The U.S. Treasury and IRS have recently issued warnings targeting a tax avoidance strategy used by wealthy investors involving the creation of new ETFs through Section 351 exchanges. This method allows investors to transfer highly appreciated stocks to a newly formed ETF without immediately recognizing capital gains taxes, effectively deferring tax liabilities. Treasury Secretary Scott Bessent emphasized that the government is serious about cracking down on transactions engineered to dodge taxes or exploit loopholes in the federal tax code, making it clear that certain ETF conversions designed for tax avoidance will not be permitted under existing law.

Section 351 of the tax code permits property transfers to a corporation in exchange for its stock without recognizing capital gains, provided certain conditions are met, such as limits on the concentration of assets in the portfolio. While this remains an accepted practice for legitimate restructuring, the IRS and Treasury have raised concerns about ETFs being used as mere conduits to obtain diversification and avoid taxes without economic substance. These actions follow observations that, since 2024, over $22 billion in ETFs were formed through such strategies, deferring up to $6.5 billion in capital gains and accelerating scrutiny from tax authorities.

The crackdown primarily impacts ultra-high-net-worth individuals, as creating an ETF to employ Section 351 exchanges involves significant costs and is viable mostly for investors with tens of millions of dollars in appreciated stock. However, the IRS notice clarifies that not all Section 351 transactions are suspect and recognizes legitimate uses such as gifting ETF shares or converting separately managed accounts to improve tax efficiency. Nevertheless, tax experts anticipate new restrictions and gray areas, especially regarding the timing of transactions after transferring securities to ETFs, signaling that further guidance is needed to specify acceptable practices.

In addition to ETF-related strategies, the IRS and Treasury are scrutinizing related tax-deferment techniques involving partnerships and options-based strategies like "box spreads." The government has invited public commentary on these issues through the end of October 2026. While regulators do not intend to disrupt the fundamental mechanics of ETF creation and redemption, they are likely to impose guardrails on aggressive tax engineering strategies. Investors are encouraged to explore other tax planning tools such as exchange funds or charitable remainder trusts to manage capital gains exposure within evolving regulatory parameters.