The IRS Is Taking Aim at a Strategy That Turns Stock Portfolios Into ETF Shares Tax-Free

Picture an investor with a $1 million stock portfolio carrying $700,000 of built-in gain. Selling it all to diversify would hit the full gain with the top 20% long-term capital-gains rate plus the 3.8% net investment income tax. That federal bill comes to about $166,600, before any state tax.

Some advisors have proposed a way around that bill called the “§ 351 conversion transaction.” On September 28, 2026, Treasury and the IRS took aim at it in Notice 2026-62. The agencies said these “are not the result of conventional, long-established tax planning that is consistent with the intent of Congress.”

Section 351 Offers Tax Deferral, With a Diversification Guardrail

Section 351 lets you move property into a corporation in exchange for its stock without paying tax on the built-in gain, as long as certain requirements are met. For tax purposes, an ETF is a “corporation that intends to qualify as a regulated investment company.”

The safeguard is the investment-company rule in § 351(e). A transfer that diversifies your holdings gets taxed. But if you bring a portfolio that is already diversified, the transfer doesn’t count as diversifying. Under the notice’s test, “diversified” means no more than 25% of the portfolio sits in any one issuer and no more than 50% sits in five or fewer issuers.

How an ETF Quietly Swaps Out Your Old Stocks

The swap runs on three pieces of everyday ETF plumbing:

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

When an authorized participant redeems shares, the ETF pays out securities instead of cash. The notice says “often, the ETF distributes appreciated securities,” and under §§ 852(b)(6) and 311(a) the fund recognizes no gain when it does. The IRS says this notice does not address those routine redemptions.

The conversion strings these steps together. Investors move appreciated securities into a newly formed ETF. The ETF then issues creation units to an authorized participant in exchange for cash or securities that fit its strategy. Next, it redeems those units by handing back the investors’ original stocks. The fund ends up holding “a materially different portfolio,” and the notice says these steps “may take place shortly after” the contribution. The IRS’s verdict: §§351 and 852(b)(6) are being combined “to achieve a result that neither provision was designed to produce.”

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

Alongside the notice, the IRS issued Rev. Rul. 2026-20. It finds 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 “undertaking a taxable exchange under §1001 with AP of the securities contributed to ETF by Investor that are used by ETF to redeem AP.” The ruling says the result is the same when several investors take part.

Return to the opening example. If all of that portfolio leaves through the redemption, the investor owes about $166,600, the same as a plain sale. The notice does carve out one case: seeding a new ETF with assets that fit its strategy and that the fund plans and expects to keep.

Partnership Workaround Lands on the Radar Too

A related “partnership variation” targets investors whose holdings are too concentrated to pass the diversification test. Investors put their appreciated stock into a partnership that holds at least 20% of its value in assets other than stocks or securities. That structure is meant to keep the partnership outside investment-company treatment, so the contributions qualify for tax-free treatment under §721(a). The advisor makes sure the partnership’s own portfolio counts as diversified. Then the partnership runs the ETF conversion.

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

Important: Meeting the 20% non-stock asset threshold doesn’t guarantee tax-free treatment. The IRS is examining whether these partnership arrangements qualify for nonrecognition under section 721 and may issue further guidance challenging the strategy.

Listed Transaction Status and Retroactive Rules Are Possible

Next steps could include regulations, more notices and revenue rulings, and “the potential identification of a transaction as a transaction of interest or a listed transaction.” Any guidance “could apply prospectively only or retroactively.” The agencies say they plans to “target specific abusive transactions” and “minimize compliance burdens.” The IRS can also challenge these deals on audit under existing law. The notice asks for public comments, including on which similar transactions deserve different treatment.

The investors most exposed are at the very top. 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-Smart Moves That Still Work for Everyday Investors

• Let step-up in basis work. Heirs generally take a basis equal to “the fair market value of the property at the date of the decedent’s death,” which wipes out the built-in gain on stock you never sell.
• Diversify a little at a time. Trimming a concentrated position over several years, and matching sales with harvested losses, spreads the gain out instead of taking it in one hit.
• ETFs can be tax-efficient in taxable accounts. The in-kind redemption process the IRS left alone tends to keep the capital-gains distributions that ETF shareholders receive low.

If you have a concentrated, low-basis position, run the diversification math with a CPA or fiduciary tax advisor before anyone proposed you a shortcut.

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