New IRS Guidance Disallows Some Sec. 351 Exchanges And Puts The ‘Yellow Light’ On Other ETF Strategies: How To Manage The ‘Tax Risk’ Of Tax-Aware Investing

Executive Summary

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.

Author: Jeffrey Levine, CPA/PFS, CFP®, AIF, CWS®, MSA

Team Kitces

Jeffrey Levine, CPA/PFS, CFP, AIF, CWS, MSA is the Lead Financial Planning Nerd for Kitces.com, a leading online resource for financial planning professionals, and also serves as the Chief Planning Officer for Focus Partners Wealth. In 2020, Jeffrey was named to Investment Advisor Magazine’s IA25, as one of the top 25 voices to turn to during uncertain times. Also in 2020, Jeffrey was named by Financial Advisor Magazine as a Young Advisor to Watch. Jeffrey is a recipient of the Standing Ovation award, presented by the AICPA Financial Planning Division for “exemplary professional achievement in personal financial planning services.” He was also named to the 2017 class of 40 Under 40 by InvestmentNews, which recognizes “accomplishment, contribution to the financial advice industry, leadership and promise for the future.” Jeffrey is the Creator and Program Leader for Savvy IRA Planning®, as well as the Co-Creator and Co-Program Leader for Savvy Tax Planning®, both offered through Horsesmouth, LLC. He is a regular contributor to Forbes.com, as well as numerous industry publications, and is commonly sought after by journalists for his insights. You can follow Jeff on Twitter @CPAPlanner.

Read more of Jeff’s articles here.

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Episode Shownotes And Transcript

The Summer Of Discontent: IRS Sharpens Scrutiny Of Certain Tax-Aware Investing Strategies

Taxes have always mattered to investors. But for much of investing history, access to the most sophisticated tax-management strategies was largely reserved for the wealthiest households. Creating customized portfolios was expensive. Advanced derivatives strategies required expertise and scale. Many tax-management techniques involved operational complexity that simply couldn't be justified for smaller accounts. And, of course, the wealthiest investors generally had both the strongest incentive to seek out such strategies and the greatest resources to implement them.

Over time, however, technology and other advances have steadily pushed increasingly sophisticated tax-management strategies down-market. Direct indexing is one obvious example. While once largely limited to institutional and ultra-high-net-worth investors, direct indexing is now readily available to a much broader group of mass-affluent and high-net-worth households. More recently, leveraged long/short Separately Managed Accounts (SMAs) have pushed the concept further.

And still more novel strategies have sought to combine different provisions of the Internal Revenue Code and regulations to create taxpayer-friendly results. Some have sought to allow investors with large, embedded gains to transform an existing portfolio into an ETF without immediately recognizing those gains. Others have attempted to generate ordinary losses alongside capital gains, potentially allowing taxpayers to use more valuable ordinary deductions while recognizing corresponding gains at preferential capital-gains rates.

As awareness of these approaches has increased and reached a broader cross-section of investors, so too has the attention they have attracted from advisors, clients, investment managers – and, increasingly, the federal government.

Treasury First Signals Concerns With Some Tax-Aware Investment Strategies

On July 21, 2026, the Wall Street Tax Association held a panel discussion entitled Developments in Tax Aware Financial Product Strategies. During the session, several Treasury officials made comments that made it clear that the IRS was interested in exploring whether some increasingly popular investment strategies were operating outside the confines of the current law, or were using tax rules in ways that were inconsistent with their underlying purpose.

Those comments led to several high-profile, largely cynical articles in major publications, such as Bloomberg's The Latest Tax Dodge for the Ultra-Rich Is a Customized ETF and A Tax Strategy for the Rich Built the World's Largest Hedge Fund, the Wall Street Journal's The Tax Strategy for People Suffering From Stock-Market Success, Reuters' US Treasury won't tolerate 'abusive' Wall Street tax strategies, Bessent says, and the Financial Times' US Treasury sends warning to hedge funds over 'tax alpha' strategies.

Although some advisors likely took notice of the Treasury's commentary, it didn't rise to the level of formal IRS guidance, which meant that little was likely to change on the part of product sponsors, advisors, and ultimately, the investors pursuing these strategies. However, it did serve as an initial indication that such guidance might be forthcoming.

IRS Issues Formal Guidance Addressing Certain Tax-Aware Investing Strategies

In what came as a surprise to many, that formal guidance (or at least the first bit of it) arrived via IRS Revenue Ruling 2026-20 and IRS Notice 2026-62 on September 28, 2026, just a little more than two months after the Wall Street Tax Association seminar.

Notably, while the documents were released together and overlap in certain respects, they should be viewed as two separate publications with two distinct purposes.

