IRS treats certain ETF conversion transactions as taxable; Treasury expands scrutiny of tax-aware investment strategies

The U.S. Department of the Treasury and the Internal Revenue Service have taken a significant next step in their scrutiny of certain tax-aware investment strategies, including some Section 351 exchange-traded funds (ETF) conversions, exchange-fund variations, and strategies designed to generate ordinary losses.

The most immediate development is Revenue Ruling 2026-20 (the Revenue Ruling), in which the IRS concludes that a particular transaction promoted as a tax-free contribution of appreciated securities to a newly formed ETF should instead be treated as a taxable exchange by the contributing investor.

The ruling applies where the investor’s contribution is part of a broader plan under which the ETF shortly thereafter uses its creation-and-redemption process to transfer some or all of those contributed securities to an authorized participant and emerges with a materially different portfolio. Applying longstanding substance-over-form and step-transaction principles, the IRS treats the ETF as a conduit and concludes that the investor effectively exchanged the appreciated securities with the authorized participant for materially different property.

Importantly, the IRS does not generally challenge an ETF’s ability to make qualifying in-kind redemptions under Section 852(b)(6). Instead, on the facts described in the ruling, the IRS focuses on the investor’s purported Section 351 contribution and concludes that the planned series of transactions should be integrated and taxed at the investor level.

That distinction matters. Investors who have completed, or are considering, similar ETF conversion transactions should understand not only whether the technical requirements of Section 351 are satisfied in isolation, but also what was intended to happen to the contributed securities after they entered the ETF.

At the same time, Treasury and the IRS issued Notice 2026-62 (the Notice), which identifies several additional ETF, exchange-fund, and derivatives-based strategies for further scrutiny and requests public comments. The Notice makes clear that Treasury is not mounting a general challenge to ETFs, exchange funds, tax-loss harvesting, or tax-aware investing. Rather, it is focused on particular transactions in which multiple tax rules are combined or sequenced in a manner Treasury believes may produce results inconsistent with their intended purpose.

Key takeaways

• Section 351 ETF conversions are now an immediate focus. Revenue Ruling 2026-20 treats a specified ETF conversion transaction as a taxable exchange by the contributing investor where the contribution and subsequent ETF redemption are part of a single plan.
• The IRS is not generally challenging ETF in-kind redemptions. The ruling instead attacks the investor’s initial Section 351 transaction by integrating the related steps and treating the ETF as a conduit.
• Existing transactions deserve review. The Revenue Ruling applies existing judicial doctrines rather than announcing a new statutory rule, and Notice 2026-62 separately states that the IRS may challenge transactions under existing law. The Notice also cautions that future guidance could, depending on the applicable authority, apply prospectively or retroactively.
• Exchange funds are not generally under attack, but certain exchange-fund-to-ETF structures are. The Notice specifically describes a partnership variation involving an exchange fund that subsequently participates in a Section 351 ETF conversion, while expressly stating that it does not address other exchange-fund transactions.
• Tax-aware long/short strategies are not treated alike. Treasury expressly acknowledges conventional tax-loss harvesting as a longstanding technique. Its focus is instead on strategies that use differences in tax character, elections, or termination mechanics to seek capital gains paired with ordinary losses.

Revenue Ruling 2026-20: The investor, not the ETF, is the focus

The transaction addressed in Revenue Ruling 2026-20 begins with an investor contributing an appreciated, diversified portfolio to a newly formed ETF in a transaction intended to qualify under Section 351.

As part of the same plan, the ETF then issues shares to an authorized participant in exchange for securities consistent with the ETF’s intended investment strategy or cash that will be used to acquire such securities. Shortly thereafter, the ETF redeems the authorized participant by distributing securities that had been contributed by the original investor. When the planned transactions are completed, the ETF holds a portfolio materially different from the portfolio initially contributed by the investor.

Rather than treat these as separate transactions—a tax-free Section 351 contribution followed by an ordinary ETF redemption—the IRS integrates the steps.

The ruling relies on longstanding step-transaction and substance-over-form principles under which transitory ownership by an intermediary can be disregarded when necessary to reflect the substance of a planned transaction. On the stated facts, the IRS concludes that the ETF functioned as a conduit through which securities effectively moved from the investor to the authorized participant.

The result is significant: The investor is treated as engaging in a taxable exchange under Section 1001 with the authorized participant with respect to the securities contributed by the investor and subsequently distributed by the ETF in redemption of the authorized participant.

