The Internal Revenue Service and the Treasury Department on Monday released Notice 2026-62, a broad statement of concern about several investment fund strategies that the agencies say can produce tax outcomes inconsistent with federal tax law. The notice was accompanied by Rev. Rul. 2026-20, which directly addresses the so-called Section 351 conversion, a maneuver increasingly used by advisors to help clients with low-basis holdings achieve diversification without triggering immediate capital gains.
Section 351 of the Internal Revenue Code generally allows investors to transfer property to a corporation in exchange for stock without recognizing gain, provided they meet control and diversification tests. A portfolio typically qualifies as diversified if no single issuer exceeds 25% of its value and the five largest issuers account for no more than 50%. The IRS, however, said the tax-free treatment does not apply when the contribution is part of a larger plan designed to circumvent the rules.
In the transactions described in the ruling, an investor seeds a new ETF with appreciated securities that do not fit the fund's stated investment strategy. The ETF then issues shares to an authorized participant in exchange for securities that do fit the strategy, or cash earmarked for such purchases. Shortly thereafter, the ETF redeems those shares in kind, returning the investor's original holdings. The net effect is that the investor ends up with a materially different portfolio while deferring tax on embedded gains. Rev. Rul. 2026-20 treats the ETF as a mere conduit in this arrangement, recharacterizing the deal as a taxable exchange between the contributing investor and the authorized participant.
The notice also flags a partnership variation designed for investors whose holdings are too concentrated to pass the diversification test on their own. The agencies left conventional practice untouched: the notice expresses no view on 351 transactions that seed a new ETF with assets that match its strategy and that the fund expects to hold. It also does not address routine ETF creations and redemptions, a structural advantage that lawmakers have previously sought to eliminate through legislation.
Beyond 351 conversions, Notice 2026-62 identifies several other strategies under scrutiny. These include box spread ETFs, which use options to mimic short-term interest rates without generating current income; funds that rotate between ETFs tracking the same index to avoid dividend income; ETFs holding commodities or digital assets that use in-kind redemptions to circumvent the 90% qualifying-income test for regulated investment companies; and derivatives trades used by tax-aware funds to produce capital gains alongside ordinary losses. The latter are already facing pressure as custodians tighten access to tax-aware long-short accounts, including Schwab's recent move to raise minimums.
The agencies said possible responses include new regulations, additional revenue rulings, or designating certain deals as listed transactions or transactions of interest. Any new guidance could apply retroactively. The IRS may also challenge abusive strategies on examination under existing law. The notice states that any future guidance will target specific abusive transactions, minimize compliance burdens, and respect market expectations for conventional, long-established tax planning consistent with congressional intent.
The action follows warnings from Treasury leadership over the summer. At a Wall Street Tax Association gathering in New York in July, senior officials said some tax-aware products may be abusive, according to Reuters. Treasury Secretary Scott Bessent reiterated that concern in a post on X on July 22, writing, "Tax rules should reward investment, not abusive financial engineering." The scrutiny comes after rapid growth in the 351 market: according to a tracker maintained by Tax Alpha Insider, more than 100 ETFs have been seeded in-kind under Section 351 since 2021, representing more than $20 billion in launch assets under management.
Treasury has opened a 30-day consultation period, inviting public comment on the strategies described in the notice. Advisors and fund sponsors should monitor the comment period and any subsequent guidance, as the IRS has signaled that retroactive application is possible. The notice does not affect conventional 351 transactions that seed a fund with assets consistent with its strategy, but the broader message is clear: the IRS is actively policing ETF tax strategies, and more guidance is likely.