Revenue Ruling 2026-20 reaches an actual conclusion about a particular Section 351 ETF conversion fact pattern, as described in more depth below. Notice 2026-62, on the other hand, is much less definitive. It identifies a number of specific tax-focused investment strategies, but instead of stating the IRS's stance towards those strategies, the Notice states instead that the IRS believes the strategies may produce results inconsistent with the purpose and proper application of existing tax rules, and signals that more guidance or enforcement action may be coming. The Notice also states that future guidance could, where Treasury has the authority to do so, apply retroactively.

Nerd Note:

  Notably, a revenue ruling is an official IRS interpretation explaining how the Internal Revenue Code, regulations, and other tax authorities apply to a specified set of facts. Unlike a private letter ruling (PLR) that applies only to the taxpayer requesting it, a Revenue Ruling applies to all taxpayers.

A notice is "a public pronouncement that may contain guidance that involves substantive interpretations of the Internal Revenue Code or other provisions of the law" – but it is only an interpretation, and isn't necessarily the definitive guidance on how the IRS will treat a certain set of facts.

Conceptually, then, Revenue Ruling 2026-20 functions much like a red light for transactions matching its specific fact pattern, and a yellow light for transactions that differ somewhat from that fact pattern, but also share some common ground. Notice 2026-62 is more like a collection of yellow lights for a variety of different transactions. Understanding the difference between the two is critical for financial advisors trying to evaluate where today's tax-aware investment opportunities sit on the spectrum from well-established planning to potentially aggressive tax strategy.

Revenue Ruling 2026-20 Draws A Line Around Certain Section 351 ETF Conversions

Revenue Ruling 2026-20 addresses a particular variation of the increasingly popular Section 351 ETF conversion. IRC Section 351 generally allows property to be transferred to a corporation in exchange for that corporation's stock without immediate recognition of gain or loss as long as the transferor subsequently owns at least 80% of the shares and voting power in the corporation immediately after the exchange.

For a client with appreciated assets, such a transfer can be extremely valuable because it defers (though does not eliminate) the embedded gain on the property.

An important limitation, however, applies when property is transferred to an investment company, such as an ETF. Section 351(e) generally prevents Sec. 351 exchanges from being used as a simple mechanism for achieving tax-free diversification. For example, if five different investors each contributed a single large stock position in a different company to a newly formed ETF in exchange for ETF shares (such that the ETF subsequently contained five companies' stock, effectively 'diversifying' each investor's holdings from a single company to a five-company portfolio), each investor would be required to recognize embedded gain or loss in their contributed positions.

Treasury regulations, however, provide that where a contributed portfolio is already "diversified," the tax-deferred contribution of stock to an investment company is still allowed. To determine whether a contributed portfolio is diversified, the regulations prescribe a "25/50 test". The 25/50 test generally requires that no more than 25% of the contributed portfolio's value be invested in the stock of any single issuer, and that no more than 50% of the portfolio's value be invested in the stock of five or fewer companies.

Thus, an investor whose existing portfolio satisfies the applicable diversification requirements may potentially contribute appreciated securities to a newly established ETF in exchange for ETF shares without immediately recognizing their embedded gain.

Example 1: An investor owns approximately $1M of NVDA shares, which have appreciated in value significantly in recent years above the investor's low tax basis. They also own an additional $1M (in aggregate) of AAPL, DELL, SNDK, and TSLA stock positions. The investor opts to combine these five stocks (NVDA, AAPL, DELL, SNDK, and TSLA – a total value of $2M) together with $3M of another multi- (many) stock portfolio into an investment company, receiving ETF shares in exchange for the combined $5M in stock. Since the $1M of NVDA (the largest position) makes up no more than 25% of the total portfolio (25% × $5M = $1.25M), and $2M invested in the largest five positions make up no more than 50% of the portfolio (50% × $5M = $2.5M), this portfolio passes the 25/50 test and is eligible for a Section 351 exchange. The investor incurs no tax upon completing the initial exchange and will only recognize capital gains tax upon the eventual sale of the ETF shares.  

ETFs' In-Kind Redemption Mechanism Creates Additional Opportunity for Tax-Deferred Securities Swaps

But Section 351 is only the first ingredient in the strategy addressed by Revenue Ruling 2026-20.

One of the primary reasons that ETFs, in general, can be extraordinarily tax efficient is their ability to conduct transactions in kind. Authorized Participants (APs), which are generally large financial institutions, can transact directly with ETFs in large blocks of ETF shares known as creation units. An AP can contribute cash or securities to an ETF in exchange for ETF shares. Conversely, the AP can present ETF shares for redemption and receive securities from the ETF.

Section 852(b)(6) provides special treatment to certain distributions made from regulated investment companies (RIC), such as an ETF, in redemption of the RIC's stock. As a result, when an ETF distributes appreciated securities in a qualifying in-kind redemption, the ETF generally does not recognize the gain embedded in those securities.

