Financial planning knowledge to help you better serve your clients.

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.

With these (and other) IRS statements in mind, financial advisors considering a particular tax-aware investment strategy for one or more clients might first determine whether there would still be a legitimate investment reason for the client to own the strategy if the projected tax benefit were materially smaller than expected (i.e., it has an attractive risk/return profile even in the absence of advertised tax benefits).

From there, the process looks much like the one advisors already use for investment risk: estimating the net benefit if the strategy works (after fees, financing, and professional costs, and recognizing that some of the 'savings' may simply be deferral), the total cost if it doesn't (including interest, penalties, and professional fees), and the strength of the tax position itself (including input from an independent tax professional and whether any outside legal opinion has been updated for the new guidance).

Further, an advisor might work with a client to assess their personal "tax risk tolerance" (i.e., their willingness to pursue a tax-aware investment strategy that might later bring them under IRS scrutiny), alongside their capacity for that risk (e.g., whether they have sufficient liquidity if the strategy is deemed impermissible and they are faced with a large tax bill and, potentially, penalties). While some clients might see the upside potential of a strategy as being worth a potential audit or even a case in Tax Court (including the accounting and legal fees they could face), others might not be willing to take that risk.

Ultimately, the key point is that while the IRS isn't 'declaring war' on tax-aware investment strategies, financial advisors and their clients can likely expect more guidance, and more scrutiny, on certain strategies that appear to push the limits on permissibility. Which suggests that financial advisors can support their clients by helping them understand their personal tax risk tolerance – and recommending particular tax-aware investment strategies (or not) accordingly!

And if you want to go deeper on this topic, hear directly from the author on the Financial Advisor Technician podcast.

Read More...