IRS Targets “351 Conversion Transactions” and Flags Various Other ETF/Investment Fund Strategies as Possibly Abusive

On Monday, September 28, 2026, the US Department of the Treasury and the IRS issued (i) Revenue Ruling 2026-20 (the “Ruling”), which targets an exchange-traded fund (“ETF”) strategy colloquially referred to as a “351 conversion transaction,” and (ii) Notice 2026-62 (the “Notice”), which flags various strategies the IRS states that ETFs/investment funds have used to defer and/or recharacterize taxable gains or losses as possibly abusive and requests comments by October 28, 2026. According to Treasury Secretary Scott Bessent, the Ruling and the Notice “makes clear Treasury is serious about cracking down on transactions designed to dodge taxes or exploit our federal tax code.” On the “351 conversion transactions,” Bessent further states that “[o]ur message is clear: they don’t work under existing law.”

Revenue Ruling 2026-20 and the “351 Conversion Transaction”

The tax benefits associated with so-called “351 conversion transactions” were, according to the IRS, to allow a taxpayer to defer taxation on the exchange of an appreciated, diversified portfolio of securities¹ for a materially different portfolio held through an ETF.

The Ruling describes a particular fact pattern in which, pursuant to a predetermined plan, a taxpayer would transfer a portfolio of appreciated and diversified securities to a newly formed ETF, which would be expected to qualify as a regulated investment company (“RIC”) for US federal income tax purposes. 

Then, pursuant to the same plan, the ETF would issue shares of the ETF to a person serving as an authorized participant in exchange for either securities that are consistent with the ETF’s investment thesis or cash (which the ETF would then use to purchase securities that are consistent with the ETF’s investment thesis). Shortly thereafter, the ETF would redeem the shares issued to the authorized participant in exchange for the securities originally contributed to the ETF by the taxpayer in a transaction intended to qualify as distribution under Section 852(b)(6), which would be tax-free to the ETF. Section 852(b)(6) allows a distribution by an ETF to a shareholder without gain recognition to the ETF “if such distribution is in redemption of its stock upon the demand of the shareholder” (i.e., no Section 311(b) gain upon such a distribution of appreciated property by the ETF).

Upon completion of the transactions, the taxpayer would take the position that its built-in gain on the originally held portfolio of appreciated securities would be preserved in the ETF shares it owns, and thus, the taxpayer would defer recognizing gain on its originally held portfolio despite exchanging such portfolio for ETF shares (which ends up holding a materially different portfolio of securities).

In the Ruling, the IRS concludes that the transfer of the portfolio of appreciated securities by the taxpayer to the ETF must be recharacterized as a taxable exchange between the taxpayer and the authorized participant and the same result applies where there are multiple taxpayers engaged in the transaction.

It is important to note that past transactions may be affected by the Ruling. In this regard, authorized participants should review prior transactions to determine the impact of the Ruling, including for tax reporting purposes. 

Notice 2026-62 and Transactions Identified as Possibly Abusive

The Notice flags various strategies used by ETFs/investment funds as possibly abusive, and requests comments and information with respect to these strategies. The comment period closes on October 28, 2026. Treasury and the IRS are considering whether additional guidance is warranted. Any additional guidance could include identifying any of the strategies as reportable transactions and could apply retroactively to transactions that already have taken place.

The Notice is divided into two broad categories. The first category describes strategies taking advantage of Section 852(b)(6). The second category describes certain so called “tax aware” strategies used by investment partnerships or separately managed accounts overseen by investment managers.

Strategies Taking Advantage of Section 852(b)(6)

• The “351 conversion transaction”: The Notice cross references the Ruling and indicates that Treasury and the IRS are considering additional guidance to address “351 conversion transactions.”

• Transfers to partnerships in connection with a “351 conversion transaction”: The Notice identifies a variation of the “351 conversion transaction” that is further intended to bypass the diversification requirement. In this variation, before engaging in the “351 conversion transaction,” multiple taxpayers, each with a non-diversified portfolio (i.e., concentrated position(s)), would first contribute their securities to a partnership that would invest at least 20% of its assets in property that is not stock or securities.
  
  The theory is that since the partnership, if incorporated, would not be treated as an investment company for purposes of Section 351(e), the taxpayers’ contribution would qualify for nonrecognition under Section 721(a). The partnership would then engage in the so-called “351 conversion transaction.”
  
  Treasury and the IRS are considering guidance that would prevent such contributions to partnerships from qualifying for nonrecognition of gain or loss or otherwise may be recharacterized in a manner that reflects what the IRS deems is the proper substance of the underlying transaction for US federal income tax purposes.

