Given some of the frictions and costs involved with implementation, many sophisticated tax planning strategies have historically been the purview of only the wealthiest investors. However, thanks to technological and other advances, in recent years certain tax-aware investment strategies have become available to a wider range of investors. At the same time, innovation in investment strategies and products can sometimes push the boundaries of what the IRS finds acceptable, potentially exposing investors who use them to greater scrutiny.
Amidst this backdrop, the IRS has issued formal guidance regarding certain tax-aware investment strategies that have been growing in popularity. Its more definitive statement, Revenue Ruling 2026-20, addresses a variation of the Section 351 ETF conversion (which investors can use to diversify concentrated positions while deferring capital gains) in which securities that don’t fit the ETF’s investment thesis are exchanged with an Authorized Participant, as part of the same plan, for securities that do. In this case, the IRS concluded that the ETF should not be respected as an independent intermediary, and that the investor should be treated as having made a taxable exchange. The agency did not, however, restrict Section 351 ETF conversions more broadly, leaving a good deal of gray area between what is clearly permitted and what is not.
The IRS also recently issued Notice 2026-62, which identifies transactions that concern the agency. The Notice describes additional guidance or enforcement actions the government may consider pending a public comment period (including guidance that could apply retroactively), making it less definitive than the Revenue Ruling, though still helpful to understand the types of transactions and products that are on the IRS’ radar. Strategies identified in the notice include a partnership/exchange-fund variation of the Section 351 transaction, box-spread ETFs (which generate interest-like income that turns into a deferred capital gain), ETFs that defer income by rotating between underlying ETFs with different dividend record dates, ETFs that seek to skirt the registered investment company qualifying-income rules, and certain strategies designed to exploit differences in the character of economically offsetting gains and losses.
