The IRS drew a line around Section 351 ETF exchanges. Here is what it covers and what it does not.

On September 28, 2026, the Treasury Department and the IRS released two pieces of guidance aimed at tax strategies built on exchange-traded funds: Revenue Ruling 2026-20 and Notice 2026-62. If you hold a concentrated stock position, or have been pitched a Section 351 exchange as a way to diversify one, it is worth understanding what the guidance says before reacting to the headlines.

First, what a 351 exchange is

Under Section 351, an investor can contribute property to a newly formed corporation in exchange for its shares without recognizing gain, provided certain requirements are met. Because an ETF is organized as a regulated investment company, investors have used this rule to contribute portfolios of appreciated stocks to newly launched ETFs in exchange for fund shares. A key condition is diversification: the contributed portfolio generally must not have more than 25 percent of its value in any one issuer, or more than 50 percent in its five largest positions.

That condition matters for anyone with a single large position. A 351 exchange was never a way to diversify one stock. It was a way to move an already reasonably diversified collection of appreciated stocks into a fund structure.

What the revenue ruling says

Revenue Ruling 2026-20 addresses a specific pattern. An investor contributes appreciated securities to a new ETF as part of a plan, and the ETF then distributes those same securities to an authorized participant through an in-kind redemption. The IRS concludes that, in substance, the investor has exchanged the securities in a taxable transaction, and the investor recognizes the gain.

The ruling does not state an effective date. Several law firms have read that to mean the IRS may apply its position to transactions that have already occurred.

What the notice flags

Notice 2026-62 describes other strategies the government says it is studying. They include:

• Partnerships that take in concentrated positions, add assets to avoid investment-company treatment, and then use the diversified result in a 351 ETF conversion.
• Funds built on option box spreads that produce interest-like returns.
• Strategies designed to avoid paying out dividends around record dates.
• Certain derivative-based tax-aware strategies in separately managed accounts and partnerships, including mixed-character straddles, currency elections made after the outcome is known, and selective terminations of swap contracts.

The notice says future action could include regulations, rulings, or designating transactions as listed transactions or transactions of interest, and that the IRS may challenge these strategies on examination under existing law in the meantime.

What it does not address

The notice states that it does not address, and expresses no view on, Section 351 transactions in which a newly formed ETF receives assets that are consistent with its investment strategy and that are intended and expected to be retained. It also does not address traditional exchange funds that do not take the additional conversion step described above.

In other words, the guidance targets arrangements where the contributed securities are passed through and out of the fund, not every use of Section 351.

If you hold a concentrated position

The practical takeaways are less dramatic than some headlines suggest, but they are real:

• The single-stock problem is unchanged. Staged diversification, exchange funds, option overlays, charitable vehicles, and loss harvesting remain the main tools, each with its own trade-offs. This guidance does not change those trade-offs.
• Diligence on any 351 offering just got more important. Questions worth asking a sponsor: Does the fund intend to retain contributed securities, or redeem them out? What is the sponsor's position after Revenue Ruling 2026-20? Has the sponsor obtained a tax opinion that addresses it, and on what assumptions?
• If you already participated in a 351 exchange, do not act on a headline. Whether the ruling touches your transaction depends on its specific facts. That is a conversation for your CPA, with your documents in hand.
• Tax-aware long/short and managed account strategies deserve a fresh look. Most do not rely on the specific techniques the notice describes, but it is reasonable to ask any manager whether theirs does.

What to watch

The comment period closes October 28, 2026. Further guidance could narrow or expand the scope, and could apply prospectively or retroactively. This brief will follow it.