IRS Targets ETF Tax Strategies Used by Wealthy Clients
(Bloomberg) — In recent years, Wall Street has turned a quirk of ETF plumbing into a $23 billion business helping wealthy investors reshape appreciated stock portfolios without immediately triggering a capital-gains tax bill.
On Monday, the Internal Revenue Service delivered the clearest threat yet to the trade, targeting its most aggressive forms and setting off a scramble among ETF professionals, lawyers and advisers over a deceptively simple question: How much can a portfolio change, and how quickly, before the transaction becomes taxable?
That question is hardly theoretical. Consider the Twin Oak Active Opportunities ETF. It launched in February 2025 with about $450 million in assets, including large stakes in two high-flying tech stocks. Within a week, those holdings were gone, replaced by an S&P 500 fund. Nearly half the portfolio had changed.
Tax was the point — both in launching the ETF and reshaping it. The investors behind the fund contributed appreciated securities, then used the ETF’s in-kind trading machinery to alter the portfolio without incurring capital-gains tax.
That looks like the kind of transformation the Treasury is now trying to police. In its ruling Monday, the IRS drew new boundaries around so-called 351 conversions, targeting cases where as part of a prearranged plan, an ETF effectively acts as a conduit for turning one set of appreciated securities into a materially different portfolio without an immediate tax bill.
In such cases, the tax treatment can be “recharacterized in accordance with its substance,” the IRS said in the revenue ruling, a type of guidance where it applies existing laws to a situation. Put simply: Depending on the scenario, a conversion that quickly and significantly alters a portfolio could end up triggering a capital-gains tax bill after all.
The guidance was long expected by the ETF industry, after Treasury officials first signaled last year that they were studying 351s. The issue now is translating it into precise guardrails.
“There is considerable uncertainty about timing — specifically, how long an ETF may hold the contributed securities before distributing them if the later distribution was contemplated as part of the original plan,” said Jeffrey Hochberg, a partner at Sullivan & Cromwell LLP.
The Investment Company Institute, an industry body for fund managers, said it was assessing the guidance and its implications, and plans to respond to the agency.
Targeting Tax Alpha
The 351 ruling was accompanied by a sweeping IRS notice that signaled a potential crackdown on a whole range of so-called “tax alpha” trades.
These investment strategies have been concocted by Wall Street to help slash tax bills for a growing class of millionaires and billionaires following years of rising markets.
Read more: Tax-Slashing ‘Holy Grail’ Popularized by AQR Dealt IRS Warning
The $16 trillion US ETF industry has been a core part of that effort because of the vehicles’ underlying tax efficiency. ETFs can offload securities to a market maker in exchange for shares, in a so-called in-kind redemption that doesn’t trigger capital-gains tax.
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At a July industry seminar, Treasury officials stressed this mechanism, known as creation-redemption, isn’t at issue. Instead they object to transactions that combine it with other tactics to achieve outcomes at odds with the law’s intent.
“Nothing in the Notice or Revenue Ruling should chill the market for using 351 ETF seeds in an appropriate manner,” said Raymond Holst, a tax lawyer at Practus LLP, which has worked on a number of such conversions.
Conversions have been rising in popularity for about two years, and had just started to attract major asset managers including Dimensional Fund Advisors and AllianceBernstein. The structure has also been popularized by firms like Alpha Architect and Cambria Investment Management, which syndicate the seed capital by asking multiple financial advisers to contribute.
In the case of the Twin Oak ETF, with ticker TSPX, the fund was launched with about $200 million of embedded gains, a filing shows, roughly equal to the value of the two tech stocks in its seed portfolio. In a week, those two holdings — in Snowflake Inc. and Datadog Inc. — were replaced with an index fund using so-called “heartbeat trades,” where artificial flows are created to support a large in-kind redemption.
A representative for Twin Oak ETF Company declined to comment.
Combining Tactics
In the separate notice — in which the IRS sought additional details on several types of transactions — the agency also detailed a particular kind of deal that combines a 351 with a so-called exchange fund. That’s a vehicle which pools the appreciated stock of multiple investors in exchange for shares of a partnership.
In a case last year, a company called Cache created an exchange fund and then contributed its shares to an Alpha Architect ETF in a 351 transaction. That combination helped solve liquidity issues connected to the exchange fund while fulfilling the diversification requirements for the 351 conversion.
Cache didn’t immediately respond to a request for comment.
To Wes Gray, the CEO of Alpha Architect, the ruling still leaves room for 351 conversions when an ETF is seeded with securities it genuinely intends to hold as part of its investment strategy, rather than assets contributed mainly to be quickly swapped out. The IRS is targeting the most egregious cases.
“You probably shouldn’t take 100 US stocks, dump into an ETF, and turn it into international bonds a week into the trade,” Gray said.