• The box spread funds: The Notice identifies a strategy in which ETFs use “box spreads” to effectively generate a yield similar to short-term interest rates without current income recognition. Here, an ETF would enter into box spreads, a combination of four options on the same underlying property that in aggregate produce a return similar to short-term interest rates. Before the options that have an unrealized gain expire, the ETF would separate the components of the box spread using a distribution intended to qualify for nonrecognition under Section 852(b)(6).
  
  As a result, the ETF would take the position that it avoids recognition of income or gain on the box spread, and the shareholder would purportedly recognize no current income. Since the box spread increases the value of the ETF’s portfolio and the value of its shares, shareholders would generally take the position that they recognize capital gain upon the sale or disposition of their shares in an amount that generally corresponds to the ETF’s income from the box spread (in other words, a shareholder benefits from a short-term interest rate return subject to capital gain tax rates rather than ordinary income tax rates).
  
  The Notice describes a variation in which an ETF also holds offsetting straddle positions and distributes gain positions pursuant to Section 852(b)(6). Here, the ETF takes the position that it can deduct the loss on the remaining straddle positions notwithstanding that the offsetting gain is never recognized, and that such loss is available to offset income from the box spread (or any other income recognized by the ETF).

• The record date strategies: Some “parent” ETFs invest in other “acquired” ETFs that track the same index. Shortly before the acquired ETF’s dividend record date, the parent ETF distributes the acquired ETF shares to an authorized participant pursuant to Section 852(b)(6) and simultaneously acquires shares in a replacement ETF tracking the same index. The parent ETF takes the position that it avoids recognizing dividend income while maintaining the same economic exposure to the underlying index. Shareholders of the parent ETF recognize no current income or capital gain until they dispose of their shares.

• The RIC income test avoidance: To qualify as a RIC, at least 90% of the corporation’s gross income must generally consist of qualifying income (e.g., dividends, interest, gains from the sale or other disposition of stocks or securities). The Notice identifies a strategy in which ETFs invest in, for example, commodities, digital assets, or grantor trusts holding these assets (i.e., non-qualifying income), and distribute such assets pursuant to Section 852(b)(6) to avoid recognizing such gain and purportedly satisfying the applicable RIC income test.

Certain “Tax Aware” Strategies

• Identified straddles with mixed character: The Notice identifies a strategy in which a fund enters into a pair of foreign currency contracts that are long and short the same foreign currency, consisting of (i) a forward contract giving rise to ordinary income or loss under Section 988, and (ii) a future contract giving rise to 60% long term capital gain or loss and 40% short-term capital gain or loss under Section 1256. Together, these contracts constitute a straddle under Section 1092 and are identified as such.
  
  Regardless of the performance of the contracts, the fund terminates the futures contract first. If the future contract is in a gain position, the fund recognizes capital gain on the futures contract and then corresponding ordinary loss on settlement of the forward contract. If the futures contract is in a loss position, the fund takes the position that the loss from the termination of the futures contract is capitalized into the basis of the forward contract, reducing the ordinary income (or producing an ordinary loss) on the forward contract at settlement. Thus, the net result is gross capital gain and gross ordinary loss from economically offsetting positions.

• Same-day acquisitions and dispositions of foreign currency forward contracts: The Notice identifies a strategy in which a fund enters into foreign currency contracts that expire or are disposed of or terminated on the same day they are entered into. After the fund completes its trading for the day, the fund elects Section 988(a)(1)(B) capital gain treatment for forward contracts that produced a gain in order for such gain to be capital, while not making the election for contracts that produced a loss (i.e., keeping those as ordinary losses).

• Selective NPC terminations used to obtain inconsistent character: The Notice identifies a strategy in which a fund that enter into multiple, often short-term, notional principal contracts (“NPCs”) which calls for one or more periodic or nonperiodic payments, and one or more of these payments are contingent on the performance of an underlying asset such as a stock.
  
  If an NPC has appreciated in value (e.g., if an underlying contingent payment becomes payable), the fund would terminate or dispose of the NPC early, treating the payment received as a “termination payment” under Treas. Reg. Section 1.446-3(h), and would claim capital-gain treatment under Section 1234A. If an NPC is in a loss position, the fund holds it to maturity and claims the resulting payment as ordinary expense.

Taxpayers engaging in these strategies may want to consider the possibility of future guidance, including designation as reportable transactions and possible retroactive effect applicable to transactions that have already taken place at the time the guidance is issued. Adequate record keeping should be high on the priority list.

¹ For such purposes, the contributed portfolio would be treated as diversified if (i) not more than 25% of the value of the total assets of the portfolio are invested in the stock and securities of any one issuer and (ii) not more than 50% of the total value of the portfolio’s assets are invested in the stock and securities of five or fewer issuers.