IRS Crackdown On 351 Tax-Free Exchanges

If you hold a big, highly appreciated stock position, you know the problem. Diversifying means selling, and selling means a capital gains bill. For the past couple of years, a strategy built on something called a “Section 351 exchange” has claimed to solve that. On September 28, the IRS pushed back.

What the IRS did.

Treasury and the IRS released Revenue Ruling 2026-20 and Notice 2026-62 together. The ruling treats Section 351 ETF “conversion” transactions as taxable sales, so investors who used the strategy may owe tax now. The notice goes further. It warns that new rules, possibly reaching back to completed transactions, may follow.

How a Section 351 exchange normally works.

Section 351 is a long-standing, legitimate part of the tax code. It lets you contribute appreciated property to a corporation in exchange for stock without recognizing a gain, which is how founders move assets into a new company without a tax bill. Generally, the people contributing property need to own at least 80% of the corporation afterward, and for a fund-type corporation like an ETF, the securities contributed need to be a diversified portfolio.

How the “351 ETF conversion” was supposed to work.

The strategy stacked several steps together:

1. An investor contributes appreciated securities to a newly formed ETF in exchange for ETF shares, intended as a tax-free 351 transfer.
2. As part of the same plan, the ETF takes in cash or other securities from an “authorized participant,” which is typically a big bank or broker-dealer.
3. Shortly after, the ETF pays back that participant using the securities the investor originally contributed. A separate rule, Section 852(b)(6), is meant to keep the ETF from recognizing gain on that handoff.

The investor ends up holding an interest in a portfolio materially different from the one they put in, with no tax triggered.

Why the IRS says it doesn’t work.

The IRS did not argue that any technical requirement of Section 351 was missed. It applied “substance over form” and “step transaction” principles, treated the ETF as a conduit, and looked at the whole plan as one transaction. In the IRS’s view, the investor made a taxable exchange. In plain English, you effectively sold your stock to the bank and then bought into the ETF.

The policy concern is two-sided. Attorneys note the transfer raises concerns when the ETF wipes out its own built-in gain by handing assets out in kind. Size also mattered. A Bloomberg analysis found about $22 billion in ETFs had been created for this purpose, deferring as much as $6.5 billion in capital gains, with activity accelerating since 2024. Treasury Secretary Bessent’s message was that these conversions don’t work under existing law.

Is this tax evasion?

No. Tax evasion means deliberately hiding income or lying on a return. The IRS calls these strategies “abusive,” which is a label for aggressive tax avoidance that stretches the rules past their purpose. Still, being on the wrong side of a ruling has real costs. Beyond back taxes and interest, tax preparers face accuracy-standard and penalty risk if they report tax-free treatment for a transaction matching the ruling without solid authority or disclosure.

What law firms and legal commentators are saying.

The published alerts are mostly cautionary rather than combative. The real debate is over how far the ruling reaches.

Voices treating the ruling as settled or warning clients to act:

• Fox Rothschild: The ruling is already in effect, and investors who used the strategy may owe tax now. Whether a deal is caught turns on whether the steps were part of a “plan” and whether the portfolios are “materially different.”
• Ropes & Gray: The ruling carries no effective date, which suggests the IRS sees it as existing law that can reach completed transactions.

One more data point: a fund told investors in an SEC filing that it believes its planned contribution is distinguishable from the ruling, while acknowledging the IRS could disagree and that future changes could apply retroactively.

The open questions are real. The ruling describes the redemption as happening “shortly thereafter” and doesn’t draw a bright line. “Materially different” is also left undefined.

What else is on the IRS’s list.

The notice names the 351 seeding transaction plus four other ETF strategies that lean on Section 852(b)(6), and three categories of “tax-aware” strategies used mainly by partnerships and separately managed accounts. One variation involves a partnership “exchange fund” that is made diversified and then does a 351 conversion into an ETF. Others include box-spread funds and strategies that dodge dividends or avoid recognizing gains on assets like commodities and digital assets.

What this does not mean.

This isn’t aimed at ETFs in general. The notice says, except as specifically discussed, it doesn’t address ordinary in-kind ETF redemptions. Traditional tax-loss harvesting also falls outside the strategies it identifies. Nothing suggests that people who simply buy and hold index ETFs are affected.

Who should pay attention.

• Anyone who contributed appreciated stock to a new ETF to diversify.
• Anyone holding an exchange fund or a “tax-aware” product.
• Executives, tech employees, and business owners with concentrated stock positions who are being pitched a solution.

Questions to ask before buying anything that promises to avoid tax.