That ability is enormously valuable in the ordinary course of ETF management, and is just one of the reasons why more and more managers have adopted ETFs as their structure of choice (as opposed to the mutual fund structure) in recent years. Instead of selling an appreciated position and generating taxable gain inside the fund, an ETF may be able to transfer appreciated securities out through an in-kind redemption. By contrast, a similar transaction by a mutual fund manager would generally create a taxable gain that must be passed along to the fund's investors.

Nerd Note:

  While mutual funds are generally not eligible for contribution as part of a 351 exchange, ETFs do qualify and, in fact, can be particularly useful as part of the process because the diversification analysis generally looks through the ETF to its underlying assets rather than treating the ETF, itself, as a single issuer. For example, if an investor contributes shares of a S&P 500 ETF into another ETF as part of a 351 exchange, the contributed portfolio is considered to contain 500+ positions, not just the single ETF position, for purposes of the diversification test.

Critically, Notice 2026-62 (more on that Notice in a bit) makes clear the IRS is not concerned about the practice of in-kind redemptions in the general sense. The Notice specifically acknowledges that ETFs routinely engage in creations and redemptions and says it is not expressing a view on those transactions, except as otherwise discussed in the Notice. Rather, the IRS's concern stems from when Section 351 exchanges and Section 852(b)(6) in-kind redemptions are used together, as part of a coordinated plan, to engage in tax-deferred diversification that the IRS believes neither provision was designed to allow.

The ETF "Middle Man" And Substance Over Form Arguments

Revenue Ruling 2026-20's facts involve an investor contributing appreciated securities to a newly formed ETF in an intended Section 351 transaction. Importantly, the contributed portfolio satisfies the applicable diversification requirement.

Some or all of the securities contributed by the investor, however, either don't fit the ETF's contemplated investment thesis, or are overrepresented relative to the portfolio the ETF is intended to hold after the planned transactions. As part of the same plan (this phrase may prove to be critical in future analyses of such transactions), an AP then transfers to the ETF securities that do fit the ETF's investment thesis, or cash that the ETF will use to purchase them. Shortly thereafter, the ETF redeems the AP's shares by transferring to the AP securities that had originally been contributed by the investor.

If all of that sounds complicated, all you really need to understand is that supposedly, once these steps are complete, the ETF owns a portfolio consistent with its investment thesis that is materially different from the portfolio originally contributed by the investor (or investors). And that it has done so without generating any taxable income (e.g., capital gains).

The IRS believes that in situations like this, the ETF should not be respected as an independent intermediary. Essentially, it is serving merely as a conduit through which an investor exchanges one group of securities for another. Accordingly, applying substance-over-form and step-transaction principles, Revenue Ruling 2026-20 stipulates that such an investor should be treated as though they have made a taxable Section 1001 exchange with the Authorized Participant, with respect to the investor's securities that the ETF uses to redeem the AP.

In short, inserting an ETF in the middle doesn't transform what is substantively an exchange of appreciated property for materially different property into a tax-free transaction.

A $100M Concentrated Position Illustrates What Clearly Doesn't Work

Consider an intentionally extreme example.

Example 2. Suppose an investor owns $100M of a single highly appreciated stock, PublicCo, with a tax basis of only $5M. By itself, the position clearly could not satisfy the diversification requirements necessary for the contemplated Section 351 ETF transaction.

So, what does the investor do? Well, one idea would be to go out and buy $300M of a broadly diversified S&P 500 ETF shortly before the transaction. Because the S&P 500 ETF is analyzed on a look-through basis for the diversification test, the combined $400M contribution – $100M of PublicCo and $300M of diversified ETF shares – now satisfies the applicable 25/50 requirements.

Next, the investor contributes the entire $400M portfolio to a newly created ETF – maybe even one that they've created themselves – in exchange for $400M of the new ETF's shares. But the new ETF never really intends to hold the $100M PublicCo position. Its actual investment thesis calls for a much more broadly diversified portfolio.

So, what does the ETF do? Well, it goes to an AP, of course, and that AP contributes $100M of securities that fit the ETF's strategy (or cash that the ETF can use to buy such securities). Shortly thereafter, the ETF transfers the $100M PublicCo position to the AP in redemption of the AP's newly created ETF shares.

The end result? The investor has gone from owning $100M of extremely low-basis PublicCo plus $300M of recently purchased diversified assets, to owning $400M of an ETF whose underlying holdings are materially different and even more diversified.

But why stop there? If the ETF shares received in the Section 351 transaction preserve the contributed portfolio's tax-lot characteristics in a manner allowing the investor to identify and sell the ETF shares associated with the $300M high-basis S&P index ETF, the intended next step might be to liquidate approximately $300M of relatively high-basis ETF shares, leaving the investor with roughly $100M of diversified ETF exposure carrying the legacy PublicCo low basis, and $300M of cash.

Economically, the strategy has attempted to transform $100M of concentrated, highly appreciated PublicCo into $100M of diversified, highly appreciated ETF exposure without recognizing the approximately $95M gain (assuming a $5M original cost basis) that a direct sale of PublicCo would have created.

