WASHINGTON — The Internal Revenue Service is putting some of Wall Street’s fastest-growing tax-reduction strategies on notice, warning that investment structures used by wealthy investors to defer or sharply reduce taxes may be pushing federal rules beyond what Congress intended.
The U.S. Treasury Department and IRS have issued two pieces of guidance targeting sophisticated transactions involving exchange-traded funds and so-called tax-aware investment funds.
The first, Revenue Ruling 2026-20, directly challenges a specific type of Section 351 ETF conversion.
The second, Notice 2026-62, identifies a broader group of investment-fund strategies that Treasury says may generate tax outcomes inconsistent with the purpose of existing law.
For investors, the significance is considerable.
Some of these strategies have become popular with wealthy individuals sitting on highly appreciated stock positions or looking to turn ordinary income into more favorably taxed capital gains.
But Treasury is now signaling that tax efficiency cannot become the sole economic purpose of a transaction.
The bigger danger is that the IRS may not wait for new regulations to begin challenging questionable structures—and some future guidance could potentially apply to transactions that have already occurred.
The IRS Is Targeting Two Broad Types of Strategies
The current crackdown can be divided into two major categories.
The first involves certain ETF conversion transactions under Section 351 of the tax code.
The second involves tax-aware funds and separately managed accounts designed to generate particular combinations of gains and losses.
CNBC described the latest action as a warning shot for investors using strategies capable of dramatically reducing tax liabilities.
But the details matter.
The government is not saying that every ETF conversion or every tax-aware investment strategy violates the law.
Instead, it is focusing on arrangements where the formal structure of a transaction may produce a tax result that does not match its underlying economic reality.
How a Section 351 ETF Conversion Can Reduce Taxes
Section 351 is an established part of the U.S. tax code.
Under certain conditions, an investor can transfer property to a corporation in exchange for stock without immediately recognizing taxable gain.
The rule can legitimately be used in many business transactions.
More recently, however, wealthy investors have used Section 351 to contribute highly appreciated securities to newly created ETFs.
Imagine an investor bought shares for $2 million that are now worth $10 million.
Normally, selling the shares would trigger tax on the $8 million gain.
A Section 351 transaction may allow the investor to contribute those securities to an ETF without immediately recognizing that gain, provided statutory requirements are satisfied.
That can give an investor a way to diversify a concentrated portfolio without generating an immediate multimillion-dollar tax bill.
The problem arises when the ETF is created as part of a prearranged sequence designed to rapidly dispose of the contributed securities through the ETF’s in-kind redemption mechanism.
IRS Says One Version Is Really a Taxable Exchange
Revenue Ruling 2026-20 addresses one such transaction directly.
In the scenario analyzed by the IRS, an investor transfers appreciated securities into a newly established ETF.
Soon afterward, as part of the same plan, the ETF distributes some or all of those securities to an authorized participant through an in-kind redemption.
The ETF then ends up holding a significantly different portfolio.
The IRS concluded that the steps should not be viewed independently.
Instead, using substance-over-form and step-transaction principles, it treated the arrangement as though the investor had effectively exchanged the appreciated securities for different investments.
That means the transaction can be taxable under Section 1001 rather than qualifying for tax-free treatment under Section 351.
Why Economic Substance Is Becoming Critical
One of the biggest lessons for investors is that merely following the mechanical steps of a tax provision may not be enough.
Tax authorities can examine the economic purpose behind a transaction.
If the entire structure exists primarily to manufacture a favorable tax outcome without meaningful non-tax economic substance, the IRS may challenge it.
ETF specialists have emphasized that a properly structured transaction should have legitimate investment reasons independent of tax savings.
For example, the securities contributed to a new ETF should make economic sense within that fund’s stated investment strategy.
Documentation can also become important.
Investors, advisers and asset managers may need to show why each step occurred and what business or investment objective it served apart from minimizing taxes.