• Does this rely on a specific tax code section, and has the IRS ever commented on it?
• What happens to me if the IRS says it doesn’t work?
• Does it still make sense if I take the tax benefit out of the picture?
• Who gets paid if I say yes?

The bottom line.

Section 351 isn’t going away, and a well-structured version may survive. But when a product promises to solve a tax problem with a clever sequence of steps, the tax benefit is the part most likely to get taken away. Less exciting tools such as spreading a sale across tax years, gifting appreciated shares to charity, and planning before you need the cash don’t come with a ruling attached.

This is general education, not tax advice. Talk to your CPA about your own situation.

If you’ve been pitched a “tax-free” way to diversify, or you hold something you’re not sure fits this description, click Book A Meeting.

FAQ: 351 Tax-Free Exchange ETFs

1. What is a Section 351 exchange?

Section 351 is a long-standing, legitimate part of the tax code. It lets you contribute appreciated property to a corporation in exchange for stock without recognizing a gain. That’s how founders move assets into a new company without a tax bill. Generally, the people contributing property need to own at least 80% of the corporation afterward, and for a fund-type corporation like an ETF, the securities contributed need to be a diversified portfolio.

2. What did the IRS announce?

On September 28, Treasury and the IRS released Revenue Ruling 2026-20 and Notice 2026-62. The ruling treats Section 351 ETF “conversion” transactions as taxable sales, so investors who used the strategy may owe tax now. The notice warns that new rules may follow, possibly reaching completed transactions. The IRS calls these strategies “abusive,” but that is a label for aggressive tax avoidance that stretches the rules past their purpose. It is not an accusation of tax evasion.

3. How was a “351 ETF conversion” supposed to work, and why does the IRS say it fails?

An investor contributed appreciated securities to a newly formed ETF, intended as a tax-free Section 351 transfer. As part of the same plan, the ETF took in cash or other securities from an authorized participant, typically a big bank or broker-dealer. Shortly after, the ETF paid that participant back with the securities the investor originally contributed, using a separate rule, Section 852(b)(6), to avoid recognizing gain. The IRS did not argue that any technical requirement of Section 351 was missed. It applied “substance over form” and “step transaction” principles, treated the ETF as a conduit, and looked at the whole plan as one transaction. In its view, the investor made a taxable exchange. In plain English, you effectively sold your stock to the bank and then bought into the ETF.

4. Does the ruling apply to deals I already completed?

Possibly. Ropes & Gray noted the ruling carries no effective date, which suggests the IRS sees it as existing law that can reach completed transactions. Fox Rothschild said investors who used the strategy may owe tax now, and that whether a deal is caught turns on whether the steps were part of a “plan” and whether the portfolios are “materially different.” Beyond back taxes and interest, tax preparers face accuracy-standard and penalty risk if they report tax-free treatment for a transaction matching the ruling without solid authority or disclosure. If you completed a transaction like this, have your CPA review how it was structured.

5. Are all Section 351 ETF transactions now off the table?

No. The notice expresses no view on Section 351 transactions that seed a new ETF with assets matching its strategy and that the fund expects to keep. The open questions are real. The ruling describes the redemption as happening “shortly thereafter” without drawing a bright line, and “materially different” is left undefined. A well-structured version may survive, but a clever sequence of steps is the part most likely to get challenged.

6. Does this affect my regular ETFs, index funds, or tax-loss harvesting?

Nothing I found suggests it does. The notice says that, except as specifically discussed, it doesn’t address ordinary in-kind ETF redemptions. Traditional tax-loss harvesting also falls outside the strategies it identifies. People who simply buy and hold index ETFs are not described as affected.

7. What other strategies did the IRS flag?

Notice 2026-62 names the Section 351 seeding transaction plus four other ETF strategies that lean on Section 852(b)(6), and three categories of “tax-aware” strategies used mainly by partnerships and separately managed accounts. One variation involves a partnership “exchange fund” that is made diversified and then does a 351 conversion into an ETF. Others include box-spread funds and strategies that dodge dividends or avoid recognizing gains on assets like commodities and digital assets. Unlike the 351 conversion, the notice doesn’t rule these taxable. It says Treasury and the IRS are considering further guidance, which could apply retroactively.

8. What should I do if I’ve done this or been pitched something similar?

If you’ve contributed stock to a new ETF to diversify, hold an exchange fund or “tax-aware” product, or are being pitched a “tax-free” way to diversify, start by reviewing what you own with your CPA. Before buying anything that promises to avoid tax, ask:

• Does this rely on a specific tax code section, and has the IRS ever commented on it?
• What happens to me if the IRS says it doesn’t work?
• Does it still make sense if I take the tax benefit out of the picture?
• Who gets paid if I say yes?