IRS Targets a Tax-Free Method for Turning Stock Holdings Into ETF Shares

A tax workaround that could let wealthy investors eliminate billions in built-in gains without triggering a federal tax bill has now drawn scrutiny from Treasury and the IRS, which are indicating they may move ahead with new rules.

Picture an investor with a $1 million stock portfolio that carries $700,000 in embedded gain. Selling the holdings to diversify would trigger tax on the full gain at the top 20% long-term capital gains rate, plus the 3.8% net investment income tax. The federal tax alone would come to roughly $166,600, before any state taxes.

Some advisers have promoted a method to avoid that bill known as a “§ 351 conversion transaction.” Treasury and the IRS moved against the strategy in Notice 2026-62, saying these deals are “not the result of conventional, long-established tax planning that is consistent with the intent of Congress.”

Section 351 Can Defer Tax, But Diversification Changes the Outcome

Section 351 allows property to be transferred to a corporation in exchange for stock without immediate tax, provided certain conditions are met. For tax purposes, an ETF is treated as a corporation that seeks to qualify as a regulated investment company.

The key limitation is the investment-company rule in § 351(e). If a transfer diversifies an investor’s holdings, it is taxable. But if the portfolio is already diversified, the transfer is not treated as diversification. Under the notice, a portfolio is considered diversified if no more than 25% is invested in any one issuer and no more than 50% is invested in five or fewer issuers.

How an ETF Can Replace Old Stocks Without an Obvious Sale

The strategy relies on several standard ETF mechanics:

• Authorized participants are large trading firms that transact directly with the fund.
• Creation units are the large blocks of ETF shares those firms buy and redeem.
• Net asset value (NAV) is the per-share value of the fund’s holdings.

When an authorized participant redeems shares, the ETF distributes securities rather than cash. The notice says ETFs “often” distribute appreciated securities, and under §§ 852(b)(6) and 311(a) the fund does not recognize gain in that process. The IRS said the notice does not affect those ordinary redemptions.

The conversion strategy combines those steps in a different way. Investors contribute appreciated securities to a newly formed ETF. The ETF then issues creation units to an authorized participant in exchange for cash or securities that fit its investment plan. After that, the ETF redeems those units by handing back the investors’ original stocks. The fund is left with “a materially different portfolio,” and the notice says those steps may occur soon after the contribution. The IRS’s view is that §§ 351 and 852(b)(6) are being used together “to achieve a result that neither provision was designed to produce.”

Revenue Ruling 2026-20 Treats the Transfer as a Taxable Sale

In a separate move, the IRS issued Rev. Rul. 2026-20. It says the ETF “was merely a conduit through which securities transferred from Investor to AP pursuant to the plan.” Under the ruling, the investor is treated as making a taxable exchange under §1001 with the authorized participant involving the securities the ETF uses to redeem AP. The IRS says the same result applies even when multiple investors are involved.

Returning to the earlier example, if the entire portfolio is distributed through the redemption, the investor would owe about $166,600, the same as on a direct sale. The notice does leave room for one exception: seeding a new ETF with assets that fit its strategy and that the fund plans and expects to keep.

Partnership-Based Version Also Draws Attention

A related “partnership variation” is aimed at investors whose holdings are too concentrated to satisfy the diversification test. In that structure, investors contribute appreciated stock to a partnership that holds at least 20% of its value in assets other than stocks or securities. The goal is to keep the partnership outside investment-company treatment so the contribution qualifies for tax-free treatment under §721(a). The adviser then makes sure the partnership’s own portfolio qualifies as diversified before the partnership carries out the ETF conversion.

Treasury and the IRS said they are considering guidance that would deny tax-free treatment to these contributions or recharacterize them “in a manner that reflects the proper substance” of the transaction.

Important: Meeting the 20% non-stock-asset threshold does not guarantee tax-free treatment. The IRS is reviewing whether these partnership arrangements qualify for nonrecognition under section 721 and may issue further guidance challenging the approach.

Further Guidance, and Possibly Retroactive Action, Could Follow

Possible next steps include regulations, additional notices, revenue rulings, and “the potential identification of a transaction as a transaction of interest or a listed transaction.” Any guidance could apply only going forward or could be applied retroactively. The agencies said they plan to target specific abusive transactions while minimizing compliance burdens. The IRS can also challenge these arrangements on audit under existing law. The notice seeks public comment, including on which similar transactions should be treated differently.

The investors most exposed are at the top end of the wealth spectrum. In the second quarter of 2026, the top 1% held 50.9% of household stocks and mutual fund shares outside workplace retirement plans, according to Federal Reserve data.

Tax-Efficient Steps That Still Make Sense for Everyday Investors

• Use step-up in basis when available. Heirs generally receive a basis equal to “the fair market value of the property at the date of the decedent’s death,” which can erase built-in gains on stock that is never sold.
• Trim concentrated positions gradually. Selling over several years, and pairing sales with harvested losses, can spread out the tax hit instead of realizing it all at once.
• ETFs can still be tax-efficient in taxable accounts. The in-kind redemption process left untouched by the IRS generally helps keep ETF capital-gains distributions low.

If you own a concentrated position with a low tax basis, review the diversification math with a CPA or fiduciary tax adviser before considering any shortcut.