Industry compliance experts are advising financial advisors and investors to meticulously adhere to the underlying intent of tax regulations when engaging in exchange-traded fund (ETF) related conversions, a strategy increasingly employed for tax planning purposes. The Internal Revenue Service (IRS) recently issued guidance aimed at curbing perceived abuses of Section 351 conversions, which allow for the transfer of asset portfolios into ETFs without immediate capital gains tax liability. While the new guidance may not directly impact advisors and investors utilizing these conversions for legitimate diversification and ongoing portfolio management, it signals a heightened level of scrutiny for those employing them primarily as tax avoidance schemes.
Rick Wedell, President and Chief Investment Officer of RFG Advisory, highlighted the potential impact of the IRS’s stance. "I think for certain players that were purely marketing this as a tax avoidance strategy, that sale becomes much harder, and they’re going to want to think about whether or not they want to go down that path," Wedell stated. He anticipates a "chilling effect on the industry," which he believes is the intended outcome for the IRS. This sentiment is echoed by compliance professionals who emphasize that the spirit of the law, which permits tax-free transfers for genuine portfolio restructuring, should not be circumvented by artificial transactions designed solely to defer or eliminate taxes.
The core of the issue lies in how Section 351 conversions are executed. These conversions allow individuals or entities to transfer a portfolio of assets, such as stocks and bonds, into an ETF structure without triggering capital gains taxes at the time of transfer. This can be particularly appealing for Registered Investment Advisors (RIAs) managing separately managed accounts (SMAs) for multiple clients. By converting these SMAs into an ETF wrapper, advisors can continue to manage the underlying assets as a cohesive strategy, potentially benefiting from the diversification and efficiency of the ETF structure. Wedell views this as a sensible approach, stating, "the conversion makes sense for managers running SMAs for multiple clients who opt to move a portfolio of assets into an ETF wrapper while continuing to manage it as a strategy."
However, the IRS’s recent guidance appears to target a specific pattern of behavior: investors who utilize the conversion to move assets into an ETF and then promptly liquidate the portfolio, effectively avoiding all taxes during the repositioning phase. This maneuver, in the eyes of the IRS, transforms a legitimate tax-deferral mechanism into an aggressive tax-evasion strategy. "I think what that requires is…whatever your contribution portfolio is and however you were managing that in the past, when you move it into the new ETF structure, you need to continue to do whatever it was that you were doing in the past with that portfolio," Wedell elaborated, underscoring the expectation that the underlying investment strategy should remain consistent post-conversion.
The Rise of Section 351 Conversions and IRS Scrutiny
The popularity of Section 351 ETF conversions has surged in recent years, particularly among RIAs seeking to mitigate concentration risk and enhance diversification. While not a widespread strategy a few years ago, Wedell observed a "large uptick in interest in the past 12 to 18 months." This trend is exemplified by the launch of ETFs by prominent RIAs, including Ritholtz Wealth Management and N10 Holdings (affiliated with Dynasty), aimed at addressing portfolio concentration issues for their clients.
This burgeoning interest did not go unnoticed by regulatory bodies. Earlier this year, Treasury officials publicly flagged their concern over Section 351 conversions, alongside other complex tax strategies such as box-spread ETFs, products designed to offset ordinary income, and funds that avoid dividend income by rapidly trading between ETFs. These pronouncements signaled that regulators were actively examining strategies that appeared to exploit loopholes for tax advantages. The IRS guidance issued this week is a direct consequence of this heightened regulatory focus, aiming to provide clarity and deter abusive practices.
A Legitimate Strategy Under Increased Scrutiny
Tim Steffen, Director of Advanced Planning at Baird Private Wealth Management, described the new guidance as unsurprising, given the Treasury’s prior warnings. He maintains that Section 351 conversions can still be a "legitimate strategy" but expressed caution regarding its promotion by RIAs until the IRS further clarifies the scope of its guidance. "We don’t know how far the IRS is going to push this ruling," Steffen commented. "Are they going to just completely try and shut these things down? That doesn’t seem like the case, but they’re definitely going after the most egregious abusers of it."
The crux of the IRS’s concern appears to be the intent behind the transaction. While the law permits tax-free transfers for genuine portfolio restructuring, the IRS is cracking down on instances where the conversion is merely a conduit for rapid liquidation and tax avoidance. Wedell surmised that the IRS is less interested in portfolio managers who continue to manage assets consistently within the ETF structure, and more focused on investors who quickly sell their portfolios after the conversion. However, a significant ambiguity remains: the IRS has not provided a clear definition of how long an advisor must wait before adjusting portfolios to be considered reasonable. This lack of explicit timelines creates uncertainty for advisors seeking to navigate the new regulatory landscape.
"The fact that they’re providing a guidance rule that is subject to interpretation means, ‘Hey, we see what you’re up to, and you should be aware – follow the spirit of the regulation, not the precise letter of the regulation,’" Wedell emphasized. He urged the industry to consider the original purpose of the regulation: to facilitate genuine portfolio management and diversification.
Navigating the Evolving Regulatory Landscape
For RIAs wary of recommending Section 351 conversions in the immediate aftermath of the IRS guidance, alternative strategies exist to address similar client needs. Steffen pointed to opportunity zone funds and direct indexing as potential replacements. However, he stressed that RIAs who are not attempting to "get too much" out of a transaction, meaning those engaging in conversions for legitimate strategic reasons rather than aggressive tax avoidance, should not be overly concerned. "If you push the line too far, those are the kinds of transactions that get caught," he cautioned.
The implications of this regulatory shift are significant. Advisors who have heavily promoted Section 351 conversions as a primary tax-saving tool may need to recalibrate their strategies and client communications. The increased scrutiny necessitates a more robust due diligence process, ensuring that any such conversions are grounded in a clear and demonstrable business purpose beyond mere tax deferral. This might involve more extensive documentation of the investment strategy, ongoing management plans, and the rationale for choosing the ETF structure.
Furthermore, the IRS’s focus on the "spirit of the law" suggests a broader trend towards examining the economic substance of transactions, rather than solely their form. This approach is common in tax enforcement and signals that the IRS is looking beyond technical compliance to identify arrangements that are primarily designed to achieve unintended tax benefits.
The recent guidance from the IRS, coupled with earlier pronouncements from Treasury officials, underscores a commitment to policing the ETF landscape for potential abuses. While Section 351 conversions remain a viable tool for legitimate portfolio management and diversification, their application as a tax avoidance strategy is now under a significantly brighter regulatory spotlight. Advisors and investors are therefore urged to proceed with caution, ensuring that their actions align with the intent of the law and are supported by sound investment principles, rather than solely by the prospect of tax savings. The coming months will likely see further clarification from the IRS, providing more concrete guidelines for navigating this evolving area of tax and investment strategy. The industry is adapting, with a growing emphasis on transparency and genuine economic purpose in all financial transactions.
This article was written by Patrick Donachie, Senior Reporter for Wealth Management, covering federal and state regulation, litigation and M&A deals in financial services.
