On September 28, 2026, the Treasury Department and the IRS released two pieces of guidance on the same day: Revenue Ruling 2026-20 and Notice 2026-62. Together they do something the government rarely does so directly — they name specific investment fund strategies that have been marketed to wealthy investors and say, in plain terms, that the tax results those strategies promise are inconsistent with the purpose of the law. The ruling holds that a popular way to diversify a concentrated stock position by "seeding" a new ETF is, in substance, a taxable sale. The notice identifies four related ETF strategies and three families of "tax-aware" fund strategies that Treasury is considering addressing next, and asks for public comment by October 28. Most investors will not find their own portfolio in these pages. But if you hold concentrated stock, have been pitched an exchange fund or an ETF "conversion," or own a tax-aware partnership or separately managed account, this is guidance worth reading — or having someone read for you. This article explains what was actually said, who is affected, the honest upside and downside, and the practical steps worth taking now.
What the IRS Actually Did
Two documents, two different weights. Revenue Ruling 2026-20 is a ruling: it applies existing law to a stated set of facts and reaches a conclusion. Notice 2026-62 is a signal and a request for information. It describes strategies the government is "considering" addressing, says that future guidance could take the form of regulations, notices, or rulings, and asks the public for comments. It expressly raises the possibility that a transaction could be identified as a transaction of interest or a listed transaction — the IRS's two heaviest labels for arrangements it views as abusive, which carry mandatory disclosure and steeper penalties.
The notice is not the final word, and it says so. Whether new guidance issues, and in what form, will depend on the facts of each transaction and the authority available. Treasury and the IRS state that any guidance will aim at specific abusive transactions, try to minimize compliance burdens, and respect market expectations for conventional, long-established tax planning. The notice also lists, strategy by strategy, variations it is not addressing — a feature we return to below, because the carve-outs matter as much as the targets.
It is also a statement about audits today. The notice reminds readers that the IRS may challenge these strategies on examination under existing law and judicial doctrines; no new rule is required. And the revenue ruling carries no effective date. Ropes & Gray, whose analysis of the guidance we relied on in preparing this article, reads that silence as a sign that the IRS views the ruling as an application of existing law — and therefore as applicable to transactions that have already taken place.
The ETF "Conversion" Trade, Explained
Start with why ETFs are tax-efficient. A mutual fund that sells appreciated stock to meet redemptions passes the gain to its shareholders. An ETF usually does not, because of a quirk in the Code. Section 852(b)(6) says that a regulated investment company (RIC) — which is what most ETFs are — does not recognize gain when it distributes property in kind to redeem its own shares on a shareholder's demand. ETFs use this routinely: large institutions called authorized participants (APs) hand the ETF shares back, and the ETF hands over a basket of appreciated securities instead of selling them. The notice states plainly that it expresses no view on these ordinary in-kind redemptions.
Now add Section 351. Section 351 lets you transfer appreciated property to a corporation in exchange for its stock without recognizing gain, if the transferors control the corporation afterward. The "investment company" rule of section 351(e) blocks that treatment when the transfer diversifies the transferors' holdings — but a transfer of an already-diversified portfolio (generally, no more than 25 percent in one issuer and no more than 50 percent in five or fewer) does not count as diversifying. So an investor with a diversified, highly appreciated portfolio can contribute it to a newly formed ETF and, on paper, owe nothing.
The promoted trade combines the two. The investor's securities are not necessarily what the new ETF wants to own. So, as part of the same plan, the ETF issues shares to an AP in exchange for the securities the ETF does want to hold (or for cash to buy them), and shortly afterward redeems the AP in kind using the securities the investor contributed. When the dust settles, the ETF holds a materially different portfolio, the investor owns ETF shares with the old built-in gain still deferred, and no one has recognized anything. In economic effect, the investor has swapped one portfolio for another without paying tax — which is precisely the diversification a concentrated-stock holder wants.
The ruling says that is a taxable exchange. Rev. Rul. 2026-20 describes exactly this fact pattern and concludes that the transfer is recharacterized to reflect its substance. The ETF is treated as a mere conduit; the investor is treated as exchanging the contributed securities with the AP in a taxable exchange under section 1001. The result is the same with multiple investors. The ruling rests on the old and well-worn doctrines of substance over form and step transactions — the idea that a result reached at the end of a straight path is not changed because it was reached by a devious one — and it relies on earlier cases and rulings that recharacterized a contribution followed by a prearranged redemption.
