The IRS and Treasury Department have fired a warning shot concerning two exchange-traded fund strategies that can sharply cut wealthy investors’ tax liabilities — and those individuals should prepare to back up their reasoning for using those tactics. Last week, the federal tax authority rolled out a pair of documents concerning these strategies. The first was a revenue ruling on certain ETF conversions under Section 351 of the tax code — in particular a strategy in which a wealthy investor with a portfolio of highly appreciated stocks uses these holdings to create a new ETF, followed by an in-kind distribution of those assets without the recognition of capital gains. The second was a notice from Treasury and the Internal Revenue Service , calling out “novel investment fund strategies” that aim to produce results that could be inconsistent with the proper application of the tax rules. Strategies in the crosshairs include those that use straddles to produce capital gains and ordinary losses from offsetting positions. So-called no-dividend strategies that aim to deliver returns tied to an index without recognizing income are also under scrutiny, according to an article from law firm Ropes & Gray . The tax authorities are seeking comments from the public by Oct. 28 on these methods. Any future guidance that rolls out related to these tax-aware funds may apply prospectively only or retroactively, according to the IRS’ notice. “Assess the situation and understand what it means,” said Damien Martin, partner in the private tax and financial services organization at EY. “Have your eyes open, be aware and pay attention. This is a take stock type situation.” Legitimate versus questionable uses Even as the Treasury and IRS are digging into these strategies, the question of whether they can pass the smell test comes down to how they’re used and the investor’s goals, among other factors, tax experts say. Section 351, which underlies the strategy of shipping off appreciated assets to an ETF to mitigate capital gains, is a long-standing provision of the federal tax code, said Cary Sinnett, certified financial planner and director of personal financial planning at the American Institute of Certified Public Accountants. “On the face of it, it’s a good idea: If you have highly appreciated shares, the biggest risk is single stock exposure,” he said. “Putting this in an ETF that can help you diversify is valuable.” Where it becomes problematic is when the investor is running through a series of steps that results in them having this diversified portfolio with no gain recognition, he said. “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 said. Questions that the IRS may ask include how much turnover did the receiving ETF have, and how quickly did this occur, said Jeffrey Levine, CPA and chief planning officer at Focus Partners in St. Louis. “The IRS is concerned about [these 351 conversions] being used to wash through with a quick redemption afterward,” he said. “The less turnover your 351 ETF has had since inception, the less likely the IRS will be to attack the transaction.” Meanwhile, with the focus on “tax aware” strategies, investors will need to consider the primary motivation behind why they’re in these funds: Would the fund still make sense for an investor’s situation without the tax benefit? “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?” said Martin. Avoid panicking but talk to your CPA Investors in 351 conversions or in “tax aware” funds shouldn’t necessarily dump their investments, but they ought to think about the following as they talk with their CPA: Be ready to back up your reasoning. Instead of allowing the tax savings to drive your decision, be sure that these funds fit within your overall investment strategy. “When the tax outcome becomes the primary reason, that is exactly when investors should expect greater scrutiny,” said Sinnett. Get your documentation in order. The revenue ruling for 351 conversions is an interpretation of existing law and may apply retroactively. That’s different — and more concrete — compared with the IRS seeking comment on the use of “tax aware” funds. “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,” said Albert J. Campo, CPA at Campo Financial Group in New York. “Make sure you have your documents in order.” Work with your CPA to get a handle on your risk appetite for tax savings. Investors are familiar with the risk tolerance spectrum for investing, but it also applies to taxes. “If you thought [351 conversions] were moderate before, I’d say it’s moderate-aggressive,” Levine said. “It’s kicked up the risk a little bit if you’re not being egregious about these things.”
