Clients with diversified yet heavily appreciated stocks could more effectively defer capital gains and avoid the tax hit of dividends by converting them into a newly burgeoning type of ETF.

Transferring the varied holdings into an ETF with a similar basket of investments based on the rules of Section 351 of the Internal Revenue Code enables what is known as an “in-kind” exchange of assets. The approach has existed for nearly a century, but a raft of new ETFs — starting with the launch last month of the Cambria Tax Aware ETF (ticker: TAX) — reflect how financial technology is applying it on a mass scale, according to Mebane “Meb” Faber, co-founder and chief investment officer of Cambria Investment Management. The quantitative management and alternative investments firm collaborated with ETF tax and operational advisory firm ETF Architect on the Dec. 18 start of TAX.

READ MORE: IRS silence allows investors to exploit ETF loophole, study finds

Appreciated stock portfolios — especially those using increasingly popular forms of direct indexing — can often get “stuck” in limbo with their rising values and the potential for realizing taxable capital gains, Faber said. Financial advisors could think of the Section 351 transfer as a 1031 like-kind exchange that is for stocks rather than other kinds of assets. Even though the tax law provision has existed for a long time, some “99.9% of people” that Cambria spoke with in several hundreds of calls last quarter hadn’t heard of Section 351 transfers, according to Faber. The Securities and Exchange Commission’s 2020 ETF Rule cleared the way for software and other technology powering new products that focus on the tax impact of asset location.

“These are all ideas and strategies that are going to get developed more over the next five years,” Faber said. “You’re going to see an enormous amount of interest in this in the next six months as people kind of get it and shift.”

‘Kind of a big deal’: How Section 351 ETFs work

The TAX ETF and other funds coming to market soon represent “a very investor-friendly trend” toward returns with less risk at a lower cost, according Brent Sullivan, a consultant on taxable investing product marketing and development to sub-advisory and ETF firms. Sullivan writes the Tax Alpha Insider blog, where he’s tracking a half dozen new or pending funds from Cambria and three other sponsors pitching the Section 351 transfer strategy. Sullivan has been following the launch of TAX closely for several months, and he wrote in a “28 Days Later” dispatch earlier this month with samples from his upcoming “memezine” explaining Section 351 conversions to advisors. (“I hate white papers,” Sullivan wrote. “They feel like homework. So, I wrote and illustrated an adviser’s guide to seeding ETFs in-kind using some words, but mostly memes.”)

READ MORE: The 10 best- and worst-performing ETFs of 2024

Section 351 exchanges revolve around the idea of moving “disaggregated assets into an aggregated fund that can achieve lower cost and also better tax deferral” without booking any capital gains, he said. They could be beneficial to, for example, clients in “separately managed accounts that are way above cost basis so they can’t do tax loss-harvesting anymore,” according to Sullivan. In effect, stock assets in a status informally known as “locked” due to their potential tax burdens flow into a diversified ETF.     

“It removes tax friction from the reallocation decision. It makes assets less sticky, and, in general, that’s good,” Sullivan said. “It’s kind of a big deal, and advisors are the ones who are going to be needing to vet these products, because oftentimes they don’t come with a track record.”

Just over a month after its inception, the TAX ETF has attracted $32.5 million of net assets. It carries an expense ratio of 0.49% and the requirements that no single positions in an incoming portfolio comprise more than 25% of the holdings and any that are over 5% add up to less than 50%. Cambria intends to open two more funds that use Section 351 conversions this year, with an ETF using the ticker “ENDW” that “tracks an endowment-style allocation” across global holdings at the end of the first quarter and another targeting global equities at the end of the second, according to Faber. Advisors have likely grown familiar with the fact that mutual funds are converting to ETFs, he noted. Section 351 transfers could drive more assets to ETFs.  

“We knew there was going to be some demand for this idea and topic, and it was 10 times what we expected,” Faber said. “If you’re a taxable investor, particularly a high-tax investor, the last thing you want is dividends, because you’re paying taxes on those every year.”

READ MORE: 10 key investment strategy stories of 2024

The new ETFs are giving more advisors and their clients the opportunity to use a tactic that was previously only available to the wealthiest households, according to Sullivan.

“Meb is doing this all out in the open,” Sullivan said. “Normally this is only offered to family offices and in really one-on-one, behind-the-scenes sales. The public appeal is specifically what’s new about this moment.”

The Internal Revenue Service doesn’t have the authority to independently verify that recipients of Low Income Taxpayer Clinic grants are eligible to receive them, according to a new report.

