The IRS is intensifying its scrutiny of certain ETF strategies used by wealthy investors to minimize taxes, particularly Section 351 conversions and “tax aware” funds. Investors must now be prepared to justify their investment choices beyond tax benefits, as the IRS probes for potential misuse of tax code provisions. Seeking advice from a CPA and ensuring thorough documentation are crucial steps for those involved.
The Internal Revenue Service (IRS) and Treasury Department have issued a clear warning to wealthy investors utilizing certain exchange-traded fund (ETF) strategies designed to significantly reduce tax liabilities. These investors are now on notice to be prepared to rigorously defend their reasoning for employing these tactics.
Last week, the federal tax authority released two key documents targeting these strategies. The first, a revenue ruling concerning ETF conversions under Section 351 of the tax code, specifically addresses a method where affluent individuals contribute highly appreciated stock portfolios to create a new ETF. This is followed by an in-kind distribution of assets, aiming to avoid capital gains recognition. The second document, a notice from the Treasury and IRS, calls out "novel investment fund strategies" that may produce outcomes inconsistent with established tax rules. Among the strategies under scrutiny are those employing straddles to generate capital gains and ordinary losses from offsetting positions, as well as "no-dividend" strategies that seek to mirror index returns without recognizing income. Law firm Ropes & Gray highlighted these points in a recent article.
The tax authorities are actively soliciting public feedback on these methods, with a deadline of October 28. The IRS's notice indicates that any forthcoming guidance on these tax-aware funds could be applied either prospectively or retroactively.
"Assess the situation and understand what it means," advises Damien Martin, partner in EY's private tax and financial services organization. "Have your eyes open, be aware and pay attention. This is a take stock type situation."
Legitimate vs. Questionable Uses
Tax experts emphasize that the validity of these strategies hinges on their application and the investor's specific goals. Cary Sinnett, a certified financial planner and director of personal financial planning at the American Institute of Certified Public Accountants, notes that Section 351, which forms the basis for transferring appreciated assets to an ETF to mitigate capital gains, is a long-standing tax provision. "On the face of it, it's a good idea: If you have highly appreciated shares, the biggest risk is single stock exposure," he explains. "Putting this in an ETF that can help you diversify is valuable."
The issue arises when a series of steps results in a diversified portfolio without gain recognition. "The IRS says you started with apples and ended up with oranges, and just because you passed it through an ETF doesn't make it tax free," Sinnett elaborates.
Jeffrey Levine, CPA and chief planning officer at Focus Partners in St. Louis, suggests the IRS will likely inquire about the turnover rate of the receiving ETF and the speed of the transaction. "The IRS is concerned about [these 351 conversions] being used to wash through with a quick redemption afterward," he states. "The less turnover your 351 ETF has had since inception, the less likely the IRS will be to attack the transaction."
Regarding "tax aware" strategies, investors must consider their fundamental reasons for engaging with these funds. The critical question is whether the fund would still align with the investor's objectives if the tax benefits were removed. "A lot of these things aren't new, but it comes down to how it's being framed: What's the primary motivator? Is it the tax alpha? Is it a function of the overall investment strategy?" asks Martin.
Navigating the Scrutiny: Advice for Investors
Investors involved in 351 conversions or "tax aware" funds are advised not to panic but to engage in proactive discussions with their CPAs. Key considerations include:
- Be Ready to Justify Your Decisions: Ensure these funds align with your overarching investment strategy, rather than being solely driven by tax savings. "When the tax outcome becomes the primary reason, that is exactly when investors should expect greater scrutiny," warns Sinnett.
- Organize Your Documentation: The revenue ruling on 351 conversions interprets existing law and may have retroactive implications. Albert J. Campo, CPA at Campo Financial Group in New York, stresses the importance of detailing what is received in exchange for appreciated shares and whether it is materially different from the contribution. "Make sure you have your documents in order."
- Understand Your Tax Risk Appetite: Work with your CPA to assess your tolerance for tax-related risks, similar to investment risk tolerance. Levine suggests that strategies previously considered moderately risky might now be viewed as moderate-to-aggressive due to increased IRS attention.
This heightened IRS focus underscores the need for transparency and a solid rationale behind investment decisions, especially when tax implications are significant.
