 'Don't Work Under Existing Law'

Wealthy investors and their advisers face a narrower path for deferring capital gains taxes through exchange-traded funds after new guidance from Treasury and the IRS on Section 351 ETF conversions.

The guidance has two pieces: an IRS revenue ruling and a notice. A revenue ruling is the agency's official interpretation of a specific set of facts under the tax code and regulations. A notice sets out more general guidance for broader circumstances.

What the strategy is

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. 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.

In the use case now drawing attention, wealthy individuals, through an intermediary, create new ETFs with a basket of highly appreciated stocks. The intent is to defer capital gains taxes. According to the new guidance from tax authorities, that remains a legitimate strategy, but with additional qualifications.

The ruling

The IRS revenue ruling relates 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.

The combined effort also covers instances tax authorities find troubling, including when an ETF is "merely a conduit" for transferring securities in an attempt to avoid taxes. According to tax authorities, by inappropriately avoiding gains, investors are subverting the intention of the rules.

Bessent said in an X post that the guidance "makes clear Treasury is serious about cracking down on transactions designed to dodge taxes or exploit our federal tax code." Of the companion revenue ruling, he added: "Our message on these conversions is clear: they don't work under existing law."

What tax specialists say

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

Brian Gray, tax partner at Gursey Schneider, put the economics plainly: "This is really about getting diversification without paying tax."

How we got here

Tax authorities said this is a problem, but the issue did not come out of nowhere. Bessent had said in a July 22 post on X that "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 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.

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.

The wider debate over investor tax avoidance

The ETF guidance lands amid broader scrutiny of wealthy investors' tax strategies. A Bloomberg series by reporter Loukia Gyftopoulou and her colleagues calls one such approach "this generation's great American tax dodge." On NPR's The Indicator, hosts Wailin Wong and Adrian Ma said some millionaires and billionaires are plowing money through a tax loophole so big it could allow them to slash their taxes to zero. Decades ago, they noted, the richest Americans paid taxes as high as 40% on their investments.

That series centers on Cliff Asness, 59, who set up the hedge fund AQR Capital Management after working at Goldman Sachs and earning a PhD in finance. Gyftopoulou says AQR pivoted toward tax-aware investing, which she summarized as: "We help rich people slash their tax bills." AQR's approach is a tax-aware long-short strategy, with portfolios engineered to generate losses that offset taxes on winning investments. The NPR episode is about that strategy, not Section 351 ETF conversions; the two are separate strands of the same broader fight over wealthy investors' taxes.

The other side

The notice does not imply all Section 351 transactions are suspect. It says it "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."

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

Some ETF experts think the guidance could even expand 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.

What comes next

For wealthy investors, as well as their investment and tax advisers, who have turned to ETFs as a tax shield, the landscape is expected to change in the wake of the new guidance. Tax regulators are placing additional restrictions in order for the transfer to be considered tax-deferred. Norman noted that the timing is key: the notice makes clear that transactions that occur "shortly after" appreciated securities are contributed are suspect.