Document Type

Article

Publication Title

DePaul Law Review

Volume

75

Publication Date

2026

Keywords

ETF, Mutual fund, Swap fund, Exchange Fund, Section 351, Taxation

Abstract

ETFs have begun to challenge mutual funds as the dominant U.S. public pooled asset vehicle.  Their constant liquidity, exposure to an ever widening range of investment strategies, and highly touted tax efficiency have driven the explosive growth in the assets under management of ETFs over the last 15 years.  The tax efficiency is due to section 852(b)(6), which permits ETFs to distribute appreciated property tax free and eliminate all fund-level taxable gains even while making portfolio adjustments, which mutual funds cannot do.

Fund sponsors have developed various strategies to exploit the benefits of section 852(b)(6), with the newest being the launch of ETF swap funds. This strategy allows wealthy investors to contribute appreciated securities tax free to an ETF, diversify their economic risks tax free, avoid future tax on fund-level capital gains, and if the ETF shares are held until death, eliminate income tax on any unrealized gains.

ETF swap funds rely on a 1996 regulation permitting tax-free transfers of diversified portfolios to investment companies, which was promulgated when ETFs were in their infancy.  It is certain the regulation’s drafters did not anticipate that securities transferred tax free to an investment company under section 351 could be immediately distributed tax free under section 852(b)(6).  

Senator Wyden’s recent legislative proposal to eliminate ETF swap funds, while necessary, addresses only one aspect of a larger problem: the expanding scope of section 852(b)(6), which is the foundation of a variety of strategies that permit investors to not only to defer tax inappropriately but to convert ordinary income into capital gains.  This article argues that Congress should not only prevent the tax-free transfer of appreciated securities to ETF swap funds but also revisit the scope of section 852(b)(6).  Without such reform, our income tax system risks being converted into a consumption tax for investment gains. 

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