IRS Challenges Section 351 ETF Conversions of Appreciated Stock
Investors with appreciated stock sometimes look for ways to diversify a portfolio without immediately recognizing the accumulated capital gain. One strategy has involved contributing appreciated securities to a newly formed exchange traded fund in a transaction intended to qualify for nonrecognition under Internal Revenue Code Section 351.
Treasury and the IRS have now drawn an important line around one version of that strategy.
Revenue Ruling 2026-20 concludes that a particular Section 351 ETF conversion is taxable when the contribution and a subsequent ETF redemption are parts of the same plan and the investor's contributed securities are effectively exchanged for a materially different portfolio. A companion document, Notice 2026-62, identifies several additional investment fund strategies that Treasury and the IRS are reviewing.
The guidance does not make every contribution of securities to an ETF taxable. The facts, transaction sequence, economic substance, and intended disposition of the contributed securities matter.
For investors considering a significant transaction involving appreciated stock, the new guidance reinforces the importance of evaluating the federal and state consequences as part of proactive tax planning before the transaction is completed.
Why Investors Use Section 351
Section 351(a) generally allows property to be transferred to a corporation without immediate recognition of gain or loss when the property is transferred solely in exchange for stock and the transferor or transferors are in control of the corporation immediately after the exchange.
Control for this purpose is generally determined under Section 368(c).
The policy behind Section 351 is that immediate taxation may not be appropriate when an investor has not economically cashed out but has instead continued the investment through a change in legal form.
This can make Section 351 attractive when appreciated assets are being transferred into a corporate structure.
Investment companies, however, are subject to additional restrictions.
Section 351 Has Special Rules for Investment Companies
Section 351(e) provides an exception to the normal nonrecognition rule for certain transfers to investment companies.
Treasury Regulation Section 1.351-1(c) generally treats a transfer as a transfer to an investment company when the transaction results in diversification of the transferors' interests and the transferee meets the applicable investment company requirements.
The regulations also contain an important rule for portfolios that are already diversified.
A portfolio of stocks and securities is generally treated as diversified for this purpose when:
- No more than 25% of the value of the portfolio is invested in stock and securities of any one issuer, and
- No more than 50% of the value of the portfolio is invested in stock and securities of five or fewer issuers.
A transferor contributing an already diversified portfolio may therefore be in a different position from an investor attempting to contribute one highly concentrated stock position.
Revenue Ruling 2026-20 involves an investor whose contributed portfolio satisfies the applicable diversification requirement. The problem identified by the IRS arises from what happens after the contribution.
What Happened in Revenue Ruling 2026-20
The ruling describes a planned series of transactions.
First, an investor transfers a diversified portfolio of appreciated securities to a newly formed ETF. The ETF intends to qualify as a regulated investment company under Section 851.
The investor intends the initial contribution to qualify under Section 351.
As part of the same overall plan, the ETF then completes two additional transactions.
- The ETF issues shares to an authorized participant in exchange for securities that fit the ETF's investment strategy or for cash that will be used to acquire those securities.
- Shortly afterward, the ETF redeems those shares by distributing securities that had originally been contributed by the investor.
The ETF intends the redemption to receive the nonrecognition treatment available under Section 852(b)(6).
After these steps are completed, the ETF owns a portfolio that is materially different from the portfolio originally contributed by the investor.
Economically, the investor has moved from the appreciated securities originally contributed into an interest in an ETF holding a substantially different portfolio.
The IRS Treats the ETF as a Conduit
The IRS concluded that the individual steps cannot be viewed in isolation when they are components of the same integrated plan.
The ruling relies on established substance over form and step transaction principles.
Those principles allow the tax treatment to follow the economic substance of an integrated transaction rather than the separate legal form of each step.
Revenue Ruling 2026-20 cites several authorities supporting that analysis, including:
- Stewart v. Commissioner, 714 F.2d 977 (9th Cir. 1983),
- Minnesota Tea Co. v. Helvering, 302 U.S. 609 (1938),
- Commissioner v. Court Holding Co., 324 U.S. 331 (1945),
- Kuper v. Commissioner, 533 F.2d 152 (5th Cir. 1976), and
- Revenue Ruling 71-336.
Under the ruling, the ETF's temporary ownership of the securities does not control the tax result. The ETF is instead treated as a conduit through which the investor's appreciated securities pass to the authorized participant.
