Section 351 ETF Conversions After Revenue Ruling 2026-20: What the IRS Said and What It Means for Investors

On September 28, 2026, the IRS issued Revenue Ruling 2026-20 and Notice 2026-62, its first formal guidance on Section 351 ETF conversions. The ruling holds that one common version of the transaction, in which an investor seeds a new ETF with appreciated securities that the fund then passes out to a market maker, is in substance a taxable exchange for those securities. The notice flags several related fund strategies for further review and warns that later guidance could apply retroactively. The guidance does not condemn every Section 351 transaction: seeding a new ETF with assets that fit its strategy and are meant to stay in the fund is expressly outside the notice. Investors who have completed a conversion, or are considering one, should review the facts with their tax advisers now.

What is a Section 351 ETF conversion?

Section 351 of the Internal Revenue Code lets property owners transfer assets to a corporation in exchange for its stock without recognizing gain, provided the transferors together control at least 80% of the corporation immediately afterward. An ETF that is taxed as a corporation and qualifies as a regulated investment company can use this rule at launch: investors contribute portfolios of appreciated stocks and receive ETF shares, deferring the gain.

There is a limit. Section 351(e) denies tax-free treatment when a transfer to an investment company diversifies the transferor's holdings. Under the regulations, a portfolio that is already diversified, with no more than 25% in any one issuer and no more than 50% in any five issuers, can be contributed without triggering that rule. That is why these transactions are generally offered to investors with broad portfolios, although the notice describes a partnership variation marketed to holders of concentrated positions.

The tax appeal is what can happen next. ETFs can redeem shares from market makers, known as authorized participants, by handing over securities rather than cash, and Section 852(b)(6) lets the fund do so without recognizing gain. A fund seeded with an investor's low-basis stocks can use those redemptions to move the stocks out and replace them with assets that fit its strategy, repositioning the portfolio without a taxable sale at either the fund or the investor level. One industry tracker counts more than 100 ETFs seeded in kind under Section 351 since 2021, not all of which follow the pattern the IRS has now challenged.

What does Revenue Ruling 2026-20 hold?

The ruling describes a single plan with three steps. An investor transfers a diversified portfolio of appreciated securities to a newly formed ETF. The ETF issues shares to an authorized participant, which pays with securities that fit the fund's investment thesis or with cash to buy them. Shortly afterward, the ETF redeems the authorized participant's shares using the investor's securities. At the end, the fund holds a portfolio that is materially different from what the investor contributed.

Applying the step-transaction doctrine and substance-over-form principles, the IRS treats the ETF as a conduit. The investor is treated as having made a taxable exchange under Section 1001 with the authorized participant of the contributed securities that the ETF used to redeem the participant. The ruling states that the result would be the same with multiple investors.

Three features of the ruling deserve emphasis. First, the taxable exchange reaches the securities used to redeem the authorized participant, not necessarily everything the investor contributed. Second, the ruling contains no effective date, and published revenue rulings apply retroactively unless they say otherwise, so it may be applied to transactions completed before September 28. Third, it leaves important questions open, including what "shortly thereafter" and "materially different" mean, how basis and holding periods work after the recharacterization, and how to identify which securities were deemed exchanged.

What else does Notice 2026-62 flag?

The notice describes several strategies the IRS is studying and asks whether they should be addressed in future guidance. They include:

• Section 351 conversion transactions generally, and a variation in which investors with concentrated positions first contribute to a partnership exchange fund that then performs the conversion.
• ETFs built around box spreads, including variants using straddles, designed to turn interest-like returns into deferred capital gain.
• Record-date strategies in which an ETF that holds other ETFs tracking the same index distributes an underlying ETF's shares in redemptions just before its dividend record date and replaces them with a similar ETF.
• ETFs that hold commodities or digital assets and distribute them in in-kind redemptions so the gains do not count against the 90% income test for regulated investment companies.
• "Tax-aware" strategies run through partnerships or separately managed accounts, such as mixed-character straddles, foreign currency elections made with hindsight, and selective termination of swaps.

The notice also states what it does not address, and expresses no view on: ordinary ETF creations and redemptions, except as it discusses, and a Section 351 transaction that seeds a new ETF with assets consistent with its investment thesis that are intended and expected to remain in the fund absent a substantial change in circumstances. That is a statement of scope, not an endorsement. The notice acknowledges that year-end loss harvesting is legitimate and that a "tax-aware" label alone is not a concern.