Tax-Aware Funds Face a Different Kind of Scrutiny
The second part of the government’s crackdown focuses on strategies used by so-called tax-aware funds.
These products may be structured as partnerships or separately managed accounts and are often marketed to high-income investors.
The goal can be to maximize after-tax returns rather than simply maximize pretax investment performance.
That concept itself is not controversial.
Conventional tax-loss harvesting—selling an investment at a loss to offset capital gains elsewhere—is a widely used and established strategy.
Treasury has explicitly said it is not attacking ordinary, long-standing tax planning consistent with congressional intent.
The concern arises when a fund deliberately combines offsetting financial positions in a way that produces capital gains on one side and ordinary losses on the other.
That can be especially valuable because ordinary losses can potentially offset salary, business income or other income taxed at higher rates.
Capital Gains and Ordinary Losses Create a Powerful Tax Advantage
U.S. tax law treats different categories of income differently.
Long-term capital gains are generally taxed at lower rates than ordinary income for many taxpayers.
Ordinary income can include salary, business earnings and certain short-term investment returns.
So imagine a strategy designed to produce:
- $1 million of capital gain, and
- $1 million of ordinary loss.
Economically, the positions may largely offset one another.
But for tax purposes, the ordinary loss may offset highly taxed income while the capital gain receives a lower tax rate or may be deferred.
That mismatch is what has attracted Treasury’s attention.
The government is examining whether certain funds are deliberately exploiting technical differences among tax provisions to create favorable tax character without corresponding economic risk.
Treasury Identifies Several Specific Strategies
Notice 2026-62 identifies multiple categories of transactions that Treasury and the IRS are studying.
These include mixed-character identified straddles, where offsetting positions produce different tax treatment depending on whether the investor realizes a gain or loss.
Another strategy involves short-term foreign-currency forward contracts.
Some arrangements may selectively elect capital treatment for profitable positions while retaining ordinary treatment for loss-producing trades.
Treasury is also examining selective termination of notional principal contracts and other derivatives strategies that may generate similar mismatches.
These transactions can be extremely complicated.
That complexity is itself part of the challenge for regulators.
Small differences in timing, instrument type or legal structure can produce very different tax outcomes.
ETFs’ Special Tax Rules Are Also Being Examined
ETFs enjoy structural tax advantages that traditional mutual funds generally cannot use as efficiently.
A major one comes from Section 852(b)(6).
Under this provision, a regulated investment company can distribute appreciated securities when redeeming shareholders without recognizing a gain at the fund level.
This in-kind redemption mechanism is one reason ETFs can be highly tax-efficient.
In normal operations, the mechanism helps ETFs handle investor redemptions without having to sell appreciated positions and generate capital-gains distributions for remaining shareholders.
Treasury says that ordinary use is not the target.
The concern arises when the rule is deliberately used in unusual transactions primarily to remove appreciated assets, avoid income recognition or create specially engineered tax outcomes.
Box-Spread ETFs and Record-Date Strategies Are Also on the List
The IRS notice reaches beyond Section 351 conversions.
It also identifies certain ETF strategies involving record dates, box spreads and regulated-investment-company income tests.
Some structures use derivative positions to create economically bond-like returns while attempting to achieve different tax treatment.
Others may use redemption mechanics to remove assets before taxable gains are recognized.
The government is asking whether these approaches represent legitimate applications of existing rules or unintended loopholes.
The fact that a strategy appears in the notice does not automatically mean it is illegal.
But inclusion is a significant warning to fund managers and investors that the IRS is examining the practice.
The Market Has Grown Rapidly
This is not a tiny corner of Wall Street anymore.
Section 351 ETF conversions have grown quickly as wealthy investors and asset managers discovered their potential for diversifying concentrated portfolios.
Venable cited BNY industry data showing that 77 U.S. ETFs had launched with approximately $16.6 billion in seed assets from individual investors by mid-2026.
ETF.com separately estimated that more than $20 billion had entered over 100 new ETFs through Section 351-style exchanges.