Revenue Ruling 2026-20 says that the planned use of the ETF contribution and AP redemption cannot produce that result.

Instead, the investor is treated as exchanging the $100M PublicCo position directly for the replacement property provided through the AP, triggering the $95M of capital gains that they had sought to avoid through the planned sequence of transactions.

Importantly, it is the prearranged exchange of the PublicCo securities – not merely the fact that securities were contributed to an ETF under Section 351 – that drives the ruling.

And that's where the guidance becomes simultaneously useful… and frustrating.

Revenue Ruling 2026-20 Tells Advisors What Is Clearly Bad – But Not Exactly Where 'Bad' Begins

As noted above, the Treasury department is not disputing the permissibility of 351 exchanges into ETFs or in-kind AP redemptions, or even the combination of the two under certain circumstances. So, there is a spectrum of scenarios involving these transactions that ranges from definitely allowable to definitely disallowed.

Revenue Ruling 2026-20 is highly useful at establishing one end of this spectrum.

If an investor contributes appreciated assets pursuant to a plan under which assets inconsistent with the ETF's intended portfolio are quickly pushed out to an Authorized Participant and replaced with materially different assets, the IRS has made its position clear: The two transactions are effectively collapsed into a single (taxable) exchange between the original investor and the Authorized Participant.

But neither Revenue Ruling 2026-20, nor Notice 2026-62, says that all Section 351 ETF conversions are abusive. In fact, Notice 2026-62 specifically states that it:

"…expresses no view regarding, transactions in which a § 351 transaction is used to seed a newly established ETF with assets that are consistent with the ETF's investment thesis and that are intended and expected to be retained by the ETF absent a substantial change in circumstances…"

So, there is fairly decent clarity regarding two opposing extremes.

At one end of the spectrum, the contributed assets totally conform to the ETF's investment thesis, and there is a genuine expectation that those assets will remain in the ETF absent unexpected changes in market or business decisions. In other words, there is little to no turnover of the underlying investments within the ETF for some meaningful period of time.

Meanwhile, at the other end of the spectrum is the scenario where assets are contributed with an understanding from the beginning that they don't really belong in the ETF and will quickly be exchanged through an AP for the portfolio everyone intended the ETF to own all along.

The problem now in front of advisors is everything between those endpoints.

Suppose 95% of the incoming portfolio fits the ETF's contemplated portfolio (as defined in its prospectus/registration documents) extremely well, but 5% does not.

Or suppose every security is technically permitted by the ETF's prospectus, but the portfolio manager opts not to keep every single one that was contributed.

What if a security fits the ETF's strategy when contributed but the manager sells it three months later? Six months later? A year later?

What if the ETF is meant to follow a specific trend or trading philosophy and expects to have 30% annual turnover on a regular basis?

What if an ETF accepts an S&P 500 index ETF as part of the contributed assets, but uses an AP to exchange the ETF for the ETF's underlying securities in an effort to reduce expenses and fulfill its fiduciary duty?

And how much difference between the contributed basket and the portfolio eventually held by the ETF is enough to make the portfolios "materially different" anyway?

Neither the Revenue Ruling 2026-20, nor Notice 2026-62, provides meaningful guidance or safe harbors to address these questions.

And while the more time between the various parts of this transaction, the stronger a taxpayer's case will be that the entire thing wasn't part of some coordinated plan (as is often pointed out in other situations where the 'step transaction' doctrine comes into play), advisors shouldn't assume that the simple passage of time eliminates all risk. Waiting an arbitrary number of days or months doesn't necessarily change the substance of a transaction if the entire series of steps was part of the original plan.

Effective 351 Exchange Due Diligence

When evaluating potential 351 exchanges in the future, advisor due diligence may need to go considerably beyond checking whether the investor's contributed assets pass the 25/50 test.

Advisors should also understand how those assets compare with the ETF's actual investment thesis, not merely the broadest reading of its prospectus. Perhaps just as important is how (or even whether) the ETF will limit the securities it accepts from other investors, as those, too, will generally need to comply with the ETF's stated investment strategy.

Furthermore, while fund managers may be reluctant to share certain details or commit to certain levels of turnover, reasonable advisor due diligence questions in the face of Revenue Ruling 2026-20 include, "How much turnover is generally expected, and over what period of time?", "How will you document and record that changes were made due to unexpected changes in market or business conditions?", and "How will you ensure that contributed securities are in line with your investment thesis to begin with?"

Those questions matter because the Revenue Ruling's analysis turns heavily on what the parties planned and what economic transformation the series of transactions was designed to achieve.

IRS Notice 2026-62 Casts A Wider Net Over Additional Tax-Aware Investment Strategies

While Revenue Ruling 2026-20 states the IRS's position on 351 exchanges that follow a particular fact pattern, Notice 2026-62 covers a much broader array of tax-aware strategies that are currently being used, in varying amounts, by some investors and asset managers.