For investors, the practical point is straightforward: The IRS’s theory is not that in-kind ETF redemptions have suddenly become taxable. It is that, where those redemptions are part of a prearranged portfolio-conversion plan, the investor’s initial purportedly tax-free contribution may instead be treated as part of a taxable exchange.

What about prior transactions? 

One of the most important questions for the market is what the new guidance means for investors who completed similar transactions before the ruling was issued.

Revenue Ruling 2026-20 does not frame its holding as a newly created prospective-only rule. Instead, its analysis rests on existing Section 1001 principles and longstanding step-transaction and substance-over-form authorities.

Notice 2026-62 likewise states that the IRS may challenge an investment-fund strategy on examination under existing provisions of the Internal Revenue Code, Treasury Regulations, and applicable judicial doctrines. The Notice further provides that additional guidance could, depending on the authority used, apply prospectively or retroactively.

This does not mean that every prior Section 351 ETF contribution is taxable. Facts matter considerably. But investors and advisers with previously completed transactions that resemble the Revenue Ruling should consider reviewing the transaction history, including what occurred after the initial ETF contribution and whether subsequent creation or redemption activity was contemplated as part of the original plan.

Not every Section 351 ETF seed is addressed

The government also draws an important limiting line. Notice 2026-62 expressly states that it does not address a Section 351 transaction used to seed a newly established ETF with assets that are consistent with the ETF’s investment thesis and that are intended and expected to remain in the ETF absent a substantial change in circumstances. That limitation may prove important.

The factual inquiry therefore extends beyond whether appreciated securities were contributed to an ETF. Relevant questions may include:

• Whether the contributed securities were consistent with the ETF’s intended strategy
• Whether they were expected to remain in the ETF
• Whether subsequent creation-and-redemption activity was contemplated before the contribution
• What actually happened to the contributed securities following the seed transaction

The dividing line may ultimately depend less on the label attached to the transaction than on whether the investor made a genuine investment in an ETF holding a strategy-consistent portfolio or participated in a planned series of transactions designed to transform one portfolio into a materially different one without current recognition of built-in gain.

Exchange funds and the partnership variation

Notice 2026-62 also addresses a related structure involving partnership exchange funds. Treasury describes investors contributing appreciated securities to a partnership in a transaction intended to qualify for nonrecognition under Section 721. The partnership is structured so that it would not be treated as an investment company for purposes of Section 721(b), including by holding sufficient assets other than stocks and securities.

The partnership then assembles a diversified securities portfolio and, as part of the same overall plan, participates in the Section 351 ETF conversion described in the Notice.

Treasury states that the planned combination of Sections 721, 351, and 852(b)(6) is being used to permit investors to move from concentrated appreciated securities into indirect exposure to a materially different ETF portfolio without recognizing the built-in gain. Treasury and the IRS indicate that they are considering additional guidance addressing the partnership contribution or otherwise recharacterizing the transaction to reflect its substance.

Importantly, however, the Notice expressly states that it does not address other transactions involving exchange funds and expresses no view regarding those transactions.

Accordingly, the Notice should not be read as a general challenge to traditional exchange funds.

Exchange-fund structures that incorporate a subsequent ETF contribution, however, deserve closer review—particularly where the contributed securities are expected to leave the ETF through the creation-and-redemption process shortly after the Section 351 contribution.

Tax-aware long/short strategies: The source of the tax benefit matters

The second major area covered by Notice 2026-62 is the growing market for tax-aware investment funds and separately managed accounts.

Here, Treasury makes an important distinction. The Notice expressly acknowledges that taxpayers may use longstanding techniques to reduce tax—for example, owning a diversified portfolio, selling securities with unrealized losses, and retaining securities with unrealized gains. Treasury further states that describing a strategy as “tax-aware” or “tax-advantaged” is not itself cause for concern.

The focus instead is on multiposition strategies that use technical differences among economically similar instruments or payments, elections, termination mechanics, or identification rules to create a pattern of capital gains and ordinary losses. Treasury notes that some such funds may pursue genuine and profitable investment activity while also engaging in the identified tax strategies.

The Notice describes three principal examples. 

Mixed-character identified straddles

Treasury describes identified straddles pairing instruments that produce different types of tax character—for example, a foreign-currency forward generating ordinary gain or loss under Section 988 and an offsetting futures position generating Section 1256 capital gain or loss.

By controlling the sequencing of the positions, the strategy seeks to produce capital gain and corresponding ordinary loss.

Selective Section 988 elections

The Notice also describes short-dated foreign-currency-forward contracts where the taxpayer makes a Section 988 election for winning positions after the result is known but does not make the election for losing positions.

