The U.S. Department of the Treasury and the IRS are drawing a clearer line between legitimate ETF seeding and tax-driven portfolio conversions, putting a spotlight on Section 351 strategies used by tax-aware investors.

Shang Chou, co-founder and managing partner at Dishmi Capital, a multi-family office specializing in tax-aware investment strategies, said the key for investors is to look beyond the tax benefits and examine the economic substance of the transaction.

Notice 2026-62 and Rev. Rul. 2026-20 say certain transactions combining Section 351 contributions with ETF creation and redemption mechanics can be treated as taxable exchanges rather than tax-deferred contributions. Chou said investors should focus on whether the securities being contributed fit the ETF's investment thesis and whether the fund actually intends to retain them.

Section 351 allows investors, under specific conditions, to contribute appreciated securities to a newly formed ETF without immediately recognizing the embedded gain.

The strategy has gained traction among tax-aware investors, with more than 100 ETFs reportedly using Section 351 seeding, including funds such as Eagle Capital Select Equity ETF (NYSE: EAGL), Kovitz Core Equity ETF (NYSE: EQTY) and Tema S&P 500 Historical Weight ETF Strategy (NYSE: DSPY).

IRS Targets the Portfolio Conversion

Section 351 allows investors, under specific conditions, to contribute appreciated securities to a newly formed ETF without immediately recognizing the embedded gain. The IRS is focusing on transactions where investors contribute a diversified portfolio even though some or all of those securities do not align with the fund's intended investment strategy.

The ETF can then use creation and redemption transactions to effectively replace those securities with a materially different portfolio. The agencies said certain such transactions should instead be characterized as taxable exchanges under Section 1001.

"Are the assets contributed consistent with the ETF's investment thesis?" Chou said. "And will the assets be retained in the ETF post-contribution?"

"The closer both of these responses are to 'no,' the more likelihood that this may be deemed a taxable contribution," he added.

What Is a 'Materially Different' Portfolio?

The IRS does not provide a bright-line definition, making the relationship between the contributed assets and the ETF's strategy particularly important.

For example, Chou said, an investor could contribute a diversified biotech portfolio that meets the relevant Section 351 diversification requirements, but use the ETF and authorized participant as a conduit to ultimately receive exposure to an oil and gas portfolio.

"That might raise issues with a taxable transaction," he said.

The notice explicitly distinguishes these transactions from legitimate ETF seeding. Treasury and the IRS said the guidance does not address a Section 351 transaction used to seed a new ETF with assets consistent with its investment thesis that are intended and expected to be retained, absent a substantial change in circumstances.

Timing Could Be Critical

The guidance also puts the spotlight on pre-planned redemptions.

"A pre-planned disposal of the contributed assets is likely to render the transaction taxable," Chou said. "A disposal of the assets immediately using the ETF creation/redemption mechanism would be quite an egregious example of this and what Treasury/IRS is looking to end."

That distinction matters because normal ETF portfolio management can involve selling securities after launch, while the IRS is targeting transactions where the subsequent steps are part of the original plan.

What ETF Investors Should Watch

The guidance does not appear to eliminate Section 351 ETF seeding altogether. Instead, it raises the importance of understanding what an ETF is actually designed to own and whether contributed securities are expected to remain in the portfolio.

Chou said investors should put "economic substance" ahead of the tax benefits being marketed by a strategy.

"Investors should talk to their tax/legal advisors first and foremost," he said.

For investors considering a Section 351 ETF, the key questions are therefore not simply how much tax can be deferred, but what securities are being contributed, whether they fit the ETF's investment thesis and whether the fund genuinely intends to retain them.