Key Takeaway
In short: The IRS guidance targets a coordinated transaction intended to exchange appreciated securities for ETF shares without recognizing taxable gain. It does not categorically prohibit conventional Section 351 ETF transfers; the tax treatment of any transfer depends on its specific facts and structure.
On September 28, 2026, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) issued Notice 2026-62 and Revenue Ruling 2026-20. The guidance addresses several investment strategies, including a particular use of Section 351 in connection with exchange-traded funds (ETFs).
Why Treasury and the IRS Are Scrutinizing Certain ETF Transactions
Notice 2026-62 identifies several novel investment fund strategies that Treasury and the IRS believe may produce results inconsistent with the purpose and proper application of federal tax law. One strategy combines Sections 351 and 852(b)(6) to seek an unintended tax result. Treasury and the IRS requested comments on this and the other identified strategies by October 28, 2026.
How Revenue Ruling 2026-20 Applies the Step-Transaction Doctrine
Revenue Ruling 2026-20 addresses a coordinated series of transactions. First, an investor transfers appreciated securities to a newly formed ETF in a transaction intended to qualify for nonrecognition treatment under Section 351. Under the same plan, an authorized participant contributes securities consistent with the ETF’s investment strategy—or cash the ETF intends to use to acquire those securities—in exchange for ETF shares. Shortly afterward, the ETF redeems the authorized participant’s shares by distributing some or all of the securities contributed by the investor. Applying the step-transaction and substance-over-form doctrines, the IRS treats the planned steps as an exchange in which the investor transfers appreciated securities to the authorized participant in return for ETF shares, resulting in gain or loss under Section 1001.
What the IRS Ruling Means for Properly Structured Section 351 ETF Transfers
The Notice and Revenue Ruling are consistent with statements previously made by Treasury and IRS representatives at a Wall Street Tax Association conference and therefore do not represent a surprising shift in position. We have long advised clients that Treasury and the IRS may invoke judicial doctrines when a Section 351 transfer is part of a coordinated plan designed to rebalance a securities portfolio without recognizing taxable gain—even if the individual steps satisfy the applicable statutory and regulatory requirements.
At the same time, the guidance does not categorically prohibit conventional Section 351 ETF transfers. A transfer may still qualify for nonrecognition treatment when an investor contributes appreciated securities to an ETF that will use them to pursue the investor’s desired investment strategy. The analysis remains fact-specific and depends on the transaction’s purpose, structure, timing, and related redemption activity.
Practical Implications for Investment Advisers and ETF Sponsors
The new guidance reinforces the approach Practus has taken in numerous Section 351 transactions. It also supports the view expressed by some of our firm’s Investment Company Act lawyers that, when launching an ETF, an investment adviser may need to consider whether a Section 351 transaction could benefit investors as part of fulfilling its fiduciary obligations. Properly structured Section 351 transactions can therefore remain valuable tools for investment advisers, ETF sponsors, and investors.
Moving Forward With Section 351 Transactions
For upcoming Section 351 transactions, we expect to issue opinions concluding that properly structured transactions do not run afoul of Notice 2026-62 or Revenue Ruling 2026-20. Because the analysis is fact-specific, advisers and sponsors should evaluate proposed structures carefully before proceeding.
Frequently Asked Questions
What transactions does Revenue Ruling 2026-20 challenge?
Revenue Ruling 2026-20 challenges a coordinated series of transactions. An investor transfers appreciated securities to a newly formed ETF. Under the same plan, an authorized participant contributes securities consistent with the ETF’s investment strategy—or cash the ETF intends to use to acquire those securities—in exchange for ETF shares. The ETF then redeems the authorized participant’s shares by distributing some or all of the investor’s contributed securities. The IRS treats the planned steps as a taxable exchange of the investor’s securities for ETF shares.
Are Section 351 ETF transfers still permitted?
The guidance does not categorically prohibit Section 351 ETF transfers. Notice 2026-62 states that Treasury and the IRS intend to target specific abusive transactions while respecting conventional, long-established tax planning consistent with congressional intent. Whether a particular transfer qualifies for nonrecognition treatment depends on its facts and structure.
How does the step-transaction doctrine apply?
The step-transaction and substance-over-form doctrines allow the IRS to evaluate formally separate but related steps according to their combined substance. In Revenue Ruling 2026-20, the IRS treats the planned transactions as an exchange in which the investor transfers appreciated securities to the authorized participant in return for ETF shares, resulting in gain or loss under Section 1001.
What should investment advisers and ETF sponsors consider?
They should assess whether the investor transfer, authorized-participant contribution, and related redemption are parts of the same plan; whether the ETF’s resulting portfolio differs materially from the investor’s contributed portfolio; and whether the arrangement is designed to achieve a portfolio exchange without recognizing taxable gain. Because the analysis is fact-specific, advisers and sponsors should obtain tax and regulatory advice before proceeding.
Considering a Section 351 transaction? To discuss how Notice 2026-62 and Revenue Ruling 2026-20 may affect a proposed structure, contact Robert Elwood at robert.elwood@practus.com or Raymond Holst at raymond.holst@practus.com.
All Section references are to the Internal Revenue Code of 1986, as amended. An authorized participant is a third-party market participant that transacts directly with an ETF and, among other functions, helps keep the ETF’s share price aligned with its net asset value per share.