The intended outcome is capital gain on the winners and ordinary loss on the losers. Treasury focuses on the use of hindsight and inconsistent character treatment for economically identical instruments.

Selective swap terminations

Finally, the Notice addresses a trader fund using notional principal contracts, or swaps. In the described transaction, appreciated swaps are terminated shortly before a scheduled payment, and the resulting gain is claimed as capital under Section 1234A. Losing swaps are instead held through the scheduled payment or maturity, with the fund claiming ordinary expense. Treasury describes the concern as using selectivity to obtain different tax character for similar payments on identical financial instruments.

For investors, this distinction is particularly important because the broad label “tax-aware long/short” can describe materially different strategies.

A conventional long/short portfolio that realizes genuine economic capital losses while maintaining market exposure presents different tax issues from a strategy whose projected benefit depends on generating ordinary deductions through character, election, or termination mechanics.

A useful diligence question is therefore deceptively simple: What, precisely, is generating the projected tax benefit?

Other ETF strategies identified in the Notice

Notice 2026-62 also identifies several additional ETF strategies that Treasury and the IRS are evaluating.

These include certain ETFs using non-Section 1256 box spreads to seek a financing-like return while distributing appreciated option positions through in-kind ETF redemptions; ETF-of-ETF strategies designed to avoid current dividend income by disposing of an underlying ETF before its dividend record date while maintaining substantially similar market exposure; and ETFs using in-kind redemptions to avoid recognizing gains that could otherwise constitute nonqualifying income under the regulated investment company income test.

Again, the Notice carefully distinguishes these transactions from ordinary ETF activity. Treasury expressly acknowledges that ETFs regularly engage in creation-and-redemption transactions involving appreciated securities and, except for the transactions specifically identified, does not express a view regarding those established practices.

What investors, family offices, and advisers should consider now

For investors and advisers, the new guidance warrants a more transaction-specific review rather than a broad retreat from tax-aware investing.

Investors who completed or are considering a Section 351 ETF conversion should understand what happened, or is expected to happen, to the contributed securities following the contribution. Particular attention should be given to transactions involving rapid post-seeding redemptions or other prearranged portfolio transformation.

Investors in exchange funds that subsequently contribute assets to ETFs should determine whether their structure resembles the partnership variation described in the Notice and whether the contributed securities are intended to remain in the ETF.

Investors in tax-aware long/short funds and separately managed accounts (SMAs) should distinguish conventional capital-loss harvesting from strategies that depend on ordinary-loss treatment, selective elections, mixed-character positions, or derivative termination mechanics.

Managers and financial advisers should consider whether existing tax analyses, offering materials, investor communications, and marketing claims should be revisited in light of the Revenue Ruling and Notice.

Across these strategies, investors may wish to ask several common questions:

• What are the underlying pre-tax investment economics?
• What specifically generates the projected tax benefit?
• What legal assumptions must hold for that treatment to work?
• Does the strategy depend on elections, sequencing, or decisions made after investment performance is known?
• What happens if the IRS challenges the intended treatment?
• Has the manager or its tax counsel revisited its analysis in light of Revenue Ruling 2026-20 and Notice 2026-62?

For family offices in particular, these issues should also be evaluated across the investor’s broader portfolio. A manager may optimize one investment sleeve, but tax attributes, wash-sale issues, hedging positions, existing gains and losses, and the investor’s ultimate ability to use projected tax benefits often must be assessed at the household or family-office level.

Treasury requests industry input

Notice 2026-62 also opens a formal comment process. Treasury and the IRS specifically ask whether they have accurately described the identified transactions, which apparently similar transactions involve materially different facts or economics, how future guidance should be scoped, and whether other market strategies are producing unintended tax results.

Comments are requested by October 28, 2026, although later comments may also be considered if doing so would not delay forthcoming guidance.

The breadth of those questions is notable. Treasury appears interested not only in addressing transactions it considers problematic, but also in understanding where factual or economic distinctions should be drawn so that future guidance does not sweep in established market practices that are consistent with congressional intent.

For affected fund sponsors, investment managers, financial institutions, RIAs, family offices, and investors, the coming weeks therefore present both a diligence issue and an opportunity to engage with Treasury and the IRS before the government determines what additional action to take.

Ashurst Perkins Coie lawyers are available to assist clients in evaluating existing or proposed tax-aware investment strategies, assessing the implications of Revenue Ruling 2026-20 and Notice 2026-62, reviewing prior transactions, and considering whether to participate in the Treasury and IRS comment process.