The investor is treated as engaging in a taxable exchange under Section 1001 with the authorized participant for the contributed securities that the ETF uses to redeem that participant.
Why the Section 1001 Treatment Matters
Section 1001 generally requires a taxpayer to determine gain or loss when property is sold or exchanged for property that differs materially in kind or extent.
Section 1001(c) generally requires realized gain to be recognized unless another provision of the Internal Revenue Code provides otherwise.
Section 351 can provide that nonrecognition rule when its requirements apply. Revenue Ruling 2026-20 concludes that the integrated transaction described in the ruling does not receive the intended Section 351 result.
That distinction can be significant for an investor holding securities with substantial unrealized appreciation.
The amount of gain recognized requires position by position basis information and analysis of the securities treated as disposed of. Investors considering or reviewing one of these transactions should therefore retain complete cost basis records and transaction documents.
The Ruling Does Not Say Every Section 351 ETF Contribution Is Taxable
This limitation is important.
Notice 2026-62 expressly states that it does not address a Section 351 transaction used to seed a newly established ETF when the contributed assets are consistent with the ETF's investment thesis and are intended and expected to be retained by the ETF absent a substantial change in circumstances.
That means the new guidance should not be summarized as a general rule that all Section 351 ETF contributions are now taxable.
The ruling addresses a specific planned transaction in which contributed securities are moved out of the ETF and replaced with a materially different portfolio as part of the same plan.
The distinction between an ordinary ETF seeding transaction and a planned conversion transaction therefore matters.
Notice 2026-62 Goes Beyond the Specific Revenue Ruling
Revenue Ruling 2026-20 reaches a specific conclusion about one transaction. Notice 2026-62 is broader but has a different legal function.
The Notice identifies additional investment fund strategies that Treasury and the IRS believe may produce results inconsistent with the purpose or proper application of existing federal tax rules. Treasury and the IRS are considering additional guidance and other action.
The Notice states that future action could include regulations, notices, revenue rulings, or identification of a transaction as a transaction of interest or listed transaction.
It also states that the IRS may challenge an abusive investment fund strategy on examination under existing law.
Importantly, those statements do not mean that every strategy described in Notice 2026-62 has already been conclusively determined to be taxable or invalid.
The Notice expressly requests information and comments and distinguishes the transaction already addressed by Revenue Ruling 2026-20 from other transactions still under consideration.
Partnership Exchange Fund Strategies Are Also Under Review
Notice 2026-62 discusses a related partnership structure involving investors whose appreciated securities are not sufficiently diversified for the Section 351 rules.
Under the strategy described in the Notice, investors contribute appreciated securities to a partnership. The partnership is structured with sufficient assets other than stocks or securities in an effort to avoid treatment as an investment company under Sections 351(e) and 721(b).
The partnership then participates in a Section 351 ETF conversion transaction.
Treasury and the IRS state that this planned series of transactions can effectively allow investors to move from appreciated securities into an indirect interest in a materially different ETF portfolio without recognizing the built in gain.
Unlike the transaction directly addressed in Revenue Ruling 2026-20, the Notice does not issue a final holding on other exchange fund transactions. It states that Treasury and the IRS are considering additional guidance and expressly says that the Notice does not address other transactions involving exchange funds.
Investors should therefore distinguish between a transaction squarely within Revenue Ruling 2026-20 and other exchange fund structures that may require a separate analysis.
Other Investment Fund Strategies Have Also Been Flagged
Notice 2026-62 identifies several other categories of transactions for further review.
These include certain strategies involving:
- Box spread transactions inside ETFs,
- ETF record date transactions intended to avoid dividend income,
- Use of Section 852(b)(6) in connection with the regulated investment company qualifying income test,
- Identified straddles involving positions with different tax character,
- Selective elections involving foreign currency forward contracts, and
- Selective termination of certain notional principal contracts.
The common concern described by Treasury and the IRS is the use of related transactions, elections, or economically offsetting positions to produce a tax result that does not correspond to the overall economics of the investment.
The Notice also makes an important distinction for ordinary tax planning. Treasury and the IRS acknowledge that established techniques can legitimately reduce tax. Merely describing a fund or strategy as tax aware or tax advantaged does not by itself make the strategy abusive.
Future Guidance Could Affect Existing Transactions
Notice 2026-62 states that Treasury and the IRS are considering additional guidance.