The Financial Times reported even broader growth, estimating that at least $21 billion had been raised through Section 351 conversion-based ETFs since 2021, while tax-alpha strategies had attracted more than $90 billion since early 2025.
Those figures explain why Treasury is paying closer attention.
A strategy that once affected a relatively small group of investors is becoming a meaningful part of the asset-management industry.
Wealthy Investors Are the Main Audience
These strategies typically matter most to investors with significant taxable wealth.
A person holding millions of dollars in appreciated company stock may face an enormous capital-gains bill if they sell.
The incentive to find a tax-efficient diversification strategy is therefore substantial.
Executives who accumulated shares through compensation are one obvious example.
Founders and early investors in successful companies can face the same problem.
Family offices and wealthy individuals may also use sophisticated long-short funds to manage taxes across multiple portfolios.
That means the government’s action could disproportionately affect the private-wealth and alternative-investment industries.
This Is Not a Crackdown on Ordinary ETFs
Investors should not interpret the announcement as a broader attack on ETFs.
Treasury explicitly said its guidance is intended to target specific potentially abusive transactions while respecting conventional, long-established tax planning consistent with congressional intent.
Traditional ETF creation and redemption activity remains a standard part of the market.
Likewise, ordinary investors who own S&P 500 ETFs or diversified retirement funds are unlikely to be directly affected by these highly specialized strategies.
The focus is on unusual arrangements engineered around tax outcomes.
Conventional Tax-Loss Harvesting Is Also Different
Selling one investment at a loss to offset realized gains elsewhere is a common tax-planning technique.
The IRS is not broadly declaring tax-loss harvesting improper.
The distinction involves whether investment decisions have genuine economic substance and whether gains and losses are being artificially characterized.
A portfolio manager can legitimately consider taxes when choosing investments.
The government’s concern is when the tax result appears disconnected from the economic reality of the transaction.
That line may become the central battleground if disputes reach court.
Retroactive Enforcement Is the Biggest Threat
Perhaps the most important part of Notice 2026-62 is Treasury’s warning about timing.
Future guidance could apply only to new transactions.
But Treasury also reserves the possibility of applying future rules retroactively to transactions that have already taken place.
Additionally, the IRS says it can challenge abusive fund strategies today under existing law during examinations, even before issuing further guidance.
That creates a very different risk for investors.
Someone who completed a transaction believing it was tax-free may later face a challenge.
If the IRS determines the transaction generated taxable gain, the investor could potentially owe the original tax plus interest and possibly penalties, depending on the circumstances.
That is why tax advisers are urging affected investors to review past transactions rather than focusing only on future deals.
Investors May Need to Document Why They Used the Strategy
CNBC’s reporting highlights another important implication.
Investors who participated in these transactions may want strong documentation showing their legitimate investment rationale.
That could include why a particular ETF was chosen, how its portfolio fit the investor’s diversification goals and why the transaction made economic sense apart from tax savings.
EY tax partner Damien Martin described the current moment as one where investors should reassess their positions and understand their exposure.
This does not mean every investor will face an audit.
But it does mean that advisers may need to prepare for greater scrutiny.
The IRS Could Label Some Strategies as “Listed Transactions”
Treasury is considering several possible forms of future action.
These could include regulations, notices or additional revenue rulings.
More significantly, the government could classify some strategies as transactions of interest or listed transactions.
Those designations can impose significant disclosure obligations.
Taxpayers and advisers participating in covered transactions may have to report them specifically to the IRS.
Failure to make required disclosures can create additional penalties.
A listed-transaction designation would therefore substantially raise the compliance risk associated with a strategy.
Public Comments Are Due October 28
Treasury is still gathering information.
Notice 2026-62 asks market participants to submit written comments by October 28, 2026.
The government wants feedback on whether apparently similar transactions have different economic characteristics that justify different tax treatment.
It is also asking whether additional investment-fund strategies may be producing unintended tax results.
The consultation means final rules have not yet been determined for many of the strategies described in the notice.
