Blog · 14 October 2026

Section 351 ETF Conversions After Rev. Rul. 2026-20 and Notice 2026-62: What US CPA Firms Should Tell Clients

By Keshav Bansal, CA

A Section 351 ETF conversion was sold as a way to swap a concentrated, highly appreciated stock portfolio for shares of a diversified exchange-traded fund without paying tax on the built-in gain. On September 28, 2026, Treasury and the IRS issued Rev. Rul. 2026-20, which treats a prearranged version of that deal as a taxable exchange, together with Notice 2026-62, which describes several other ETF and “tax-aware” fund strategies the government may target next. Dechert’s October 8, 2026 OnPoint notes the ruling could be applied to contributions made before it was published. Comments on the Notice are due October 28, 2026.

Realization vs. nonrecognition: the starting point

Notice 2026-62 restates the familiar rule in §1001 and Treas. Reg. §1.1001-1(a): gain is generally realized when property is exchanged for other property “differing materially either in kind or in extent,” and §1001(c) says realized gain is recognized unless the Code provides otherwise. Swapping one portfolio of appreciated stocks for a different portfolio is, in principle, a taxable sale.

Section 351 is one of those exceptions. Under §351(a), no gain or loss is recognized when property is transferred to a corporation solely for its stock and the transferors control the corporation (as defined in §368(c)) immediately afterward. The investor’s basis carries over into the stock, so §351 defers the gain; it does not forgive it. Rev. Rul. 2026-20 quotes Portland Oil Co. (1st Cir. 1940): §351 covers “a mere change in the form of ownership.”

The §351(e) investment-company exception

Section 351(e) switches off nonrecognition for a “transfer of property to an investment company.” Under Treas. Reg. §1.351-1(c)(1), a transfer is to an investment company if it results in diversification of the transferors’ interests and the transferee is a RIC, a REIT or a corporation with more than 80 percent of its assets in stock and securities. An ETF taxed as a RIC sits squarely in that definition.

The workaround the promoters relied on is §1.351-1(c)(6)(i): a transfer is not treated as diversifying if each transferor contributes a portfolio that is already diversified. Per the Notice, a portfolio is generally diversified if no more than 25 percent of its value is in any one issuer and no more than 50 percent is in five or fewer issuers (the §368(a)(2)(F)(ii) tests). So an investor whose portfolio cleared those lines could argue §351(e) did not apply.

Why ETFs are tax-efficient: §852(b)(6)

Like any corporation, a RIC generally recognizes gain under §311(b) when it distributes appreciated property. Section 852(b)(6) turns that rule off for a RIC distribution “in redemption of its stock upon the demand of the shareholder.” ETFs use this daily: authorized participants (APs) buy and redeem blocks of shares called creation units, and the ETF chooses which securities, often appreciated ones, to hand out. Except for the strategies it describes, the Notice expresses no view on these ordinary redemptions.

What Rev. Rul. 2026-20 holds

The ruling’s facts: as part of a plan, an investor transfers an appreciated, diversified portfolio to a newly formed ETF that intends to be a RIC. Under the same plan, the ETF issues shares to an AP for securities (or cash) consistent with the ETF’s investment thesis and, shortly afterward, redeems those shares under §852(b)(6) using the investor’s securities. When the steps are finished, the ETF holds a portfolio that matches its thesis and is materially different from what the investor contributed.

Applying substance-over-form and step-transaction principles (citing Court Holding Co., Kuper and Rev. Rul. 71-336), the IRS concluded the ETF was “merely a conduit” for moving the securities from the investor to the AP. Holding: the investor is treated as making a taxable exchange under §1001 with the AP of the contributed securities the ETF used to redeem the AP, and the result is the same with multiple investors. As Venable observes, the IRS did not say the §351 tests failed, and there is no holding-period or percentage safe harbor; the plan for the contributed assets is the key fact.

Important limit: the Notice expressly does not address, and expresses no view on, using §351 to seed a new ETF with assets that are consistent with its investment thesis and are intended and expected to be retained absent a substantial change in circumstances.

Notice 2026-62: the other strategies on the list

Beyond the §351 conversion, the Notice describes:

• Partnership exchange funds: investors with non-diversified positions contribute to a partnership holding at least 20 percent non-securities assets to claim §721(a) treatment, and the partnership then does a §351 conversion.
• Box spread funds: ETFs earning a short-term-rate-like return on box spreads, then redeeming out appreciated options.
• Record date and RIC income test strategies: dodging dividends from acquired ETFs, or non-qualifying income on commodities or digital assets, via redemptions.
• Identified mixed straddles under §1092(a)(2) pairing §988 ordinary forwards with §1256 capital futures.
• Same-day §988(a)(1)(B) elections: electing capital treatment, with hindsight, only for foreign currency forwards closed at a gain that day.
• Selective NPC terminations: terminating appreciated swaps for claimed capital gain while holding loss swaps for ordinary expense.

As EY points out, the Notice itself does not change any rules or designate anything as a listed transaction or transaction of interest. But it says future guidance may include that identification, “could apply prospectively only or retroactively,” and that the IRS may challenge these strategies on examination under existing law.

What US CPA firms should do now

• Ask about past contributions. Identify clients who contributed appreciated securities in kind to a newly launched ETF and learn what the ETF did with them afterward.
• Get the plan documents. Seeding agreements and redemption records show whether contributed securities were meant to stay.
• Re-examine basis reporting. If a past deal fits the ruling, the client may have a recognized gain that was never reported; discuss amended-return and penalty exposure with tax counsel. Our post on §6662 accuracy-related penalties after Clear Sky covers how penalties follow recharacterized deals.
• Review private-fund K-1s. Exchange funds and tax-aware funds pairing capital gains with ordinary losses deserve questions now. The SIH Partners qualified-dividends case is another 2026 reminder that tax savings far exceeding pretax profit invite scrutiny.
• Don’t confuse the guidance numbers. Rev. Rul. 2026-20 (ETF conversions) is different from Rev. Proc. 2026-20 on crypto staking by investment trusts.
• Diarize October 28, 2026. Comments go to regulations.gov (IRS-2026-1255) or by mail and should reference Notice 2026-62; late comments may not be considered if that would delay guidance.

Where this fits for Tax Brew readers

Tracing basis through fund statements and reconciling 1099-Bs with K-1s is detail work that piles up fast. If you need support with tax prep and bookkeeping, see how we work with US CPA firms or email info@taxbrewglobal.com.

Check current guidance: this article summarizes Rev. Rul. 2026-20 and Notice 2026-62 (issued September 28, 2026, per the IRS documents and Dechert’s October 8, 2026 OnPoint), with commentary from EY and Venable; IRC §§351, 852(b)(6), 1001 and Treas. Reg. §1.351-1(c). Confirm the Code, regulations and current IRS guidance before advising. This is general information, not tax or legal advice. Sources as of 14 October 2026.