Helen retired from engineering in Los Alamos with about $2.4 million in two dozen stocks bought since the 1990s, combined basis near $300,000. In April 2025 her adviser moved it all into a newly launched exchange-traded fund and called it tax-free. Within weeks the fund handed her old shares to a broker-dealer.
On September 28, 2026, Treasury and the IRS released Revenue Ruling 2026-20, which treats that plan as a taxable exchange, and Notice 2026-62, which flags it and its partnership “exchange fund” cousin for possible tax shelter reporting. Her 2025 return is filed. The harder question is what she must now disclose, and what silence would cost.
What is a section 351 ETF conversion, and what does Revenue Ruling 2026-20 change?
Section 351 lets people move property into a corporation “solely in exchange for stock” without recognizing gain if they control it immediately afterward (26 U.S.C. § 351(a)). An ETF is a corporation that qualifies as a regulated investment company, and 26 U.S.C. § 852(b)(6) lets it hand appreciated securities to a redeeming shareholder, typically an authorized participant (a broker-dealer that creates and redeems shares in blocks), without paying tax on the gain. Stocks go in tax-free and come out tax-free.
The ruling (2026-43 I.R.B. 511) collapses the steps. When the fund, under one plan, issues shares to an authorized participant and “shortly thereafter” redeems them with the investor’s securities, the ruling treats the investor “as undertaking a taxable exchange under § 1001” with the participant. It states no effective date, and under 26 U.S.C. § 7805(b)(8) rulings apply retroactively unless the IRS limits them, so I read it as reaching 2025 conversions. The Notice excludes seeding a fund with assets it means to keep.
A direct conversion needs an already diversified portfolio, because § 351(e)(1) excludes transfers to an investment company unless each contributor holds no more than 25 percent in one issuer and 50 percent in five or fewer (Treas. Reg. § 1.351-1(c)(6)(i); 26 U.S.C. § 368(a)(2)(F)(ii)). Helen cleared that line. A one-stock owner does not, and gets pitched an exchange fund.
Is a partnership exchange fund still an option for concentrated stock in New Mexico?
An exchange fund pools concentrated positions in a partnership. Contributions are normally tax-free under 26 U.S.C. § 721(a), but § 721(b) withdraws that when the partnership “would be treated as an investment company (within the meaning of section 351) if the partnership were incorporated.” Under Treas. Reg. § 1.351-1(c)(1), the test is whether more than 80 percent of its assets are readily marketable stocks or securities held for investment (§ 351(e)(1) counts even REIT shares). So exchange funds keep at least 20 percent in something else, usually real estate held directly.
The Notice does not condemn that. Section 2.03 targets a partnership that, once it holds everyone’s pooled stock, runs its own 351 conversion into an ETF. The IRS is weighing guidance denying nonrecognition to those contributions and offers no view on other exchange funds. If a Santa Fe adviser pitches one, ask whether the documents contemplate a later ETF conversion. The Notice’s box spread and “tax-aware” derivative strategies operate inside funds and reach investors mainly if later guidance names them.
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What happens if the IRS makes this a listed transaction or a transaction of interest?
Nothing is designated yet. Listed transactions and transactions of interest are reportable under Treas. Reg. § 1.6011-4, and each participant must attach Form 8886 to the return and send a copy to the IRS Office of Tax Shelter Analysis (OTSA). “Substantially similar” deals count, a phrase that “must be broadly construed in favor of disclosure.”
The rule I would flag is § 1.6011-4(e)(2)(i). If a transaction is designated after you file a return reflecting it, while that year is still open for assessment, Form 8886 goes to OTSA “within 90 calendar days” of the designation. Helen’s 2025 return, filed in April 2026, stays open under 26 U.S.C. § 6501(a) until April 2029.
Missing it costs money even if the position holds. 26 U.S.C. § 6707A imposes 75 percent of the tax decrease from the transaction, at least $5,000 for an individual and at most $100,000 for a listed transaction or $10,000 for other reportable transactions. For an undisclosed listed transaction, § 6501(c)(10) keeps the year open until one year after the information is furnished. Section 6662A adds 20 percent of a “reportable transaction understatement” (30 percent if undisclosed), figured at the highest § 1 rate. Its reasonable cause defense under 26 U.S.C. § 6664(d) requires disclosure, and a promoter’s opinion does not count.
Why is October 28, 2026 the comment deadline, and can the IRS list these deals by notice?
Comments are due October 28, 2026, the day this post is published. In my reading that is an information request, not the rulemaking courts now require before a listing.
In Mann Construction, Inc. v. United States, 27 F.4th 1138 (6th Cir. 2022), the Sixth Circuit held that a listing notice is a legislative rule and set aside Notice 2007-83 for skipping notice and comment under the Administrative Procedure Act. Green Rock LLC v. IRS, 104 F.4th 220 (11th Cir. 2024), did the same for the conservation easement listing, as did the Tax Court in Green Valley Investors, LLC v. Commissioner, 159 T.C. 80 (2022). In AOD 2024-01 the IRS acquiesced, giving up reportable transaction penalties for post-2004 listings that skipped notice and comment.