Notably, while IRS Notices are official public pronouncements and may contain substantive interpretations of tax law, this particular Notice primarily identifies transactions that concern Treasury and the IRS, requests comments about them, and describes additional guidance or enforcement actions the government may consider. The Notice is, therefore, less definitive than Revenue Ruling 2026-20 about the IRS's stance on the strategies it describes. But that does not make the Notice unimportant.

The Notice specifically warns that the IRS may challenge one or more of the strategies described therein based on existing statutes, regulations, anti-abuse provisions, and judicial doctrines. It further notes that future guidance may be prospective or, of potentially greater concern to advisors and their clients, retroactive.

For advisors, then, Notice 2026-62 serves as a 'yellow light' with regards to the strategies that it describes – meaning that while clients who are currently or planning to use the strategies aren't necessarily engaging in problematic transactions, it's safe to assume that the IRS is going to be viewing those transactions with a higher level of scrutiny – and that they could be identified as problematic by the IRS in the future.

Additional ETF And Fund Strategies Flagged By Notice 2026-62

Notice 2026-62 identifies several strategies involving "novel investment fund strategies that purport to produce tax results that may be inconsistent with the purpose and proper application of the relevant federal tax rules."

The following is a brief synopsis of the strategies involving "atypical usage of IRC Section 852(b)(6)" – the tax-free in-kind redemption via an AP (in addition to the ETF strategy described in Revenue Ruling 2026-20) – and why the IRS is concerned about them.

• Partnership/exchange-fund variation of the Section 351 transaction – In short, investors whose appreciated portfolios aren't sufficiently diversified to qualify for the desired Section 351 transaction (i.e., fail the 25/50 test) first contribute assets to a partnership intended to avoid investment-company treatment, such as an exchange fund, and then, as part of a coordinated plan, the now-diversified-partnership engages in a Section 351 conversion. The IRS is concerned that this is a potential abuse/workaround of the 25/50 test and allows investors to convert a concentrated holding into a diversified portfolio inside an ETF wrapper (effectively deferring taxes on the portfolio and its embedded gains indefinitely).
• Box-spread ETFs – Funds that use option positions that economically resemble a financing or interest return are placed in an ETF structure and appreciated positions may ultimately leave the ETF through in-kind redemptions. The IRS is concerned that what is economically interest-like income turns into a deferred capital gain, rather than annual taxation of returns at ordinary income tax rates
• ETFs that Defer Income By Rotating Between Underlying ETF Funds with Different Dividend Record Dates – An ETF holding shares of another ETF may sell or redeem those shares immediately before a dividend record date and replace the position with a substantially similar ETF, preserving essentially the same economic exposure while avoiding receipt of the dividend that otherwise would have generated taxable income. The IRS is concerned that what should be taxable income is deferred using this approach.
• ETFs that Seek to Skirt the RIC Qualifying-Income Rules – Assets capable of generating income that does not qualify toward a RIC's 90% gross-income test, such as certain commodity or digital-asset exposures, are removed through in-kind redemptions before the associated income or gain is recognized. The IRS is concerned that these ETFs are circumventing the RIC requirement that at least 90% of the company's income arise from dividends, interest, payments with respect to securities loans, gains from the sale of securities or foreign currencies, or specified income.

In addition to the 852(b)(6) strategies described above, Notice 2026-62 identifies three strategies designed to exploit differences in the character of economically offsetting gains and losses. More specifically, these strategies generate roughly equivalent amounts of ordinary losses and capital gains, producing no economic gain or loss but nevertheless creating risk-free tax 'alpha' by letting the taxpayer deduct the losses against higher-taxed ordinary income while the gains receive capital treatment, which means lower rates if they are long-term and, regardless of holding period, more opportunities to reduce or eliminate them (e.g., through leveraged long/short SMAs or opportunity zone funds). The specific strategies identified were:

• Mixed-Character Identified Straddles – A fund pairs economically offsetting positions with different tax treatment, such as a foreign-currency forward generating ordinary gain or loss under IRC Section 988, and a regulated futures contract generating 60/40 capital gain or loss under IRC Section 1256.

The fund closes the futures position first. If it has a $1M gain while the forward has a $1M loss, the result may be $1M of capital gain and $1M of ordinary loss despite roughly zero economic gain. If the futures position loses, the fund may instead add that capital loss to the basis of the forward, potentially converting the later result into less ordinary income or even an ordinary loss.

Treasury's concern is that straddle rules intended primarily to govern timing are being used to manipulate the character of the taxable gain or loss.

• Same-Day Foreign-Currency Trades – IRC Section 988 generally makes foreign-currency gains and losses ordinary, but taxpayers may elect capital treatment for certain qualifying transactions by the end of the day they are entered into.

