Quick version: Wealthy investors had been moving portfolios of highly profitable shares into brand-new ETFs to spread their money around without paying tax on the profit. On 28 September the IRS said that move is a taxable sale. Ordinary ETF investing is untouched.

What even is this?

  • ETF (exchange-traded fund): a basket of investments you buy and sell like a single share, such as an S&P 500 fund.
  • Capital gain: the profit when you sell something for more than you paid. Tax is normally due only when you sell (see realised vs unrealised gain).
  • Section 351: a rule that lets you hand property to a new company in exchange for its shares without paying tax, because you haven't really cashed in. An ETF counts as a company, and for a fund the rule only works if what you hand over is already spread across enough different stocks.
  • Section 852(b)(6): when an ETF pays out a departing investor with shares instead of cash, the ETF pays no tax on the profit in those shares. It is why ETFs rarely hand investors a tax bill.

The story

What happened. Say you own 30 stocks you bought for $1 million and they are now worth $10 million. You would rather hold a cheap index-style fund, but selling means a $9 million gain and, at the 20% top federal rate, about $1.8 million of tax.

The "351 conversion" was built for this. You, often with other investors, hand your shares to a new ETF and get ETF shares back, tax-free under section 351. Soon after, a large trading firm (an "authorised participant", one of the firms that create and cash in ETF shares) buys into the ETF with stocks that fit the fund's strategy, then cashes out and receives your old stocks. The ETF pays no tax on handing them over (section 852(b)(6)). Result: you own the fund you wanted, and nobody has paid tax on the $9 million gain.

On 28 September the IRS and Treasury issued Revenue Ruling 2026-20: the deal is judged as a whole, by what really happened, not the label on each step. Because the plan was always for your shares to end up with the trading firm, the IRS treats it as if you swapped your shares with that firm directly. That is a taxable exchange, so the $9 million gain is taxed.

Left alone: everyday ETF trading, and new ETFs seeded with shares that fit the fund's strategy and stay in it.

A companion notice, Notice 2026-62, lists other strategies under review, including a partnership version of the trick, ETFs built on options trades called box spreads, and derivatives trades that funds use to produce capital gains plus ordinary losses (losses that can cut tax on salary-type income, which is worth more). The IRS says it may label some of these "listed transactions" or "transactions of interest", which forces the people involved to report them, and that future guidance could reach deals already done.

Why now. The market grew fast. A tracker run by Tax Alpha Insider counts more than 100 ETFs seeded this way since 2021, with over $20 billion of launch assets, according to InvestmentNews. It follows a public warning from Treasury officials in July.

What it means for funds

For private fund managers: the notice is not only about ETFs. It names the derivatives-based "tax-aware" strategies that investment funds run. Managers selling them should expect investor questions and, possibly, mandatory reporting to the IRS.

For investors with big old gains: people holding long-held, highly profitable portfolios were the natural market for these conversions, and those with one large stock had turned to the partnership version. Both routes now carry real tax risk, so switching may mean paying the tax or spreading sales over several years.

Why you should care

If you own an ETF in a pension or brokerage account, nothing changes for you. The bigger lesson is how the IRS thinks: lining up several legal steps does not make a sale disappear if the plan, from the start, was to sell.

What to watch next

Comments on the notice are due by 28 October 2026. Then watch whether 351 conversions get the "transaction of interest" label, whether the partnership version gets its own ruling, and whether Congress returns to a past idea of ending the ETF tax break in section 852(b)(6) altogether.

Sources — go double-check us

This is plain-English information, not tax advice.