Treasury Sec. Bessent, IRS crack down on ETF strategy the wealthy are using to avoid capital gains taxes
The IRS and Treasury issued a warning this week on an ETF strategy wealthy investors have been using to shield capital gains income from taxes.
TL;DR
- Wealthy investors may need to reconsider certain ETF tax-deferral strategies due to new IRS and U.S. Treasury guidance.
- The guidance addresses the use of Section 351 exchanges, where investors create new ETFs with highly appreciated stocks to defer capital gains taxes.
- Treasury Secretary Scott Bessent stated that these ETF conversions designed to avoid taxes "don't work under existing law."
- The IRS and Treasury are focusing on transactions where an ETF is used as a 'conduit' to avoid taxes, deeming them abusive.
- Section 351 generally allows property transfer to a corporation for stock without recognizing capital gains under specific conditions, which are still generally accepted.
- The new guidance specifically targets situations where an ETF distributes contributed securities shortly after formation, resulting in a materially different portfolio without recognizing built-in gains.
- This strategy has reportedly been used to defer billions in capital gains, with activity accelerating.
- Creating an ETF can be costly, generally requiring investors to have significant appreciated stocks (e.g., $25 million to $100 million) for it to be a viable option.
- The notice clarifies that not all Section 351 transactions are suspect, specifically excluding those where assets are consistent with the ETF's investment thesis and intended to be retained.
- Tax regulators are imposing additional restrictions, with timing of transactions being key; transactions occurring 'shortly after' appreciated securities are contributed are considered suspect.
- The IRS and Treasury are seeking comments on the notice by October 28.
- Other tax strategies, including transfers to partnerships and 'box spread' strategies involving options, could also be targeted.
- Investors seeking to manage capital gains taxes might consider exchange funds or charitable remainder trusts as alternatives.