Rev. Rul. 2026-20, 2026-20 I.R.B. 1, September 28, 2026

Notice 2026-62, 2026-20 I.R.B. 1, September 28, 2026

In a coordinated regulatory release, the Department of the Treasury and the Internal Revenue Service issued Revenue Ruling 2026-20 alongside Notice 2026-62 to address what tax administrators describe as “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.” Targeted at certified public accountants, enrolled agents, and corporate tax counsel, these administrative pronouncements draw a decisive boundary between conventional, long-established exchange-traded fund (ETF) operations and tax-motivated, structured transactions designed to circumvent gain recognition under Subchapter M and Subchapter C of the Internal Revenue Code (Code).

At the center of this enforcement initiative is Section 852(b)(6), a specialized nonrecognition provision applicable to regulated investment companies (RICs). While Section 852(b)(6) historically shields a RIC from recognizing gain under Section 311(b) when distributing appreciated portfolio property in redemption of its stock upon a shareholder’s demand, tax advisors have increasingly paired this provision with Section 351 corporate formation rules and partnership exchange fund mechanisms under Section 721. Through Revenue Ruling 2026-20, the IRS invokes longstanding step-transaction and substance-over-form doctrines to recharacterize so-called “Section 351 conversion transactions” as direct, taxable asset exchanges under Section 1001. Concurrently, Notice 2026-62 serves as a broad warning shot across several other atypical usages of Section 852(b)(6) and multi-position derivative strategies, signaling prospective or retroactive regulatory action, potential transaction-of-interest designations, and direct examination challenges.

Fact Patterns and Transactional Dynamics in Revenue Ruling 2026-20

Revenue Ruling 2026-20 evaluates a specific, multi-step transaction executed pursuant to a single integrated plan. Under the facts presented in the ruling, an investor (Investor) holds a portfolio of appreciated securities. Desiring to diversify or alter this investment holding without incurring an immediate federal income tax liability, Investor transfers the appreciated securities portfolio to a newly formed entity (ETF). ETF is a domestic corporation intended to qualify as a RIC under Section 851 and subject to tax under part I of Subchapter M. At the time of the transfer, the contributed portfolio satisfies the statutory diversification requirements of Treasury Regulation § 1.351-1(c).

As part of the same prearranged plan, two subsequent transactions occur in close temporal proximity:

First, ETF issues creation units (large blocks of ETF shares) to a designated “authorized participant” (AP), an institutional broker-dealer or financial institution. In exchange for these creation unit shares, the AP transfers to ETF either cash or a portfolio of securities that aligns with ETF’s ultimate investment thesis and operational mandate. If cash is contributed, ETF uses the cash to acquire securities matching its investment thesis.
Second, shortly thereafter, ETF redeems the creation unit shares tendered by the AP. In complete or partial satisfaction of this redemption demand, ETF distributes to the AP the specific appreciated securities originally contributed by Investor. This redemption distribution is formally structured to qualify for fund-level nonrecognition of gain under Section 852(b)(6).

Upon completion of these planned steps, Investor retains an equity interest in ETF, which now holds a portfolio of securities that is consistent with its investment thesis and “materially different from the portfolio transferred by Investor.” Meanwhile, the AP has received the appreciated securities originally owned by Investor, and ETF’s transitory holding of Investor’s contributed assets is fully terminated.

Rationale and Administrative Purpose of the Guidance

The IRS and Treasury Department issued Revenue Ruling 2026-20 and Notice 2026-62 because investment advisors have actively promoted these structured strategies as a mechanism to achieve tax-free portfolio diversification for wealthy individual and institutional investors. In traditional market practice, Section 351 allows taxpayers to transfer assets to a corporation without immediate gain recognition when the transfer represents a mere change in the form of ownership, provided the transferors control the transferee corporation immediately after the exchange and do not receive a diversified portfolio of stock and securities within the meaning of Section 351(e). However, where an investor holds a portfolio that is already technically diversified under Treasury Regulation § 1.351-1(c)(6), but contains unwanted, low-basis single stocks or sector concentrations, traditional Section 351 rules do not permit a tax-free swap for a completely different portfolio of assets.