What the ruling does not reach. The notice says it expresses no view on a section 351 transaction used to seed a new ETF with assets consistent with the ETF's investment thesis that are intended and expected to be retained, absent a substantial change in circumstances such as an unexpected shift in market or business conditions. The line the IRS is drawing runs between seeding an ETF with what it plans to keep and using the ETF as a pass-through to change an investor's portfolio. Ropes & Gray observes that the ruling leaves a number of crucial terms undefined and many important questions unanswered. In our reading, that includes what counts as a "plan," how soon is "shortly," and how different is "materially different."
The Other Seven Strategies at a Glance
The notice pairs the seeding trade with four other strategies that rely on section 852(b)(6), and with three families of "tax-aware" fund strategies. The table below summarizes each in plain English, along with the variations the notice says it is leaving alone. Section references are to the notice.
| Strategy | How the notice describes it | Expressly left open |
|---|---|---|
| Partnership "exchange fund" variation (§2.03) | Investors with non-diversified positions contribute to a partnership holding at least 20% non-securities assets, aiming to avoid section 721(b). The now-diversified partnership then runs the ETF conversion above. | Other exchange fund transactions |
| Box spread ETFs (§2.04) | The ETF distributes in kind the gain-side option legs before expiry, so holders earn an interest-like return with no current income and are taxed only as capital gain when they sell. A straddle variant deducts losses on the remaining legs. | Other box spread transactions |
| "No dividend" ETF-of-ETFs (§2.05) | A parent ETF redeems out its holdings of a lower-tier ETF shortly before the record date and replaces them with another ETF tracking the same index, eliminating dividend income with no change in economics. | ETFs holding ETFs that track different indices |
| Non-qualifying income avoidance (§2.06) | An ETF holding commodities or digital assets distributes them in kind so that realized gain never counts against the 90% qualifying-income test for RICs. | Other structures, such as investments through controlled foreign corporations |
| Identified straddles of mixed character (§3.02) | A fund pairs a foreign-currency forward (ordinary under section 988) with a futures contract (60/40 capital under section 1256), identifies them as a straddle, and closes the futures first — producing capital gain on one leg and ordinary loss on the other. An equity index swap paired with index futures is described similarly. | Identified straddles with consistent character and holding period |
| Hindsight section 988 elections (§3.03) | A fund trades forwards that open and close the same day, then elects capital treatment only for those that made money, after knowing which did. | No carve-out stated |
| Selective swap terminations (§3.04) | A trader fund ends appreciated swaps shortly before a scheduled payment to claim capital gain, while holding losing swaps to payment and claiming ordinary loss. | No carve-out stated |
The Tax-Aware Fund Warning — and Why It Matters for Long-Short Investors
What section 3 targets. The notice's third section addresses "tax-aware" funds, typically organized as investment partnerships or separately managed accounts. The concern is a pattern: multi-position strategies that use technical differences between economically similar instruments, or timing and identification rules, to generate gross capital gain alongside ordinary loss — depending on which leg is closed, which election is made, or which rule applies. The purported result is ordinary losses that offset unrelated ordinary income, paired with capital gains that are taxed at lower rates, deferred, or otherwise absorbed. The notice says some of these funds look primarily tax-motivated, while others run bona fide investment programs but also use the transactions it describes.
What section 3 does not say matters just as much. The notice states that the "tax-aware" label is not itself a cause for concern, and that long-standing techniques such as selling securities with unrealized losses at year-end while keeping those with gains remain consistent with congressional intent. The target is what the notice calls "character electivity": choosing, with hindsight or by selective timing, to give identical economic items different tax character.
Readers of our tax-aware long-short series will recognize the neighborhood. In Part 3 we described limited-partnership structures that use monthly-reset total return swaps, terminate winning positions before the reset date, and let losing positions generate ordinary deductions — and we wrote then that this design invites scrutiny and that the IRS had signaled awareness of it. Section 3.04 of the notice describes a strategy that shares a central feature: ending appreciated swaps shortly before a scheduled payment to claim capital gain while holding losing swaps to claim ordinary expense. We are not saying that any particular fund is the one the notice describes. The notice's facts are specific — a trading fund without a section 475(f) election, payments in some cases added solely so the contract qualifies as a swap — and every fund's documents differ. But this is the right category of question to bring to a sponsor.
The distinction that matters is character consistency. The strategies in Part 1 and Part 2 — separately managed accounts that harvest capital losses to offset capital gains — keep character consistent: capital losses against capital gains. None of the three families in section 3 describes that approach. That is not an approval; the notice also asks the public whether other strategies are producing unintended results, and says it expresses no view where it does not speak. But it is a meaningful difference in kind from a design whose purpose is to turn the same economics into capital gain on one side and ordinary loss on the other.
Retroactivity, Audits, and Disclosure
Future guidance may reach backward. The notice says that guidance addressing these transactions could apply prospectively only, or retroactively to transactions already completed. Section 7805(b)(3) of the Code allows regulations to take effect retroactively where needed to prevent abuse, and the notice cites it. For anyone who completed one of these transactions in an earlier year, "wait for the final rules" is therefore not a safe assumption.