The Notice also cautions that future guidance could apply prospectively or, where legally permitted, to transactions that occurred before the guidance is issued.
Comments requested by the Notice are due October 28, 2026. Treasury and the IRS state that the facts, economics, applicable legal authority, and information received from market participants will affect the form and scope of future action.
This creates a different risk profile for investors entering a transaction today than for a strategy governed by long established and settled tax treatment.
What Investors Should Review Before an ETF Conversion
An investor considering a Section 351 ETF transaction should understand the entire planned series of transactions rather than evaluating only the first contribution.
Important questions include:
- What securities will be contributed to the ETF?
- Is the contributed portfolio already diversified under the applicable Section 351 rules?
- What percentage of the securities is concentrated in one issuer or a small group of issuers?
- Will the ETF retain the contributed securities?
- Were any redemptions involving the contributed securities planned before the initial contribution?
- Will the ETF hold a materially different portfolio shortly after the transaction?
- What representations has the investment manager or transaction sponsor made regarding federal income tax treatment?
- What tax opinion or supporting analysis has been provided?
- What is the adjusted tax basis of every security being contributed?
- What capital loss carryforwards or other tax attributes could affect the cost of a taxable disposition?
- What state income tax consequences would result if gain is recognized?
The transaction documents, contribution agreement, fund investment policy, redemption arrangements, basis records, and written tax analysis may all become important if the expected treatment is later examined.
Completed Transactions May Deserve Another Review
An investor who already completed a transaction resembling the facts of Revenue Ruling 2026-20 should not assume that the issue applies only to future ETF conversions.
The Revenue Ruling states the IRS interpretation of existing Sections 1001, 351, and 852 and the judicial doctrines applied to the described transaction. It is not a proposed regulation with a future effective date.
The appropriate analysis will depend on the actual transaction documents and facts, including which contributed securities were subsequently distributed, when the transactions occurred, whether the transactions were components of the same plan, and whether the ETF ultimately held a materially different portfolio.
A transaction that differs materially from the facts of the ruling should be analyzed on its own facts rather than assuming the Revenue Ruling automatically controls.
Recognizing Gain May Change the Broader Tax Planning Analysis
If an investor determines that a contemplated diversification strategy will cause current gain recognition, the analysis does not end there.
The investor can evaluate the transaction together with other items on the return, including capital loss carryforwards, charitable planning, estimated taxes, investment income, and state taxes.
Capital loss carryforwards can materially affect the current cost of recognizing investment gains. Because those attributes can originate many years earlier, the supporting history should be preserved. See how long tax records supporting carryforwards should be retained.
An investor with charitable objectives may also evaluate whether contributing appreciated securities directly to charity fits the broader plan rather than selling the securities first. The deduction rules and limitations changed beginning in 2026, as discussed in the 2026 charitable giving tax changes.
These alternatives do not replicate a Section 351 ETF conversion. They illustrate why the tax consequences of a concentrated or appreciated portfolio should be modeled as part of the investor's complete tax position rather than evaluating one transaction in isolation.
California Investors Need a Separate State Tax Calculation
California taxpayers should also model the state consequences of any recognized gain.
California generally conforms to the federal rules for computing capital gains and losses as of its applicable conformity date, subject to California modifications. California does not provide a preferential personal income tax rate for net capital gains. Capital gains are instead taxed under the regular California personal income tax rate structure.
Residency can also matter. A California resident is generally taxed on income regardless of source, while a nonresident or part year resident can require a separate sourcing analysis.
A transaction that was structured primarily around federal nonrecognition can therefore create a significant combined federal and California cash tax requirement if the expected federal treatment is not available.
Revenue Ruling 2026-20 Makes Transaction Sequence Important
The broader lesson from Revenue Ruling 2026-20 is that satisfying the technical requirements of one Code section does not necessarily establish the tax result when that step is part of a larger prearranged transaction.
For the transaction described in the ruling, the IRS looked through the temporary ETF ownership and examined what the investor economically accomplished after all planned steps were completed.
That does not eliminate Section 351 planning or ordinary ETF seeding transactions. It does mean that investors using Section 351 as part of a portfolio diversification strategy should understand what happens to the contributed securities after the initial transfer and whether subsequent transactions were already contemplated as part of the same plan.
That analysis is most useful before an appreciated portfolio is transferred and before the resulting gain recognition becomes difficult to change.
