IRS Cracks Down on Tax-Slashing ETFs: What Investors Need to Know

The Internal Revenue Service (IRS) and Treasury Department have issued a stern warning to wealthy investors utilizing specific Exchange-Traded Fund (ETF) strategies designed to significantly reduce tax liabilities. Individuals employing these tactics are advised to prepare to justify their reasoning, as federal tax authorities are increasing their scrutiny.

Two key documents have been released by the tax authorities. The first addresses revenue ruling concerning certain ETF conversions under Section 351 of the tax code. This particular strategy involves a wealthy investor transferring a portfolio of highly appreciated stocks into a newly created ETF. Subsequently, the investor receives an in-kind distribution of these assets, effectively avoiding the recognition of capital gains.

The second document is a notice from the Treasury and IRS that specifically calls out "novel investment fund strategies" which may produce outcomes inconsistent with established tax rules. Among the strategies under examination are those employing "straddles" to generate capital gains and ordinary losses from offsetting positions. Additionally, "no-dividend" strategies, which aim to mirror index returns without recognizing income, are also facing increased scrutiny, according to an analysis by the law firm Ropes & Gray.

The tax authorities are actively seeking public comments on these methods, with a deadline of October 28th. Any future guidance issued concerning these tax-aware funds could potentially be applied prospectively or retroactively, the IRS notice indicates. Damien Martin, partner in the private tax and financial services organization at EY, advises investors to "Assess the situation and understand what it means. Have your eyes open, be aware and pay attention. This is a take stock type situation."

Legitimate Use vs. Questionable Tactics

Tax experts emphasize that the legitimacy of these strategies hinges on their application and the investor's objectives. Section 351, the basis for transferring appreciated assets to an ETF to mitigate capital gains, is a long-standing tax provision. Cary Sinnett, CFP and director of personal financial planning at the American Institute of Certified Public Accountants, notes that "On the face of it, it's a good idea: If you have highly appreciated shares, the biggest risk is single stock exposure. Putting this in an ETF that can help you diversify is valuable."

The issue arises when a series of steps results in 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 explains. The IRS may inquire about the ETF's turnover rate and the speed of these transactions. Jeffrey Levine, CPA and chief planning officer at Focus Partners, suggests that "The IRS is concerned about [these 351 conversions] being used to wash through with a quick redemption afterward. 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 evaluate whether the fund remains suitable without the tax benefit. Martin observes, "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?"

Guidance for Investors

Investors involved in 351 conversions or "tax aware" funds are not necessarily advised to liquidate their holdings immediately. However, they should engage in crucial discussions with their CPAs. Key considerations include:

• Be Ready to Back Up Your Reasoning: Ensure that these funds align with your overall investment strategy, rather than being driven solely by tax savings. "When the tax outcome becomes the primary reason, that is exactly when investors should expect greater scrutiny," states Sinnett.
• Get Your Documentation in Order: The revenue ruling for 351 conversions is an interpretation of existing law and could apply retroactively. Ensure all documentation is meticulously organized. Albert J. Campo, CPA at Campo Financial Group, advises, "What are you getting back in exchange for [appreciated shares]? Is it materially different from what you contributed? If it is, there is a deeper conversation to be had. Make sure you have your documents in order."
• Assess Your Risk Appetite for Tax Savings: Understand that tax strategies carry their own risk profile. Levine likens the risk of 351 conversions to "moderate-aggressive," noting that the IRS's increased focus has elevated the risk.