Disclosure obligations may follow. If a strategy is later designated a listed transaction or a transaction of interest, participants are generally required to disclose it to the IRS on Form 8886, and failure to disclose can bring significant penalties and keep the assessment period open far longer than usual. No such designation has been made — the notice raises it only as a possibility — but the mere prospect is a reason to know exactly what you hold and what the documents say.
The Upside: What This Guidance Gets Right
For most investors, nothing changes today. Ordinary ETF creation and redemption is explicitly outside the notice, and so is plain year-end loss harvesting. An investor holding broad-market ETFs, or running a conventional tax-loss harvesting program, is not the subject of this guidance.
A gray area has an answer. Anyone weighing an ETF conversion now has a direct statement from the IRS before putting a seven-figure position at risk. Learning the answer now is cheaper than learning it in an examination three years from now.
The targeting is narrow, and the carve-outs are explicit. Almost every strategy in the notice comes paired with a list of related transactions that are not addressed. Treasury commits to aim at specific abusive transactions, minimize compliance burden, and respect conventional planning. That is a more disciplined posture than a blanket rule against anything labeled "tax-aware."
The structures that work are left intact. The tax efficiency of conventional ETFs rests on in-kind redemptions, and the notice signals no intention to disturb them. Drawing a line around abuse is, in a sense, protection for the legitimate core.
It gives you a due diligence tool. The "tax-free diversification" pitch and the "ordinary losses against your salary" pitch now have an official counterpoint. A sponsor who cannot explain how their structure differs from what the ruling and notice describe has told you something.
The Downside: Where the Risk Actually Sits
Completed transactions may be exposed. Because the ruling has no effective date, an investor who completed an ETF conversion in an earlier year may face a taxable exchange, with interest and potentially penalties. What to do about that is a legal question, and it deserves careful, unhurried advice rather than a reflexive reaction.
The boundaries are blurry. With terms like "plan," "shortly," and "materially different" left undefined by the ruling, transactions that sit near the line will remain uncertain until more guidance arrives. The notice itself invites comment on similar transactions with different facts, which signals that the boundary is still being drawn.
Fund-level risk can reach holders who did nothing aggressive. An investor who simply bought shares of a box spread ETF or a "no dividend" ETF, or who holds a limited partnership interest in a tax-aware fund, may be exposed to a challenge at the fund level — and under the centralized partnership audit regime, an adjustment at the partnership level can reach every partner at once. The notice does not say how shareholders would be taxed if a strategy is recharacterized, which is itself part of the uncertainty.
Fewer tools for concentrated holders. The conversion route was marketed as an alternative to selling. Its removal pushes investors toward options that are slower, costlier, or less complete — staged sales, lock-up periods, or hedges that reduce risk without eliminating it.
A sponsor's opinion is not a shield. A tax opinion obtained by the promoter of a structure may help on the question of penalties, but it does not change what the IRS or a court concludes about the tax itself. Fees paid to enter a structure, and the cost of unwinding it, are real and are not refunded by a change in the law.
Possible Solutions: What to Do, Depending on Where You Stand
The right response depends on which of three situations describes you. None of the steps below is a substitute for advice from your own tax counsel and CPA on your own facts.
If you are weighing how to diversify a concentrated position
The ETF conversion route now carries serious risk, but there are other ways to reduce concentration, and each has a different cost-and-control profile. The best answer is often a combination.
- Staged sales with lot selection and loss offsets. Sell over several tax years, choose highest-basis lots first, and pair gains with harvested losses elsewhere in the portfolio. The tax is real but predictable, and bracket and net investment income tax thresholds can be managed year by year.
- A conventional exchange fund. A partnership that holds at least 20 percent in qualifying non-securities assets, typically with a seven-year lock-up, can deliver diversification without a sale. The notice says it does not address other exchange fund transactions, but it does target a partnership variation that is followed by an ETF conversion. Ask the sponsor, in writing, whether any such step is part of the plan. We cover the mechanics in our article on concentrated stock strategies.
- Charitable techniques. Gifts of appreciated shares to a donor-advised fund, or contributions to a charitable remainder trust, can reduce a position without recognizing gain at the point of transfer, for investors with philanthropic intent.
- Hedging overlays. Collars and prepaid forward structures can reduce downside risk without a sale, but must be designed with the constructive sale and straddle rules in mind.
- Capital-loss generation alongside a diversification plan. Tax-aware long-short strategies that keep character consistent — capital losses against capital gains, as in our tax-aware long-short series — can create losses to absorb gain from a staged sale. The ordinary-loss variants carry a materially higher bar, and the notice sharpens it.