The notice does not designate any strategy as a listed transaction or transaction of interest, but it says future guidance may do so and could apply prospectively or retroactively. Comments were due October 28, 2026.

What should investors do now?

If you completed a conversion.Gather the transaction documents and determine, with the fund sponsor's help, which of your contributed securities left the fund through authorized participant redemptions and when. That is the information a tax adviser needs to assess exposure under the ruling. The decision whether to amend a return, file a disclosure, or maintain the original position depends on the facts and on penalty considerations: a revenue ruling is not binding on courts, but taking a position contrary to one can expose you to accuracy-related penalties unless the position is adequately disclosed or has strong support. This is a question for your CPA or tax counsel, not one to resolve from general commentary.

If you are considering one.The narrow path the notice leaves open, seeding a fund with assets it intends to keep, is a different transaction from one designed to reposition a portfolio through redemptions. Ask the sponsor how its structure differs from the facts in the ruling, what it expects to happen to the contributed securities, and whether it will furnish the records you would need on examination. Weigh the deferral against the remaining uncertainty and against alternatives, such as staged sales, direct indexing with loss harvesting, charitable gifts of appreciated shares, or the exchange funds and structured approaches used for concentrated positions.

If you simply own ETFs.For most ETF investors nothing changes; the notice does not address the ordinary creations and redemptions that make most ETFs tax efficient. If you own a fund that relies on one of the flagged strategies, such as a box-spread ETF, its tax treatment could change under future guidance.

A worked example: what the ruling could mean in dollars

The following is a hypothetical illustration of one reading of the ruling, simplified and ignoring state tax. An investor contributes a diversified $5,000,000 portfolio with a $2,000,000 basis to a new conversion ETF. Within weeks, the fund uses $2,000,000 of those securities, with an $800,000 basis, to redeem an authorized participant, and it uses the participant's securities to build its target portfolio.

Under the form of the transaction, the investor recognizes no gain. Under Revenue Ruling 2026-20, the investor is treated as having exchanged the $2,000,000 of securities used in the redemption, recognizing $1,200,000 of gain. Assuming long-term gain taxed at the top 20% rate plus the 3.8% net investment income tax, that is about $285,600 of federal tax for the year of the transaction, plus interest if that year is already filed. The ruling's holding addresses only the securities used in the redemption; how the IRS would treat the remaining $1,800,000 of gain is not addressed, and the IRS could examine the transaction on other grounds. How basis in the ETF shares would be adjusted is one of the questions the ruling leaves open. The figures are hypothetical.

Key numbers at a glance

Frequently asked questions

What is a Section 351 ETF conversion?An investor contributes a diversified portfolio of appreciated securities to a newly formed ETF in exchange for its shares, relying on Section 351 to defer the gain. The fund may then use in-kind redemptions to move low-basis securities out and reposition the portfolio.

Are Section 351 ETF conversions still allowed?Yes, but with new risk. Revenue Ruling 2026-20 treats one structure as a taxable exchange of the securities the fund uses to redeem market makers. Notice 2026-62 states that it does not address seeding a new ETF with assets consistent with its strategy that are intended to stay in the fund.

Does the ruling apply to conversions completed before September 2026?It may. The ruling has no effective date, and published revenue rulings generally apply retroactively unless they state otherwise. Investors who completed a conversion should review it with a tax adviser.

Does this affect ordinary ETF investors?For most, no. The notice does not address ordinary ETF creations and redemptions. Funds built on the flagged strategies, such as box-spread ETFs, could be affected by future guidance.

Is a Section 351 conversion now a listed transaction?Not yet. Notice 2026-62 says future guidance could identify some strategies as listed transactions or transactions of interest, which would bring disclosure obligations, and that such guidance could apply retroactively.

Sources

• Internal Revenue Bulletin 2026-43: Revenue Ruling 2026-20 and Notice 2026-62, Internal Revenue Service
• Notice 2026-62, Internal Revenue Service
• 26 U.S. Code § 351: Transfer to corporation controlled by transferor, Legal Information Institute, Cornell Law School
• 26 U.S. Code § 852: Taxation of regulated investment companies and their shareholders, Legal Information Institute, Cornell Law School
• 26 CFR § 1.351-1: Transfer to corporation controlled by transferor, Legal Information Institute, Cornell Law School
• Treasury and IRS guidance target certain ETF transactions and other investment fund strategies, Morgan Lewis
• IRS targets "351 conversion transactions" and flags various other ETF/investment fund strategies as possibly abusive, Mayer Brown