To bypass this limitation, promoters combined Section 351(a) with the RIC redemption nonrecognition rule of Section 852(b)(6). By using the ETF as an intermediary conduit and the AP as a redeeming counterparty, investors sought to execute what was functionally a taxable portfolio exchange, while asserting formal compliance with statutory nonrecognition rules at every intermediate step. The IRS observed in Notice 2026-62 that “transactions purporting to be governed by §§ 351 and 852(b)(6) are being combined as part of a plan to achieve a result that neither provision was designed to produce.”

The administrative purpose of issuing the ruling and notice concurrently is twofold: (1) to establish an immediate, binding legal determination under Revenue Ruling 2026-20 that Section 351 conversion transactions fail to qualify for nonrecognition treatment and constitute taxable Section 1001 exchanges, and (2) to broadcast through Notice 2026-62 that Treasury and the IRS are aggressively scrutinizing a broader family of related strategies involving atypical Section 852(b)(6) redemptions, partnership exchange funds under Section 721, box spread options, record-date dividend stripping, and derivative character manipulation.

Statutory and Regulatory Framework

A rigorous technical analysis of the IRS’s position requires examining the intersection of Subchapter C, Subchapter M, and general gain realization principles under the Code.

General Realization and Recognition Rules: Section 1001(a) provides that gain or loss from the sale or other disposition of property equals the difference between the amount realized and the adjusted basis provided in Section 1011. Realization occurs upon an exchange of property for other property “differing materially either in kind or in extent.” Treasury Regulation § 1.1001-1(a). Under Section 1001(c), realized gains and losses must be recognized across all taxable transactions unless a specific nonrecognition provision of Subtitle A applies.

Corporate Distribution and Redemption Rules: In Subchapter C, Section 311(a) establishes a general rule that a corporation recognizes no gain or loss on non-liquidating distributions of stock or property to shareholders. However, Section 311(b) operates as a sweeping exception, requiring a corporation to recognize gain on the distribution of appreciated property (other than its own obligations) to a shareholder as if such property were sold to the shareholder at fair market value. Under Section 317(a), “property” encompasses money, securities, and other assets, excluding stock of the distributing corporation.

Subchapter M Exception for Regulated Investment Companies: A RIC under Section 851 is a domestic corporation that satisfies specific gross income source, asset diversification, and annual dividend distribution tests under Section 852(a)(1). While RICs generally remain subject to Section 311(b) on distributions of appreciated property, Section 852(b)(6) carves out a fundamental statutory exception. Section 852(b)(6) specifies that Section 311(b) “shall not apply to any distribution by a regulated investment company of property if such distribution is in redemption of its stock upon the demand of the shareholder.” In standard ETF operations, authorized participants routinely create and redeem creation units in-kind. When an ETF distributes appreciated portfolio securities to an AP in an in-kind redemption, Section 852(b)(6) shields the ETF from recognizing fund-level built-in gains, leaving the redeeming AP to recognize gain or loss under Sections 302(a) and 1001(a) based on the difference between the NAV of shares surrendered and the basis in those shares. Because APs are market makers acquiring ETF shares at NAV immediately prior to redemption, APs realize negligible gain or loss and take a cost basis in the distributed property under Section 1012(a).

Section 351 Formation and Investment Company Limits: Section 351(a) provides that no gain or loss is recognized if property is transferred to a corporation by one or more persons solely in exchange for stock, provided the transferors are in control (as defined in Section 368(c)) immediately after the exchange. However, Section 351(e)(1) explicitly denies nonrecognition treatment to a “transfer of property to an investment company.” Under Treasury Regulation § 1.351-1(c)(1), a transfer is treated as a transfer to an investment company if (i) the transfer results, directly or indirectly, in diversification of the transferors’ interests, and (ii) the transferee is a RIC, REIT, or a corporation more than 80 percent of whose assets consist of stock and securities. Treasury Regulation § 1.351-1(c)(6)(i) incorporates the portfolio diversification standards of Section 368(a)(2)(F)(ii), establishing that a portfolio is diversified if not more than 25 percent of total assets are invested in a single issuer and not more than 50 percent are invested in five or fewer issuers.

