IRS Rules Section 351 ETF Conversions Are Taxable and Opens Comment on Wider Fund Strategies Through Oct. 28

Since Treasury and the IRS released Notice 2026-62 and Revenue Ruling 2026-20 on September 28, wealth managers and tax lawyers have been working through what the documents mean for ETF and long-short fund strategies marketed to high-net-worth clients. The public comment window closes October 28.

What the ruling says

Revenue Ruling 2026-20 takes on the so-called Section 351 ETF conversion. An investor with a basket of highly appreciated stocks contributes it to a newly formed ETF and claims tax-free treatment under Section 351. Soon afterward, as part of the plan, the ETF hands those same securities back out through a redemption involving an authorized participant. The investor ends up holding a materially different portfolio and has recognized none of the built-in gain.

The IRS applies substance-over-form and step-transaction principles and treats the ETF as a mere conduit. The investor is treated as making a taxable exchange under Section 1001, so Section 351 does not shield the securities used in the redemption. According to a tax-law summary of the ruling, it states no effective date and offers no transition relief.

Treasury Secretary Scott Bessent posted on X that the action shows Treasury "is seriously cracking down on transactions designed to evade taxes or exploit our federal tax laws." On the conversions, he wrote: "Our position on these conversions is clear: under current law, they do not work."

The wider notice

Notice 2026-62 reaches further. It describes "novel investment fund strategies" the agencies say produce results inconsistent with the purpose and proper application of the tax code. Law firm Ropes & Gray identified two groups: strategies using straddles to produce capital gains and ordinary losses from offsetting positions, and "no-dividend" strategies that deliver index-like returns without recognizing income.

Many of the structures lean on Section 852(b)(6), which lets a regulated investment company distribute appreciated property to redeem shares without recognizing gain. ETFs use that rule daily, and it is a main reason they are more tax-efficient than mutual funds. The notice says it does not address ordinary creation and redemption activity. Its concern is the mechanism being used "not simply to operate an ETF in the normal course."

The IRS also says ordinary ETF seeding is not covered, meaning a Section 351 transfer of assets that fit the fund's investment thesis and that the fund expects to keep.

What could come next

The notice is a warning, not a final rule. Future guidance could take the form of regulations, revenue rulings, or designation of the transactions as listed transactions or transactions of interest. The IRS says that guidance may apply prospectively or retroactively. It also says it may challenge these strategies on examination under existing law, including judicial doctrines.

The scale is large. A Bloomberg review in July found roughly $22 billion in ETFs launched for this purpose, potentially deferring up to $6.5 billion in gains, with activity picking up since 2024. The Briefs news site reports that IRS and Treasury officials discussed disputed Section 351 exchanges with the Wall Street Tax Association in July.

The long-short fund side

Bloomberg reported that the notice puts a spotlight on strategies popularized by AQR Capital Management. The IRS notice does not name AQR, and AQR did not comment specifically on the announcement, per that report. Bloomberg said AQR's TA Delphi Plus Fund held about $6.6 billion in assets in mid-year, based on documents it reviewed. Bloomberg also cited industry estimates that tax-aware long-short strategies have drawn more than $150 billion over three years. AQR has previously said it modifies its strategies to comply with applicable rules and guidance.

Bloomberg reported that the IRS said broad stock-focused strategies can in some cases be consistent with established methods of managing tax liability. The agency's concern, per the report, is transactions where tax considerations appear to be the primary motivation rather than investment returns. Strategies designed to produce ordinary losses draw particular attention because those losses can offset wages, salaries and bonuses, not just capital gains.

Where tax professionals differ

The practitioners quoted do not treat the strategies uniformly. Cary Sinnett of the American Institute of CPAs noted that Section 351 is a long-standing provision. "On the face of it, it's a good idea: If you have highly appreciated shares, the biggest risk is single stock exposure," he said, adding that moving them into a diversified ETF is valuable. Where it turns problematic, he said, is a series of steps that yields a diversified portfolio with no gain recognized.

Brian Gray of Gursey Schneider described the targeted transaction as "essentially achieving diversification without paying taxes." Fordham law professor Jeffrey Colon said the agencies are focused on strategies they consider abusive.

Kitces.com notes that a standard Section 351 diversification test bars any single asset from exceeding 25% of a portfolio's value and the top five holdings from exceeding 50%. Investors whose holdings are too concentrated to qualify have different problems than those using the conversion.

Damien Martin of EY, a partner in private tax and financial services, advised clients to "assess the situation and understand what it means." He called it "a take stock type situation."

The IRS stresses that ordinary investors who simply buy and sell publicly traded ETFs see no change in basic tax treatment.

Open questions

The unresolved issue is timing. The ruling states no effective date, and the notice leaves open whether follow-on guidance reaches transactions already completed. Treasury and the IRS will take public comments on the notice through October 28, 2026.