I found no Tenth Circuit decision on point. A New Mexico individual’s Tax Court case appeals there under 26 U.S.C. § 7482(b)(1)(A), and the Tax Court has Green Valley. I expect any listing here to come as a proposed regulation. That buys time; it is not a defense.
How does a federal recharacterization reach a New Mexico income tax return?
New Mexico “base income” starts from federal adjusted gross income (NMSA 1978, § 7-2-2). The capital gains deduction barely helps: starting with 2025, NMSA 1978, § 7-2-34 allows the greater of $2,500 of net capital gain or 40 percent of up to $1 million of gain from selling a business; the 2024 amendment (Laws 2024, ch. 67) ended the general 40 percent deduction. A stock portfolio is not a business. The 2025 top rate is 5.9 percent on single filers’ taxable income over $210,000 (NMSA 1978, § 7-2-7).
After an IRS adjustment or an amended federal return, NMSA 1978, § 7-1-13(E) requires a federal adjustments report and payment within 180 days after the final determination date, and § 7-1-18(E) runs the state’s assessment window from that report (see the firm’s Form 872 post). How the Taxation and Revenue Department applies these rules is a question for New Mexico-licensed counsel.
What would the numbers look like for a Los Alamos retiree?
Illustration only. Assume Helen files single, the fund used all her shares to redeem the authorized participant, and her other 2025 taxable income is $120,000 (federal and state), with $140,000 of adjusted gross income. She recognizes $2.1 million of long-term capital gain.
For 2025 a single filer’s 15 percent rate ends at $533,400 of taxable income (Rev. Proc. 2024-40), so $413,400 is taxed at 15 percent ($62,010) and $1,686,600 at 20 percent under 26 U.S.C. § 1(h) ($337,320). The 3.8 percent tax of 26 U.S.C. § 1411 on modified AGI above $200,000 adds $77,520, for about $476,850 federal. (The 2026 threshold is $545,500 under Rev. Proc. 2025-32.) New Mexico: after the $2,500 deduction, $90,000 is taxed at 4.9 percent and $2,007,500 at 5.9 percent, about $122,850.
Amending before the IRS first contacts her about an examination makes it a qualified amended return, removing the 20 percent accuracy-related penalty of 26 U.S.C. § 6662 on that tax (Treas. Reg. § 1.6664-2(c)); an IRS promoter examination of the arrangement can also close that window. Interest runs from April 15, 2026 regardless (26 U.S.C. § 6601(a)). If she waits, the deal is listed, and she misses the 90-day filing, the § 6707A penalty hits its $100,000 cap. This is rarely a case for the IRS voluntary disclosure practice, which is aimed at criminal exposure.
| Strategy | IRS position | Who bears the risk | What to check |
|---|---|---|---|
| 351 conversion into a new ETF | Rev. Rul. 2026-20: taxable § 1001 exchange | Contributing investor | Whether your securities left the fund quickly |
| Exchange fund that converts to an ETF | Notice § 2.03: may deny § 721 nonrecognition | Contributing partner | Whether documents contemplate a conversion |
| Box spread ETF | Notice § 2.04: questions § 852(b)(6) redemptions of options | Fund, unless guidance names investors | Fund tax disclosures |
| Tax-aware straddles, forwards, swaps | Notice § 3: elective character concerns | Fund; results flow to partners | K-1s pairing capital gain with ordinary loss |
| 351 seeding with retained assets | Not addressed | No change announced | That holdings stayed |
Frequently Asked Questions
Is every 351 ETF conversion taxable now?
No. The ruling covers plans where the fund uses contributed securities to redeem an authorized participant shortly afterward. Seeding a fund with assets it keeps is outside the Notice.
Do I have to file Form 8886 for a 351 conversion today?
Not because of Notice 2026-62, which designates nothing. A duty would arise if later guidance designates the transaction and covers investors, or if your deal already fit another category, such as a deal offered under confidentiality conditions for a fee of at least $50,000.
Can I still comment on Notice 2026-62?
Comments are due October 28, 2026, at regulations.gov (IRS-2026-1255) or by mail. Later comments will be considered unless that would delay guidance.
Does New Mexico tax the gain if the IRS recharacterizes my conversion?
Yes. New Mexico starts from federal adjusted gross income. For 2025 and later a stock investor generally gets only a $2,500 capital gains deduction.
What is the most an individual can owe under section 6707A?
$100,000 per listed transaction and $10,000 for other reportable transactions, with a $5,000 minimum. Within those limits it is 75 percent of the tax decrease.
How North Star Law Firm Can Help
North Star Law Firm reviews completed 351 conversions and exchange fund investments for New Mexico investors through its tax defense practice, including whether to amend, and represents clients in IRS audits and penalty abatement requests.
Phillip Zagotti, JD/CPA, represents taxpayers before the IRS and the U.S. Tax Court and is admitted to the U.S. District Court and Bankruptcy Court for the District of New Mexico. The firm works alongside New Mexico-licensed counsel on state-law questions. If an adviser moved your portfolio into a new ETF or exchange fund and you doubt your 2025 return, contact North Star Law Firm.