- Holding with an estate plan. For some families, keeping a position and relying on the basis adjustment at death, paired with an estate plan, is a deliberate choice — with the concentration risk accepted in exchange.
If you already own something that resembles a flagged strategy
Start by identifying what you hold. The table below pairs common holdings with the questions worth asking.
| If you hold… | Ask… |
|---|---|
| An ETF that was "seeded" with a contributed portfolio | When did the contribution happen, and what share of the contributed securities left the fund shortly afterward through redemptions? |
| An exchange fund interest | Is any conversion into an ETF part of the fund's plan? Is the 20 percent qualifying-asset test being met and documented? |
| A box spread or "stable return" ETF with little or no income distribution | Does the fund rely on distributing option legs in kind? What does the sponsor say happens to holders if the position is challenged? |
| An equity or bond ETF-of-ETFs with unusually low distributions | Does it redeem out of acquired-ETF shares ahead of record dates? |
| A commodity or digital-asset ETF taxed as a RIC | How does the fund satisfy the 90 percent qualifying-income test, and does it distribute assets in kind? |
| A tax-aware LP or SMA using swaps, futures, or currency forwards | Which instruments does it use? Are positions identified as straddles? How are terminations and elections timed? Is there a written tax position memo? |
If the answers suggest your holding sits inside one of the patterns the ruling or notice describes, a sensible order of operations is this:
- Gather the paper. Subscription documents, offering memoranda, tax opinions, K-1s, and trade confirmations for the relevant period.
- Get independent counsel. Retain tax counsel who is not affiliated with the sponsor, and ask for a view on your specific facts.
- Quantify the exposure. Model the tax, interest, and potential penalties under a recharacterization scenario, so decisions are made against numbers rather than fear.
- Decide with counsel how to proceed. Options range from monitoring, to adjusting return positions, to unwinding or restructuring. This is a legal decision with real consequences; it should not be made quickly or alone.
- Plan liquidity. If an adverse outcome is plausible, make sure a recognition event would not force a sale at a bad time.
A due diligence test for any proposal you are shown from here
- Would the strategy make economic sense without the tax result?
- Is there a prearranged plan in which a contribution is followed, shortly, by a redemption or termination that changes the economic outcome?
- Does it produce capital gain on one leg and ordinary loss on an offsetting leg of the same economics?
- Who bears the risk if the IRS prevails — you, the sponsor, or no one? Does the sponsor indemnify anything in writing?
- Is the supporting opinion from independent counsel, and does it address this ruling and notice by name?
- What is the exit if the law changes, and what would it cost?
How We Help
We have nothing to sell you. As a fee-only fiduciary, we are not paid by fund sponsors, ETF issuers, or promoters of tax strategies, so our analysis of what you hold — and what to do about it — is not shaded by who pays us. We are not a law firm and do not issue tax opinions; our role is to organize the decision, quantify the trade-offs, and work alongside your CPA and tax counsel.
What a first conversation covers. We review the holdings and documents you bring against the strategy families in the notice and the ruling; identify what to ask each sponsor; model the after-tax outcome of the realistic alternatives for a concentrated position — sale, staged sales, exchange fund, charitable techniques, hedging, or a combination — including federal and state tax; and build a coordinated plan with your other advisors. For founders and executives with concentrated equity, and for families with larger and more complex portfolios, these questions usually overlap with equity compensation planning and broader tax and estate planning, which is why we address them together.
Timing. Comments on the notice are due October 28, 2026, and the guidance that follows may prove narrower or broader than anyone expects today. Nothing here calls for a rushed decision — but finding out what you actually hold is worth doing now, so that every later choice is made on facts rather than headlines.
Sources & Further Reading
IRS — Revenue Ruling 2026-20 (section 351 ETF seeding transactions)
Ropes & Gray LLP — IRS Targets ETF Seeding Transactions and Other Tax-Aware Fund Strategies in New Guidance (September 2026)
Legal Information Institute (Cornell) — 26 U.S.C. § 852, Taxation of regulated investment companies and their shareholders
Legal Information Institute (Cornell) — 26 U.S.C. § 351, Transfer to corporation controlled by transferor
Legal Information Institute (Cornell) — 26 U.S.C. § 721, Nonrecognition of gain or loss on contribution
Legal Information Institute (Cornell) — 26 U.S.C. § 1092, Straddles
Legal Information Institute (Cornell) — 26 U.S.C. § 7805, Rules and regulations (retroactivity)
We review what you own against Notice 2026-62, model the after-tax cost of each alternative, and coordinate with your CPA and counsel — fee-only, with nothing to sell you.
