Two weeks after the Treasury Department and IRS issued Notice 2026-62 and Rev. Rul. 2026-20, tax experts are still parsing the implications for Section 351 ETF conversions. Tim Steffen, managing director and director of advanced planning at Baird Private Wealth Management in Milwaukee, says the guidance targets the most aggressive uses of the strategy, but properly structured deals remain viable for the right clients.
The September 28 guidance also flagged box spread ETFs and other tax-aware strategies, but Steffen was not surprised by the focus on 351 conversions. "They've kind of alluded to this in some prior announcements that some of these strategies were things that they had their eye on," he said in an interview. The IRS is "really addressing some of the most egregious misuses of it or abuses of it," he added, particularly strategies designed solely for tax benefits "without an underlying investment thesis."
What the IRS ruling means for 351 exchanges
Section 351 of the Internal Revenue Code generally allows investors to transfer property to a corporation in exchange for its stock without recognizing capital gains, provided they meet control and diversification tests. A portfolio typically counts as diversified if no single issuer exceeds 25% of its value and the five largest issuers account for no more than 50%.
Rev. Rul. 2026-20 addresses deals where investors seed a new ETF with appreciated securities that don't fit the fund's strategy. The ETF issues shares to an authorized participant for securities that do fit, then quickly redeems those shares in kind using the investors' original holdings. In such cases, the IRS treats the ETF as a conduit and recharacterizes the arrangement as a taxable exchange.
The notice expresses no view on 351 deals that seed a new ETF with assets consistent with its investment thesis that the fund expects to keep. Law firm Ropes & Gray noted the ruling carries no effective date, suggesting the IRS sees it as existing law that can reach completed transactions.
The market has grown quickly: more than 100 ETFs have been seeded in-kind under Section 351 since 2021, representing over $40 billion in AUM, according to Tax Alpha Insider. "If these things are done properly, they are still viable," Steffen said. "It's only the abusive ones that they're really going after. Now, where they draw that line remains to be seen."
Why client interest fades after the headlines
Baird has fielded a steady stream of questions about 351 exchanges over the past year, but Steffen says inbound curiosity rarely develops into action. "When people read the headlines of what these are, they get very interested," he said. "I think most of the initial wave of interest in these died off some once people better understood how it worked."
Advisors who call him have usually read careful coverage of the strategy, but questions that start with clients "tend to come from the less reputable sources. The people who promote the benefits without talking about the details. And that's where people are getting misled."
The most common misconception involves a single concentrated holding. "So often it's somebody who has stock in one company that has done really well, and they're thinking they can trade that stock for an ETF," Steffen said. "But ... it has to be a portfolio of stocks that have to be diversified." Minimums are usually larger than many clients will commit, and Baird is concerned about the funds themselves, which launch with no track record. "These don't have any history behind them," he said. "You don't have anything we can look to as to how they're going to be run."
Tax deferral, not tax elimination
Steffen emphasized that many clients misread what the strategy actually does. "This is simply a tax deferral technique. It's not a tax elimination technique," he said, describing it as a diversification tool that doesn't trigger taxes right away. "There's other good ways to do that [tax deferral]. This one isn't the one that works for most people."
Baird itself doesn't offer 351 products, and Steffen said every advisor or client he's walked through the brass tacks came away feeling it wasn't a fit, though he emphasized "[that] doesn't mean it can't happen. It just hasn't happened to me yet."
In the meantime, he expects sponsors touting 351 conversion strategies are in scramble mode, working to show the IRS where legitimate deals sit while reassuring prospective clients that "what they're coming after is not what they do."
For advisors, Steffen offered a firm message: "If you're going to promote a product that has tax advantages, you need to understand the disadvantages too. How can these things go right and how can they go wrong? The days of advisors saying, that's a tax question, I can't answer that, are gone."