IRS Analysis of the Law and Judicial Doctrines

In Revenue Ruling 2026-20, the IRS grounds its rejection of Section 351 conversion transactions in established judicial doctrines and historical anti-abuse case law, emphasizing that formal statutory compliance cannot override transactional substance.

The ruling begins its legal analysis by emphasizing the foundational statutory purpose of Section 351. Quoting the First Circuit Court of Appeals in Portland Oil Co. v. Commissioner, 109 F.2d 479, 488 (1st Cir. 1940), the IRS notes that:

“the purpose of [Section 351] [is] to save the taxpayer from an immediate recognition of a gain, or to intermit the claim of a loss, in certain transactions where gain or loss may have accrued in a constitutional sense, but where in a popular and economic sense there has been a mere change in the form of ownership and the taxpayer has not really ‘cashed in’ on the theoretical gain, or closed out a losing venture.”

To evaluate whether a transaction represents a “mere change in the form of ownership” or a substantive economic disposition, the IRS applies substance-over-form and step-transaction principles. Citing Stewart v. Commissioner, 714 F.2d 977, 987 (9th Cir. 1983), the ruling stresses that the overarching purpose of the substance-over-form doctrine is to “deny legal effect to transactions that comply with the formal requirements of a statute but violate the purpose of the statute.”

The IRS further underscores that multi-step transactions executed pursuant to a single integrated plan must be evaluated based on the end result rather than intermediate mechanics. Citing the Supreme Court’s landmark decision in Minnesota Tea Co. v. Helvering, 302 U.S. 609, 613 (1938), the ruling reinforces that “[a] given result at the end of a straight path is not made a different result because reached by following a devious path.” This principle is matched with the Supreme Court’s mandate in Commissioner v. Court Holding Co., 324 U.S. 331, 334 (1945), where the Court stated:

“A sale by one person cannot be transformed for tax purposes into a sale by another by using the latter as a conduit through which to pass title. To permit the true nature of a transaction to be disguised by mere formalisms, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress.”

To reinforce its recharacterization analysis, the IRS relies heavily on corporate redemption and reciprocal transfer precedents:

In Kuper v. Commissioner, 533 F.2d 152 (5th Cir. 1976), shareholders of an operating corporation (KE) contributed their KE shares to a sister corporation (KV) owned by the same shareholders. On the following day, KV distributed the KE shares to one shareholder in complete redemption of that shareholder’s KV interest. The Fifth Circuit collapsed the formal contribution and redemption steps, holding that the transaction was in substance a taxable, reciprocal stock exchange between the continuing KV shareholders and the redeemed shareholder.
In Revenue Ruling 71-336, 1971-2 C.B. 299, a group of shareholders contributed appreciated stock of Corporation Y to Corporation X pursuant to a prearranged plan. Shortly thereafter, Corporation X redeemed the stock held by another shareholder in exchange for the newly contributed Corporation Y stock. The IRS ruled that the intermediary corporation was a mere conduit, recharacterizing the transaction as a direct, taxable stock-for-stock exchange among the shareholders. (Revenue Ruling 2026-20 explicitly amplifies Revenue Ruling 71-336).
In Waterman Steamship Corp. v. Commissioner, 430 F.2d 1185 (5th Cir. 1970), and Revenue Ruling 75-360, 1975-2 C.B. 110, pre-acquisition distributions and redemptions were integrated with subsequent stock acquisitions and recharacterized as sales proceeds or boot because the formal steps failed to reflect the underlying economic reality.

