Last updated: October 2, 2026 · By the Flex Tax and Consulting Group team
On September 28, 2026, the IRS released Revenue Ruling 2026-20 and Notice 2026-62, its first formal guidance on 351 exchange ETFs. These “conversion” ETFs have been marketed as a way to swap a concentrated, highly appreciated stock position for a diversified fund without paying capital gains tax. The ruling says that when contributed securities are passed out of the new ETF to an authorized participant shortly after launch as part of the same plan, the investor is treated as having made a taxable exchange, not a tax-free Section 351 transfer. It affects investors who have already done a 351 conversion and anyone considering one, including many Bay Area tech employees with large single-stock positions.
Key takeaways
- Rev. Rul. 2026-20 treats certain 351 ETF conversions as taxable exchanges under Section 1001 between the investor and the authorized participant.
- The target is the pattern where your contributed stock doesn’t fit the fund’s strategy and is redeemed out shortly after launch, leaving you with a materially different portfolio.
- The IRS says the notice does not address ETF launches seeded with assets that match the fund’s strategy and are expected to be kept.
- Notice 2026-62 also flags partnership exchange funds that later convert to ETFs, box spread ETFs, record date strategies and several “tax-aware” fund techniques.
- None of these are listed transactions yet, but the IRS says future guidance could apply retroactively. Public comments are due October 28, 2026.
- California has no lower rate for capital gains, so any gain recognized can carry a large state tax bill too.
What is a 351 exchange ETF?
Section 351 of the Internal Revenue Code generally lets you transfer property to a corporation in exchange for its stock without recognizing gain, as long as the transferors control the corporation right after the exchange. ETFs are generally taxed as corporations (regulated investment companies), so a group of investors can, in principle, contribute appreciated stock to a brand-new ETF and receive ETF shares in return.
There is a built-in limit. The regulations say Section 351 doesn’t apply to a transfer to an investment company if the transfer results in diversification of the transferors’ interests. A transfer isn’t treated as diversifying if each investor already contributes a diversified portfolio, measured by the 25% and 50% tests (generally, no more than 25% of the portfolio’s value in one issuer and no more than 50% in five or fewer issuers). That’s why 351 conversions are usually limited to portfolios that already pass those tests.
After launch, an ETF can use in-kind redemptions under Section 852(b)(6) to hand appreciated securities to authorized participants without recognizing gain at the fund level. The IRS’s concern is the combination of the two steps.
What Revenue Ruling 2026-20 says
As the IRS describes it in Notice 2026-62, the ruling looks at this sequence:
- Investors contribute appreciated securities to a newly formed ETF, claiming Section 351 treatment.
- An authorized participant contributes different securities (or cash) that fit the ETF’s strategy.
- Shortly afterward, the ETF redeems the authorized participant using some or all of the investors’ original securities.
- All of the steps are part of one plan, so the investors end up holding an interest in a materially different portfolio.
The IRS applies substance over form. It treats the investors as having exchanged their securities with the authorized participant in a taxable exchange under Section 1001, rather than making a contribution that qualifies under Section 351. In practical terms, the built-in gain on the contributed stock would be recognized in the year of the exchange, as if it had been sold. Any gain recognized must be reported on your return for that year.
Other strategies flagged in Notice 2026-62
| Strategy | What the IRS described | Status |
|---|---|---|
| 351 conversion ETFs | Off-strategy stock contributed, then redeemed out to an authorized participant | Taxable exchange under Rev. Rul. 2026-20 |
| Partnership exchange funds that convert to an ETF | Concentrated stock pooled in a partnership, then moved into an ETF through a 351 conversion | Under review; comments requested |
| Box spread ETFs | Option combinations that earn an interest-like return with no current taxable income | Under review |
| Record date strategies | Fund-of-funds ETFs that move holdings out before dividend record dates | Under review |
| Non-qualifying asset ETFs | Redeeming out appreciated commodities or digital assets to sidestep the fund income test | Under review |
| “Tax-aware” fund techniques | Mixed-character currency straddles, same-day currency forwards and selective swap terminations | Under review |
The notice does not designate any of these as listed transactions or transactions of interest today. It says Treasury and the IRS may issue regulations, rulings or other guidance, including identifying a transaction as listed or of interest, and that guidance may apply prospectively or retroactively.
