Full Breakdown
Treasury and IRS Tighten Rules on Section 351 ETF Conversions
By Drooid · · How we work
New Guidance Targets Tax-Deferral Strategies
The Treasury Department and the Internal Revenue Service issued a revenue ruling and a notice that limit the use of Section 351 exchanges to create new exchange-traded funds (ETFs) when the primary purpose is to avoid capital-gains tax. The guidance declares that transactions in which an ETF acts merely as a conduit for transferring appreciated securities “don’t work under existing law.” It also warns that rapid redemption and a materially different post-conversion portfolio are suspect.
Background and Scale of the Practice
Section 351 permits an investor to transfer property to a corporation for stock without recognizing gain, provided no single asset exceeds 25 % of the portfolio and the top five holdings stay below 50 %. Wealthy individuals have used this provision to seed ETFs that immediately diversify holdings, thereby deferring tax. A Bloomberg analysis from July reported roughly $22 billion of ETFs created for this purpose, deferring up to $6.5 billion in gains. Creating an ETF can cost $200,000–$300,000, and practitioners suggest a viable transaction typically involves at least $100 million of appreciated stock.
Official Statements & Treasury Position
The IRS and Treasury have opened a comment period that runs until October 28.
Expert Views and Criticism
Jeffrey Colon, a Fordham Law professor, called the targeted practices “abusive financial engineering.” Brian Gray, tax partner at Gursey Schneider, described the strategy as “getting diversification without paying tax.” Joshua Norman of Cerity Partners warned that the timing of post-conversion redemptions is a key factor, while Mel Faber of Cambria Funds argued the notice could open the door for well-designed Section 351 structures to become mainstream. Ed Zollars, tax partner at Thomas, Zollars & Lynch, cautioned practitioners to understand emerging audit exposures.
Verbatim Quotes
- “This is really about getting diversification without paying tax,” — Brian Gray, tax partner at Gursey Schneider
- “Non consensus view: Regulators opened the door this week for well designed 351s to hit the mainstream,” — Mel Faber, founder of ETF manager Cambria Funds
- “The timing behind it is also key,” — Joshua Norman, principal in the Bardstown, Kentucky, office of Cerity Partners
- “Tax practitioners must understand these highlighted strategies to advise clients on emerging audit exposures,” — Ed Zollars