On September 28, 2026, the Treasury Department and the IRS concurrently issued Revenue Ruling 2026-20 (Rev. Rul. 2026-20) and Notice 2026-62 addressing, as they describe, novel investment strategies that may produce tax results inconsistent with the proper application of the tax rules.
Rev. Rul. 2026-20 recharacterizes certain exchange-traded fund (ETF) contributions intended to be tax-deferred under IRC Section 351 as deemed sales not qualifying for tax-deferred treatment of built-in-gains for shareholders contributing to an ETF. Notice 2026-62 additionally discusses certain ETF seedings and transactions that defer gain recognition, accelerate loss recognition, and/or change the character of income or loss in ways that may not align with the underlying economics of a transaction and requests comments from the industry.
The new guidance clarifies these identified transactions are different from ordinary course of seeding ETFs and redemptions in kind (pursuant to IRC Sec. 852(b)(6)), which are not the focus of the Treasury and IRS. However, taxpayers engaging in the transactions detailed below must be aware of ramifications for both future and potentially even prior transactions.
While this marks the first time the Treasury and IRS are taking specific action to address these transactions, these developments build on discussions that have been ongoing within the industry for some time, including those highlighted in our prior blog and at a recent industry event attended by representatives of the Treasury and IRS.
The Treasury and IRS suggest that when these provisions are combined, they may achieve results the tax rules were not designed to produce. They appear to be targeting specifically sequenced transactions — and not each individual tax provision — where the substance of the transactions is carried out as part of a broader plan.
The focus of Rev. Rul. 2026-20 and some of the discussion in Notice 2026-62 is on certain tax-deferred ETF seedings. Treasury and IRS have noted in the past that while they are looking at several high-profile transactions in the industry, their primary focus is on ETF seedings followed by significant redemptions in kind.
Below is the example transaction specifically detailed in Rev. Rul. 2026-20:
The Ruling then holds if an ETF seeding follows the above steps, the transaction is recharacterized from the originally intended tax-deferred transfer to a sale from the investor to the AP under Sec. 1001. As such, the gain would be recognized by the investor on the amount originally contributed to the ETF.
Further, Notice 2026-62 explicitly states it does not address a new ETF seeding with assets consistent with its intended strategy and retained by the ETF, absent a substantial change in market or business circumstances. Therefore, it would appear the main focus of Rev. Rul. 2026-20 is only a transaction that results in “materially different” portfolio than originally contributed to the ETF. However, the Notice does not provide a definition for a materially different portfolio, which may present some quantitative analysis challenges.
It is worth noting while the Ruling states under Step 3 that the AP redemption happens “shortly thereafter,” which would suggest that the timing is relevant to the example transaction, the Notice makes a reference to the redemption happening shortly after in many cases, which would suggest it’s possible the sequence of events could be problematic regardless of timing.
While the Ruling is the guidance that provides a binding recharacterization of the described transaction and the Notice is merely flagging other transactions, it is worth noting the Notice discusses Sec. 351 contributions and issues with diversification.
Specifically, Notice 2026-62 discusses a “conversion transaction” advertised and used to achieve diversification without recognizing built-in-gains, which is inconsistent with the rules under Sec. 351. In the example provided, a portfolio satisfies the diversification requirements (not more than 25% in a single position and not more than 50% in five or less issuers). However, the resulting portfolio is inconsistent with the ETF strategy or has “overconcentrated” positions inconsistent with strategy. The strategy inconsistency is then resolved through redemptions in kind as described in the above example with the same result of a portfolio that is materially different than the original contributed portfolio.
Notice 2026-62 further discusses a similar scenario achieving diversification through a contribution of an appreciated portfolio to an ETF, but the initial step is contribution of a nondiversified portfolio. In this scenario, multiple investors contribute nondiversified portfolios to a partnership, the new combined partnership portfolio is diversified and the partnership then converts to an ETF. Ultimately, the investors achieve diversification without recognizing built-in-gains, which is not allowed by the tax rules. According to the Notice, Treasury and the IRS are considering guidance to provide that such contribution to a partnership does not qualify for nonrecognition treatment.
As used in Notice 2026-62, the term “box spread” is used to describe the combination of four options on the same underlying property, such as an S&P 500 index ETF, that in aggregate produces a return similar to a short-term interest rate. The options described in Notice 2026-62 are not Sec. 1256 contracts.
Prior to expiration of the option contracts, any option at an unrealized gain is distributed in kind to an AP. The ETF reports no dividends to shareholders, and therefore the shareholders do not include any income from the ETF. Because the ETF’s net asset value increases without distribution, ordinary income to the shareholder is converted to capital gain that is only recognized upon the disposition of ETF shares by the shareholder.
Notice 2026-62 describes a scenario where an ETF, referred to as a parent ETF in the Notice, seeks a return that tracks an index through investing in other ETFs, referred to as acquired ETFs, that track that index. Prior to the record date of an acquired ETF’s distribution, the parent ETF disposes of the acquired ETF in an in-kind redemption transaction. The parent ETF then purchases an ETF from a different issuer that tracks the same index as the initial acquired ETF. This new acquired ETF has a different record date from the initial acquired ETF. This process is repeated each time an acquired ETF approaches the record date to avoid the taxable dividend income, without any material change to the economic characteristics of the assets of the parent ETF. As a result, no dividend income is recognized by shareholders because no cash distribution is made by the parent ETF.
At least 90% of a RIC’s gross income for a taxable year must be from qualifying sources, which include interest, dividends, gain from the sale or disposition of stock or securities, or other income connected with a RIC’s business of investing in stock or securities.
Notice 2026-62 describes a situation where an ETF holds a nonqualifying asset and disposes of that asset using an in-kind redemption transaction. Because gain is not recognized in the in-kind redemption transaction, the ETF does not take this transaction into account when computing its qualifying income percentage for the taxable year.
Notice 2026-62 also described several strategies used by so-called “tax-aware” funds. These strategies are used by partnerships and separately managed accounts, not typically by RICs, and relate primarily to transactions that convert the character of income between ordinary income or loss and capital gain or loss in a manner that may be inconsistent with the economic results of these transactions. These strategies may use the identified straddle, foreign currency forward contract or notional principal contract rules to achieve these results.
Taxpayers engaging in any of the above transactions should be aware of the holding of the facts described in Rev. Rul 2026-20 and of the transactions described in Notice 2026-62. This guidance or any future guidance may be applied retroactively, so taxpayers should also consider any exposure from past transactions.
Contact Jay Laurila, Andreana Shengelya or a member of your service team to discuss this topic further.
In this blog Cohen & Co is not rendering legal, accounting, investment, tax or other professional advice. Rather, the information contained in this blog is for general informational purposes only. Any decisions or actions based on the general information contained in this blog should be made or taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.