What the notice says it doesn’t address
The IRS states that the notice expresses no view on a Section 351 transaction used to seed a new ETF with assets that are consistent with the ETF’s investment thesis and that are intended and expected to be retained, absent a substantial change in circumstances. So the issue isn’t Section 351 itself. It’s whether your contributed stock was ever meant to stay in the fund.
Why this matters in California
The FTB states plainly that California doesn’t have a lower rate for capital gains; they are taxed as ordinary income. California’s personal income tax generally follows the federal rules for transfers to corporations, so if a conversion is treated as a taxable exchange federally, expect California to look at it the same way. For a Bay Area employee who contributed long-held company stock, that can mean a large federal and state bill for a year that may already be closed.
If you have also moved out of California, the sourcing of equity compensation income adds another layer. See our guide to California equity compensation when you move out of state.
What to do now
- Find out if you participated. Check whether any ETF you hold was acquired by contributing securities at launch, and pull the offering documents and your transfer confirmations.
- Gather basis records for the securities you contributed and the ETF shares you received.
- Ask the fund sponsor how it views Rev. Rul. 2026-20 and what happened to the contributed securities after launch.
- Don’t amend or change your reporting on your own. Whether, and how, a past return is affected depends on the specific facts. Get a professional review first.
- If you’re considering a 351 conversion, get an independent tax review before you transfer anything. A sponsor’s marketing materials are not tax advice.
- Watch for follow-up guidance. Comments close October 28, 2026, and more IRS action is expected.
Concentrated stock usually comes from equity compensation. For the basics, see Selling RSUs or ESPP Shares Without a Tax Plan, our Scale AI / Meta transaction case study and the 2026 Year-End Tax Planning Checklist.
FAQ
Are 351 exchange ETFs still allowed?
Section 351 still applies to ETF launches in general. The IRS says Notice 2026-62 doesn’t address seeding a new ETF with assets that fit its strategy and are expected to be kept. Rev. Rul. 2026-20 targets conversions where contributed stock is redeemed out shortly after launch as part of a plan.
What is Revenue Ruling 2026-20?
It is IRS guidance released September 28, 2026, holding that certain contributions of appreciated securities to a new ETF, followed shortly by a redemption of those securities to an authorized participant, are taxable exchanges under Section 1001 rather than tax-free Section 351 transfers.
I already did a 351 conversion. Do I owe tax?
It depends on how the transaction was structured and what the fund did with the contributed securities. The IRS warns that guidance may apply to past transactions, so have the documents reviewed before your next filing.
Is a 351 exchange a listed transaction?
Not yet. Notice 2026-62 does not designate any listed transactions or transactions of interest, but it says the IRS may do so in future guidance.
How does California tax gain from a 351 exchange?
California generally follows the federal treatment of transfers to corporations and taxes capital gains at ordinary income rates, with no lower capital gains rate.
Related reading
- Selling RSUs or ESPP Shares Without a Tax Plan: How to Avoid Overpaying the IRS
- Scale AI / Meta Transaction: What That Cash Dividend Means for Your Taxes
- California Equity-Based Compensation Guidelines: Moving from CA to Other States
- 2026 Year-End Tax Planning Checklist for High Earners, Business Owners & Investors
Sources
Last reviewed October 2, 2026.
- IRS: Notice 2026-62 (describes Rev. Rul. 2026-20; comments due October 28, 2026)
- 26 U.S.C. § 351: Transfer to corporation controlled by transferor
- 26 C.F.R. § 1.351-1(c): Transfers to investment companies
- California FTB: Capital gains and losses
Holding a 351 ETF or a concentrated stock position?
This article provides general information only and is not tax or legal advice. Tax outcomes depend on individual facts and circumstances. Contact us about your specific situation.