Fund managers and tax professionals therefore have an opportunity to argue that some transactions have legitimate economic purposes and should not be swept into overly broad restrictions.
Wall Street Could Push Back Hard
The asset-management industry has powerful incentives to defend legitimate tax-efficient investment techniques.
Tax management has become a major selling point for private-wealth firms.
If Treasury restricts the most aggressive approaches, asset managers could lose part of the value proposition they offer wealthy clients.
But industry participants may also welcome greater clarity.
Ambiguous tax treatment creates risk for both managers and investors.
A strategy is far less attractive if a client fears the IRS may challenge it several years later.
Clear rules could therefore remove uncertainty even if they narrow the range of available tax techniques.
The Political Backdrop Is Becoming More Aggressive
The crackdown also comes amid growing political scrutiny of how wealthy Americans reduce taxes on investment income.
The Financial Times reported that lawmakers and policymakers are increasingly questioning whether complex financial engineering has allowed capital income to escape taxation in ways unavailable to ordinary wage earners.
Separately, recent federal court rulings have strengthened the IRS’s hand against hedge-fund managers who attempted to use limited-partner status to avoid certain self-employment taxes.
These developments suggest the ETF guidance is part of a broader debate about high-income tax planning rather than an isolated regulatory action.
Treasury Secretary Scott Bessent Has Backed the Crackdown
The policy direction is particularly notable because the administration is generally viewed as business-friendly.
Treasury Secretary Scott Bessent has nevertheless supported stronger action against investment arrangements the government considers abusive.
The Financial Times reported that Treasury’s September move was intended to draw a clearer boundary between legitimate tax planning and strategies designed primarily to avoid tax through financial engineering.
That indicates the issue may not divide neatly along traditional political lines.
Governments of either party have incentives to protect the tax base when highly engineered transactions become widespread.
The Legal Fight Could Ultimately Center on Congressional Intent
Many of the relevant tax provisions were enacted long before today’s ETF industry existed in its current form.
That creates an important legal question.
Asset managers may argue that they are simply applying the statute as written.
Treasury may respond that the transactions exploit technical rules in ways Congress never contemplated.
Courts often have to decide such disputes using doctrines including substance over form, step transaction and economic substance.
That means sophisticated investors cannot assume a transaction is safe merely because each individual step appears technically permitted.
How the steps fit together can matter just as much.
What Investors Should Watch Next
Several developments will be important after the October 28 comment deadline.
Treasury could issue narrower guidance targeting specific transactions.
It could designate certain arrangements as transactions of interest.
The IRS could begin audits or examinations of completed deals.
Asset managers may modify products before any final rules appear.
And litigation could eventually determine how broadly the government’s interpretation can be applied.
For investors who used these strategies, the immediate issue is documentation and tax advice.
For everyone else, the broader lesson is simpler.
Tax efficiency remains legitimate.
But aggressive tax engineering becomes much riskier when the IRS believes the investment structure exists mainly to manufacture a favorable tax result.
The Bigger Question Is Whether Tax Alpha Has Gone Too Far
Wall Street has spent years turning taxes into another source of investment performance.
Instead of focusing solely on market returns, sophisticated managers increasingly advertise after-tax alpha—the additional wealth an investor keeps after minimizing tax drag.
That can be entirely legitimate.
But as strategies become more complicated, the difference between prudent tax planning and aggressive tax avoidance becomes harder to define.
Treasury is now drawing that line more aggressively.
The IRS has already ruled that one type of ETF conversion can be treated as a taxable exchange.
It is now examining tax-aware funds that generate combinations of capital gains and ordinary losses, along with other unusual ETF strategies.
But the biggest risk for wealthy investors may be what happens next: future guidance could reach backward, forcing some taxpayers to defend transactions they believed had already been settled.
The coming fight will determine whether Wall Street’s tax-management boom continues—or whether one of the fastest-growing corners of private wealth management has finally pushed the tax code too far.
