The notice is not a final rule. It is a warning. It describes the transactions, asks for comments by October 28, 2026, and says that future guidance could include regulations, revenue rulings, or designating the transactions as listed transactions or transactions of interest. Any such guidance could apply retroactively . The IRS also says it may challenge these strategies on examination under existing law, including judicial doctrines .
If you have invested in, sponsor, or advise on any of the funds described below, now is the time to review your position.
Why ETFs Are at the Center
Most of the strategies rely on Section 852(b)(6). Under that rule, a regulated investment company (RIC) does not recognize gain when it distributes appreciated property to redeem shares at a shareholder's demand . ETFs use this rule every day. When an "authorized participant" redeems a creation unit, the ETF can hand over low-basis securities without triggering gain. This is a big reason ETFs are more tax-efficient than traditional mutual funds .
The IRS is not challenging ordinary ETF creation and redemption activity. The notice expressly says it does not address those routine distributions . The concern is that the redemption mechanism is being used "not simply to operate an ETF in the normal course," but to eliminate income or gain that Subchapter M and other Code provisions expect to be taxed .
The Strategies Under Scrutiny:
1. Section 351 ETF Conversions (See Rev. Rul. 2026-20)
In this strategy, investors transfer diversified portfolios of appreciated stock to a newly formed ETF and claim tax-free treatment under Section 351. Soon after, as part of the plan, the ETF issues creation units to an authorized participant for cash or "on-thesis" securities. It then redeems those units with the investor's original securities. The result is that the investor ends up owning a fund with a materially different portfolio, without recognizing any built-in gain .
Rev. Rul. 2026-20 applies substance-over-form and step-transaction principles and treats the ETF as a mere conduit. The investor is treated as making a taxable exchange under Section 1001 with the authorized participant, so Section 351 does not apply to the securities used to redeem the authorized participant assets.law360news+1. The ruling does not state an effective date or offer transition relief.
The notice does carve out ordinary ETF "seeding." A Section 351 transfer of assets that fit the ETF's investment thesis, and that the fund expects to keep, is not covered .
2. Partnership "Exchange Fund" Variations
Investors whose holdings are too concentrated to qualify as a diversified portfolio under Section 351(e) have been offered a different path. They first contribute appreciated stock to a partnership that holds at least 20% non-securities assets, which is meant to avoid "investment company" status under Section 721(b). The partnership then carries out a Section 351 conversion . Treasury and the IRS are considering guidance that would deny nonrecognition to these contributions or recharacterize them .
3. Box Spread Funds
Some ETFs build returns similar to Treasury bills using "box spreads," which combine four options that together produce a short-term interest rate return. Before the gain options expire, the fund distributes them to redeem creation units. Shareholders receive no current dividends and instead recognize capital gain only when they sell . A related version pairs the box spread with a straddle, distributes only the gain leg, and deducts the loss leg .
4. Record Date Strategies
A "parent" ETF that holds other index ETFs can redeem out the acquired ETF shares just before a dividend record date and replace them with a different ETF tracking the same index. The parent ETF takes the position that it never recognizes the dividend income, even though its economic exposure stays essentially the same .
5. RIC Income Test Avoidance
To qualify as a RIC, a fund must get at least 90% of its gross income from qualifying sources under Section 851(b)(2). Some ETFs that hold commodities or digital assets, directly or through grantor trusts, distribute appreciated non-qualifying assets through redemptions. They then take the position that the unrecognized gain does not count against the income test . Commentators note that this piece could affect certain commodity and crypto fund structures.
"Tax-Aware" Funds: Manufacturing Capital Gain and Ordinary Loss
Section 3 of the notice moves beyond ETFs. It addresses "tax-aware" partnerships and separately managed accounts that use technical rules to pair capital gains (taxed at lower rates or deferred) with ordinary losses that offset wages or other ordinary income . The IRS says labeling a strategy "tax-aware" is not a problem in itself, and it recognizes traditional tax-loss harvesting as legitimate . The strategies it flags are:
Mixed-character identified straddles. These pair a Section 988 foreign currency forward (ordinary) with an offsetting Section 1256 futures contract (60/40 capital), or an equity index swap with an index future. The futures leg is always terminated first, so gains come out capital and losses come out ordinary .
Hindsight Section 988(a)(1)(B) elections. The fund enters into same-day currency forwards and elects capital treatment only for the winners after the trading day ends, leaving the losers ordinary .
Selective NPC terminations. The fund terminates appreciated short-term swaps just before a scheduled payment to claim capital treatment under Section 1234A, but holds losing swaps to maturity to claim ordinary expense .
What Taxpayers and Advisors Should Do Now
Inventory exposure. Find clients who took part in a Section 351 ETF conversion or an exchange fund feeding one, or who hold interests in box spread, fund-of-ETF, commodity/digital asset, or "tax-aware" long-short vehicles.
Revisit the reporting positions. Rev. Rul. 2026-20 sets out the IRS's view of current law. Clients who treated a conversion as tax-free should evaluate whether they need to amend, disclose, or take other protective steps, especially for years that are still open.
Watch for listed transaction status. If any of these strategies becomes a listed transaction or transaction of interest, participants and material advisors could face Form 8886 and Form 8918 disclosure duties and significant penalties for failing to comply.
Get the documentation from sponsors. Ask fund sponsors for their tax opinions, their descriptions of how redemptions are handled, and whether the fund plans to change its structure.
Consider commenting. Sponsors and industry groups that believe their products are legitimately different from the transactions described have until October 28, 2026 to say so .
The Bottom Line
Notice 2026-62 shows that Treasury and the IRS are paying close attention to fund structures that turn Section 852(b)(6) and similar technical rules into tools for eliminating or recharacterizing income. The Section 351 ETF conversion has already been ruled a taxable exchange. The other strategies are clearly on the path to further guidance, possible listed transaction designation, and examination. Taxpayers who used these products should talk with their tax advisor before the next filing season.
Have IRS Tax Problems?
www.TaxAid.com or www.OVDPLaw.com
or Toll Free at 888 8TAXAID (888-882-9243)
This post is for general information only and is not legal or tax advice. The application of these rules depends on the specific facts. Please contact us to discuss your situation.
References
Internal Revenue Service, Notice 2026-62, Guidance and Other Actions Being Considered Regarding Certain Potentially Abusive Investment Fund Strategies Involving Financial Products (Sept. 28, 2026). https://www.irs.gov/pub/irs-drop/n-26-62.pdf (also available at https://assets.law360news.com/2530000/2530914/n-26-62.pdf)
Internal Revenue Service, Rev. Rul. 2026-20, Determination of Amount of and Recognition of Gain or Loss (Sept. 28, 2026). https://www.irs.gov/pub/irs-drop/rr-26-20.pdf
KPMG TaxNewsFlash, "Rev. Rul. 2026-20 and Notice 2026-62: Potentially abusive transactions involving investment funds" (Sept. 28, 2026). https://kpmg.com/us/en/taxnewsflash/news/2026/09/tnf-rev-rul-2026-20-and-notice-2026-62-potentially-abusive-transactions-involving-investment-funds.html
Mitrade, "The IRS May Be Coming for Crypto ETFs Next: Which Funds Are at Risk?" (Sept. 28, 2026). https://www.mitrade.com/ae-en/insights/news/live-news/article-3-2122030-20260929
Internal Revenue Code §§ 311(b), 351(e), 721(b), 851(b)(2), 852(b)(6), 988(a)(1), 1092(a)(2), 1234A, 1256; Treas. Reg. §§ 1.351-1(c), 1.446-3.
No comments:
Post a Comment