The report, released Tuesday by the Treasury Inspector General for Tax Administration, found the IRS’s LITC Program Office is restricted by the White House Office of Management and Budget regulations from viewing LITC client information. TIGTA reviewed a sample of grant applications along with interim and year-end review summary reports for 15 out of 130 LITCs from the 2022 grant year and found the Program Office mainly relied on self-certified information from the LITCs. The Program Office is able to administer and monitor the LITC Program, but it lacks the ability to independently validate client information to ensure the terms of the grants are being followed.  

The LITC Program is a federal grant program administered through the Taxpayer Advocate Service that provides matching grants up to $100,000 per year to qualifying organizations. The goal of the program is to provide low-income taxpayers who are involved in tax controversies with the IRS with free or nominal cost legal assistance to ensure that they have access to representation and to provide Limited English Proficiency taxpayers with education on their taxpayer rights and responsibilities.  For an organization to qualify for an LITC grant, it needs to meet the requirements specified in Section 7526 of the Tax Code. The LITC Program had the authority to grant up to $26 million and $28 million to qualified LITCs in calendar years 2023 and 2024, respectively. 

Nevertheless, for the 2023 grant year, over 75% of the LITCs were subject to an independent audit. The auditor has to determine whether the entity has complied with federal statutes, regulations, and the terms and conditions of federal awards, which includes grants. The Treasury Department could subject the LITC Program to more focused oversight by including it in a supplementary audit guide prepared annually. This guide directs the external auditor’s testing to the compliance requirements most likely to cause improper payments, fraud, waste, or abuse, or generate audit findings for which the IRS would impose sanctions. Lastly, we determined that the Program Office’s workflow lacks a consolidated centralized system; therefore, reviews of LITC data are a manual and labor-intensive process, making the process vulnerable to human error. 

TIGTA recommended the National Taxpayer Advocate should add an attestation on forms where data about taxpayers whose income exceeds the 250% of the poverty level limitation is reported, affirming accuracy, and acknowledging the penalty for making a false statement. The report also suggested the Taxpayer Advocate Service should work with the Treasury Department to request that LITC grant requirements be included within the Treasury Department’s Compliance Supplement to ensure that grant recipients are abiding by the rules. The Taxpayer Advocate should also develop a centralized system to administer the LITC grant program.  The Taxpayer Advocate Service management agreed with all of TITA’s recommendations and stated that they have started to take or plan to take corrective actions. 

National Taxpayer Advocate Erin Collin said in response to the report that the Taxpayer Advocate Service has entered into an agreement with the Treasury’s Chief Information Officer to develop a new grants management system for the LITC program office that will “streamline processes by centralizing operations, reducing manual tasks and minimizing reliance on other systems.”

She also noted that the LITC review process for current grantees includes evaluating their history of performance derived from report, site visits and interactions. Application evaluations are not solely based upon applicant-provided information but also includes observations of grantees by staff.

The American Institute of CPAs is asking the Treasury Department and the Internal Revenue Service to increase the safe harbor for companies to avoid determining whether the corporate alternative minimum tax would apply to them.

In a comment letter to the Treasury and the IRS on their proposed regulations, the AICPA asked them to increase the $500 million safe harbor for purposes of determining applicable corporation status. The AICPA also requested a simplified methodology that would be available to non-applicable corporations and/or applicable corporations with high effective federal tax rates. The Institute also suggested an irrevocable election to use pretax book income as adjusted applicable financial statement income for CAMT liability purposes.

The Inflation Reduction Act of 2022 created the CAMT, which imposes a 15% minimum tax on the adjusted financial statement income, or AFSI, of large corporations for tax years starting after Dec. 31, 2022. The CAMT generally applies to large corporations with average annual financial statement income exceeding $1 billion. However, the proposed regulations require far smaller companies to determine whether the tax applies to them, and the AICPA pointed out this could be burdensome to them. The IRS and the Treasury released the proposed regulations last September.

“The proposed regulations impose a massive compliance burden on all U.S. taxpayers that do not meet the $500 million AFSI safe harbor while only a small group, approximately 100 of those taxpayers, will pay the CAMT liability,” said Reema Patel, senior manager of AICPA tax advocacy and policy, in a statement Thursday. “The AICPA’s comment letter provides a non-exhaustive list of items in the proposed regulations with a high compliance burden for the taxpayers.”

The AICPA’s comments also discuss other aspects of the proposed regulations, including general concepts and methods and periods, international tax, passthrough, and mergers and acquisitions issues. The latest comments from the AICPA come after previously submitted letters to Congress in 2021 and 2022 asking for immediate guidance on the CAMT rules along with letters submitted to the Treasury and the IRS on interim guidance issued on CAMT in 2023 and 2024.