A fund can therefore open and close numerous currency forwards on the same day, identify the winners and losers before the election deadline, elect capital treatment only for the winners, and leave the losers ordinary.

Thus, $2M of gains and $2M of losses could produce $2M of capital gain and $2M of ordinary loss from a tax perspective despite no net economic gain.

Treasury's concern is hindsight: the taxpayer selects character after already knowing which trades succeeded.

• Selective Termination Of Notional Principal Contracts (NPCs) – Periodic swap payments generally produce ordinary income or expense, while certain payments received upon terminating a swap may potentially qualify for capital treatment.

Accordingly, a fund might terminate a winning swap shortly before a scheduled payment and claim capital gain, while allowing an offsetting losing swap to continue and claiming the resulting payment as an ordinary expense. The intended tax result is again capital gain paired with ordinary loss despite little or no net economic gain.

Treasury's concern is that economically similar payments are receiving different tax treatment largely because the winner is deliberately terminated while the loser is allowed to mature.

Ultimately, these are tax positions being claimed by funds and taxpayers – but not necessarily outcomes that the IRS has accepted as correct. In fact, to the contrary, Notice 2026-62 signals that the IRS is actively questioning whether these approaches are permissible under the current law.

Managing The "Tax Risk" Of Strategies The IRS May (Or May Not) Scrutinize

The issuance of Revenue Ruling 2026-20 and Notice 2026-62 need not cause advisors (or their clients) who have engaged in these strategies to panic.  The Ruling and Notice should, however, inform advisor practices going forward – including a reconsideration of which clients these strategies are truly appropriate for.  

For clients already participating in affected strategies, that doesn't automatically mean that positions should be exited. It does mean the risk assessment should be revisited.

The Investment Case Should Come Before The Tax Case

One of the best initial screens for a sophisticated tax-aware investment may also be one of the simplest: Would there still be a legitimate investment reason for the client to own this strategy if the projected tax benefit were materially smaller than expected?

The answer need not be yes under every conceivable circumstance. Taxes are real costs, and reducing unnecessary taxes can itself create substantial economic value. But there's an important difference between choosing among otherwise reasonable investments partly because one offers superior after-tax results, and entering a transaction whose economics become unattractive without a particular tax outcome. (The oil and gas and real estate tax shelters of the 1980s offer a cautionary example: when the Tax Reform Act of 1986 curtailed their tax benefits, many investors were left holding partnerships with little underlying value.)

Advisors should therefore begin with the underlying investment case. Why does the strategy belong in the client's portfolio? What return is it expected to generate before taxes? What risks does it introduce? What role does it play relative to the client's other investments?

Only after those questions produce satisfactory answers should the incremental tax benefit become the deciding factor. The closer an investment comes to having 'generate a tax result' as its principal economic purpose, the more careful the advisor's diligence should become.

Financial Advisors Need To Begin Assessing A Client's "Tax Risk Tolerance"

Financial advisors are intimately familiar with the concept of investment risk tolerance. Clients understand, at least conceptually, that pursuing higher expected returns generally requires accepting additional uncertainty. Advisors, therefore, spend significant time determining how much investment risk a client is willing to take, how much risk the client has the financial capacity to bear, and whether taking that risk is actually necessary to accomplish the client's objectives.

But increasingly sophisticated tax-aware investments that operate within gray areas of the law create another type of risk that deserves a similarly explicit planning process: Tax Risk Tolerance.

Notably, tax positions don't all exist at the same level of certainty. At one end of the spectrum are strategies supported by clear statutory language, regulations, and longstanding practice. At the other end of the spectrum are positions whose expected benefits depend on an interpretation of multiple Code provisions, favorable characterization of complex financial instruments, unsettled proposed regulations, anti-abuse doctrines not applying, and a conclusion that the IRS or a court will ultimately agree with the taxpayer's analysis.

Unfortunately, between those extremes is an enormous amount of gray.

The fact that a strategy hasn't been prohibited doesn't make it risk-free. Likewise, the fact that a strategy carries tax risk doesn't necessarily mean it is inappropriate. Instead, the question should be whether the amount and type of tax risk are appropriate for the particular client. That requires an analysis surprisingly similar to the process advisors already use when discussing investment risk.

Start With The Size Of The Potential Reward

The first question is straightforward: If things go as planned, how much is this strategy actually expected to save on a net basis? Critically, the answer isn't simply the size of the loss generated, or even the amount of tax deferred in the current year. Rather, advisors should consider the value of the tax benefit after accounting for the strategy's management fees (above and beyond the fees that would otherwise apply to the client's portfolio), transaction costs, financing costs, incremental CPA and legal fees, investment drag, and the possibility that some of the 'savings' represent tax deferral rather than permanent tax avoidance.

Even a strategy expected to reduce current year's taxes by $300,000 may be considerably less compelling if it costs $75,000 per year to implement, introduces additional investment risk, and simply shifts much of the $300,000 into future years.

