IRS identifies transactions of potential concern
Bloomberg via Getty Images
The Internal Revenue Service released
Processing Content
Revenue Ruling 2026-20 applies substance over form and step transaction doctrines to reject the tax benefits sought under Code Sec. 852(b)(6). Notice 2026-62 identifies that transaction and other transactions that the IRS is reviewing for possible guidance. The IRS also states that its guidance, once issued, may be applied retroactively.
Rev. Rul. 2026-20 involved the transfer by an investor of appreciated securities to a newly formed exchange-traded fund. The ETF then distributed some or all of the securities to another investor in the ETF in redemption of shares with the intent to qualify the transaction as a tax-free redemption under Code Sec. 852(b)(6). The IRS rejected the taxpayer’s characterization of the transaction and treated the entire transaction together as a taxable exchange under Code Sec. 1001.
Notice 2026-62 alerts taxpayers to a series of transactions where the IRS is concerned that taxpayers are seeking tax benefits that are not intended under the law. The IRS seeks comments on the appropriate scope of forthcoming guidance.
Code Sec. 852(b)(6) transactions
The notice addresses Code Sec. 351 conversion transactions involved in Rev. Rul. 2026-20 where a taxpayer engages in a series of transactions involving new ETFs designed to diversify holdings without incurring capital gain taxes. The notice goes on to say that the IRS is considering similar treatment for transactions involving partnerships and Code Sec. 721(a).
The notice also highlights “box spread funds” where a taxpayer, instead of paying out interest or taxable dividends, uses Code Sec. 1256 options and triggers an in-kind redemption to clear out the gain before expiration of the options. The investor seeks to defer taxes until the shares are sold or where the fund deducts the corresponding loss while flushing out the gain tax-free. The IRS is also concerned about similar transactions with both a box spread transaction and a separate transaction involving offsetting positions that constitute a straddle under Code Sec. 1092(c)(1) where the position in the straddle that has unrealized gain for federal income tax purposes is distributed.
The notice also highlights ETF timing maneuvers around corporate dividend issuance dates. It discusses situations where the ETF parent holds ETFs tracking an index. Just before the fund’s dividend record date, the parent ETF issues a creation unit to an authorized participant in exchange for property in a different ETF that tracks the same index. The parent ETF subsequently distributes to the authorized participant the shares of the acquired ETF in redemption of the parent ETF shares.
The notice also addresses income test avoidance by mutual funds. Some ETFs are taking the position that Code Sec. 852(b)(6) permits them to circumvent the income test in Code Sec. 851(b)(2) by avoiding the recognition of gains with respect to distributed assets that would not be qualifying income.
Strategies of tax-aware funds
The IRS is also concerned about several multiposition strategies of “tax-aware” funds that use technical differences among economically similar financial products, payments, or timing and identification rules to create a pattern of generating capital gains and ordinary losses.
The notice addresses Code Sec. 1092 (a)(2) identified straddles with mixed character, identified straddles used to convert character, same-day acquisitions and dispositions of foreign currency forward contracts, selective notional principal contract terminations used to obtain inconsistent character, and selective notional principal contract termination strategies.
Next steps
The IRS is seeking comments to try to help it focus on abusive transactions without interfering with normal business transactions. It intends to issue guidance in the form of regulations, notices, revenue rulings or other guidance applying anti-abuse rules and judicial doctrines with the goal of identifying transactions of interest or listed transactions.
The IRS requested comments by Oct. 28, 2026. However, it also indicated that it would try to consider later comments if it did not delay the issuance of forthcoming guidance.
The agency further indicated that it may apply some guidance retroactively in appropriate circumstances, with Notice 2026-62 providing notice to taxpayers of potentially problematic transactions.