Attempt To Quantify The Downside If The Tax Position Fails

The next question is: What happens if the IRS disagrees?

Suppose a strategy is expected to save $500,000 of Federal and state income tax. If the position is ultimately unsuccessful, is the client simply back where they started, paying the $500,000 they otherwise would have owed? Or could the result include interest, accuracy-related or other penalties, additional state liabilities, professional fees, amended returns, and tax consequences spilling into later years?

A useful tax-risk conversation shouldn't stop at the taxes alone. The relevant downside is the total economic cost of being wrong, which could include CPA fees to amend returns, legal fees incurred in defending a position, etc. – to say nothing of the psychological/emotional toll that such an outcome could incur. 

Evaluate The Strength Of The Tax Position

Next comes perhaps the most difficult question: How strong is the legal support?

It's at this point – if not before – that most advisors will need to lean on the support of additional professionals, such as CPAs or tax attorneys. Deciphering gray areas of the law should be left to tax professionals, who should be engaged and 'on board' before a client commits any capital.

That said, advisors should understand the need for the analysis, and should have a cursory understanding of what might go into such an evaluation so that they can have informed conversations with the relevant parties.

It's worth noting that this part of the due diligence process should involve independent specialists. An ETF sponsor or SMA manager that employs an aggressive tax strategy might say, "Our lawyers are comfortable with this," – but that tells an advisor very little and does very little to protect a client (or their tax preparer) if things go sideways. Engaging an independent tax pro who is familiar with the client's specific circumstances to weigh in on the proposed strategy also presents a natural opportunity to educate the client on the tax/legal ambiguity associated with it (and to diligently document such communication so there are no misunderstandings later about what the advisor represented). 

What actual authorities support the position? Is there statutory or regulatory language directly on point? Are there revenue rulings, court decisions, or other meaningful authorities? Does the strategy depend on proposed rather than final regulations? Does it rely on form prevailing despite an economically different substance?

Has the IRS recently identified the exact transaction – or something substantially similar – as an area of concern?

Revenue Ruling 2026-20 and Notice 2026-62 make the last question particularly important. A transaction may not have changed mechanically from one month to the next, but a formal IRS announcement that the government believes that type of transaction may produce an inappropriate tax result can significantly change the risk profile associated with taking the position. The investor is practically assured that the IRS will view the strategy with higher scrutiny, and even if the result ends up being in the taxpayer's favor, it's possible that they will need to spend time and resources defending their position under audit.

Obtaining Outside Legal Opinion

For more aggressive strategies, a client's tax professionals should also determine whether the investment sponsor has obtained one or more written tax opinions from outside, independent counsel. But the diligence shouldn't end with checking a box marked "Tax Opinion: Yes."

Who wrote the opinion? Is the law firm genuinely experienced in the relevant area of tax law? Is the opinion addressed to, or otherwise capable of being relied upon by, the client? What level of confidence does the opinion express – for example, does counsel conclude that the position "should" prevail or merely that it is "more likely than not" to prevail?

Does the opinion meaningfully grapple with contrary authorities and anti-abuse doctrines, or primarily develop the strongest possible argument for the desired result?

And perhaps most importantly in the current environment: When was the opinion written, and has it been updated to address Revenue Ruling 2026-20, Notice 2026-62, or other subsequent guidance?

A strong opinion from highly qualified independent counsel does not eliminate tax risk, but it can go a long way towards minimizing the possibility of future penalties and is quite a bit more meaningful from a due diligence perspective than reliance on a manager's marketing materials.

Assess The Client's Willingness To Deal With IRS Scrutiny

Just as determining the appropriate level of investment risk requires analyzing both quantitative and qualitative factors, so too does analyzing a client's Tax Risk Tolerance. For instance, some clients may be perfectly comfortable receiving an IRS examination notice, gathering documentation, paying professionals to respond, and waiting months or years for the matter to be resolved. Others may lose sleep the night an IRS envelope arrives.

Neither reaction is inherently right or wrong. But they are different. Advisors should be cautious when recommending investments that incorporate highly aggressive tax strategies to clients who will immediately abandon the position at the first sign of IRS scrutiny.

To that end, another useful data point to assess is how far the client is willing to go if they disagree with an IRS position. Would the client pay specialized tax counsel to pursue the matter through IRS Appeals? Would the client be willing to litigate? Could the client emotionally and financially tolerate years of uncertainty if a material issue reached Tax Court?

Or is the client likely to settle quickly regardless of the strength of the underlying position simply because the cost and aggravation of fighting aren't worth it? Two taxpayers presented with exactly the same investment and exactly the same tax opinion can rationally reach opposite decisions based on their answers.

That's Tax Risk Tolerance.

Tax Risk Tolerance And Tax Risk Capacity Aren't The Same Thing

There is another lesson advisors can borrow directly from the investment-planning world: A client's willingness to take risk isn't necessarily the same as the client's ability to take risk. The same distinction applies to taxes.

A client may have very high Tax Risk Tolerance psychologically. They may be willing to defend an aggressive position to the end and be completely unbothered by the prospect of an audit. But what happens if they lose?

If an adverse determination could produce a multimillion-dollar assessment and the client lacks sufficient liquidity to pay it without selling an illiquid business, disposing of real estate at an unattractive time, or borrowing on unfavorable terms, then the client may have substantial Tax Risk Tolerance but inadequate Tax Risk Capacity.

Conversely, another client may have more than enough liquidity to absorb the worst possible tax outcome but may find even routine correspondence from the IRS intolerably stressful. That client has substantial Tax Risk Capacity but low Tax Risk Tolerance. Good planning should consider both.

The IRS Is Not Declaring War On Tax-Aware Investing

With such an extensive list of transactions under scrutiny, it would be easy for advisors or clients reading headlines to reach an overly broad conclusion: "Tax-aware investing is now under attack."

That isn't what Notice 2026-62 says.

In fact, the Notice is remarkably deliberate about distinguishing the strategies under examination from conventional tax-efficient investing. Treasury and the IRS acknowledge that taxpayers routinely engage in longstanding planning intended to reduce Federal income tax and that such planning may be fully consistent with Congressional intent.

The Notice specifically contrasts the strategies at issue with conventional tax planning and states that future guidance is intended to target abusive transactions, while respecting established market practices (though it remains to be seen how the IRS will thread that needle).

The distinction that the IRS appears to be drawing, therefore, isn't between investments that consider taxes and those that don't. Rather, it's more along the lines of distinguishing between legitimate investments that seek to manage taxes efficiently and transactions in which the tax outcome begins to look like the principal investment product. For financial advisors, that distinction should become an increasingly important part of product due diligence.

Advisors Can Expect More Guidance – And More Scrutiny

Revenue Ruling 2026-20 and Notice 2026-62 are almost certainly not the end of this story. Notice 2026-62 asks market participants for extensive feedback about whether the IRS has accurately described the transactions, which economically similar transactions deserve different treatment, and what future guidance could address perceived abuse without interfering with legitimate longstanding market practices.

Meanwhile, Notice 2026-62 specifically identifies a wide range of actions that the IRS may consider, including regulations, additional revenue rulings and notices, and potentially designating certain transactions as listed transactions or transactions of interest. Such designations could dramatically increase the disclosure, compliance, and enforcement consequences associated with the affected strategies.

Perhaps most importantly, advisors shouldn't assume that taxpayers are necessarily safe simply because they acted before future guidance is published. The Notice explicitly says the IRS may challenge abusive strategies under existing law during examinations. It also leaves open the possibility that future guidance may apply retroactively when Treasury has authority to do so.

A strategy entered into when IRS scrutiny appeared relatively remote may look different after the IRS has publicly identified its mechanics as problematic. A tax opinion prepared before the guidance may need to be revisited. And a client who was willing to accept yesterday's tax risk may rationally decide that today's risk is different.

Tax-Aware Investing Isn't Going Away – But Tax-Risk-Aware Advice Will Matter More

Nothing in Revenue Ruling 2026-20 or Notice 2026-62 changes the basic fact that taxes matter. For high-income and high-net-worth households in particular, thoughtfully managing taxes can create enormous long-term value. Tax-loss harvesting, direct indexing, thoughtful asset location, charitable giving, appropriate exchange funds, and many other tax-aware approaches can all remain important parts of a financial plan.

Innovation shouldn't be considered abusive merely because it creates a tax benefit. Indeed, Notice 2026-62 itself takes pains not to reach that conclusion. But financial engineering, technology, and increasingly sophisticated tax expertise are allowing investment managers to create strategies that push ever closer to the boundaries of existing tax law.

Revenue Ruling 2026-20 has now drawn one of those boundaries with significantly greater clarity. When an investor contributes appreciated securities to an ETF as part of a plan in which those securities are quickly transferred to an AP in exchange for materially different assets, the IRS believes the steps should be integrated and the investor treated as having completed a taxable exchange. Notice 2026-62 tells us that Treasury is examining where several other boundaries should be drawn.

For financial advisors, the answer shouldn't be to reflexively reject every strategy the IRS identifies. Nor should the answer be to proceed simply because the government hasn't yet definitively prohibited a particular transaction.

Instead, advisors will increasingly need to help clients answer two different questions for relevant strategies: "Is the investment risk associated with this strategy appropriate for me?" and "Is the tax risk associated with this strategy appropriate for me?"

Because ultimately, sophisticated tax planning isn't just about identifying what might work. It's about understanding the benefit if it does, the consequences if it doesn't, the strength of the position in between – and whether the client is both willing and able to live with the answer.