Finally, the IRS distinguishes previous administrative rulings—specifically Revenue Ruling 75-447, 1975-2 C.B. 13 (concerning integrated redemptions and share sales under Section 302) and Revenue Ruling 88-32, 1988-1 C.B. 833 (concerning Section 351 transfers of stock followed by corporation sales on the open market)—noting that those rulings involved genuine, independent corporate transactions rather than conduit distributions designed to effectuate reciprocal shareholder exchanges.

Application of the Law to the Facts and IRS Holdings

Applying these legal standards to the factual matrix of Revenue Ruling 2026-20, the IRS concludes that ETF’s brief ownership of Investor’s contributed securities must be disregarded for federal income tax purposes.

Because Investor contributed the appreciated securities portfolio to ETF as part of an integrated plan wherein those identical securities were distributed shortly thereafter to the AP in redemption of creation unit shares, ETF acted as a “merely a conduit through which securities transferred from Investor to AP pursuant to the plan.” The true economic substance of the transaction is not a tax-free Section 351 contribution to an ETF followed by an independent Section 852(b)(6) fund redemption. Instead, the transaction represents a direct, taxable exchange between Investor and the AP.

The specific holdings established by Revenue Ruling 2026-20 are as follows:

First, the formal transfer of securities by Investor to ETF is recharacterized under general step-transaction and substance-over-form principles to reflect its true economic substance.
Second, Investor is treated as having engaged in a direct, taxable exchange under Section 1001 with the AP. Investor must recognize gain or loss equal to the difference between the fair market value of the ETF creation unit shares (or the underlying portfolio property acquired from the AP) and Investor’s adjusted basis in the contributed securities.
Third, the IRS explicitly holds that this recharacterization result applies equally regardless of whether the transaction is executed by a single investor or multiple investors acting in concert.

Broader Potentially Abusive Fund Strategies Identified in Notice 2026-62

While Revenue Ruling 2026-20 delivers a definitive holding on Section 351 conversion transactions, Notice 2026-62 expands the regulatory footprint by identifying several additional transaction structures involving atypical usages of Section 852(b)(6) and sophisticated financial derivatives. Tax practitioners must understand these highlighted strategies to advise clients on emerging audit exposures.

Transfers to Partnerships in Connection with Section 351 Conversions (Partnership Exchange Funds): Promoters have marketed a partnership variation under Section 721 for investors holding non-diversified portfolios. Investors contribute appreciated single stocks to a partnership that invests at least 20 percent of its assets in non-stock/non-security real estate or commodity property, asserting that the fund escapes Section 721(b) investment company status. The partnership, now holding a diversified portfolio, subsequently executes a Section 351 conversion transaction with an ETF. The IRS noted that Sections 351, 721, and 852(b)(6) are being chained together in a manner inconsistent with statutory intent and is considering guidance to recharacterize or disallow nonrecognition on these partnership contributions.

Box Spread Option Funds: Certain ETFs utilize “box spread” option combinations (four options on the same underlying asset producing a synthetic short-term interest rate return) using non-Section 1256 option contracts. Prior to the expiration of options holding unrealized gain, the ETF issues creation units to an AP and distributes the appreciated option legs in redemption of the creation units, asserting fund-level nonrecognition under Section 852(b)(6). Consequently, the ETF eliminates taxable income from the box spread, allowing investors to enjoy capital gain treatment upon share sale without current ordinary income recognition. A similar variation utilizes offsetting straddle positions under Section 1092, attempting to deduct straddle losses while eliminating offsetting gains via Section 852(b)(6).

Record Date Strategies: Equity parent ETFs hold shares of acquired equity ETFs that track the same index. Shortly before an acquired ETF’s dividend record date, the parent ETF issues creation units to an AP, redeems the AP using the acquired ETF shares under Section 852(b)(6), and reinvests in a substitute ETF tracking the same index. The parent ETF asserts that it eliminates dividend income recognition under Section 852(b)(6) while maintaining uninterrupted index exposure.

RIC Income Test Avoidance under Section 851(b)(2): Section 851(b)(2) requires a RIC to derive at least 90 percent of its gross income from qualifying investment sources (dividends, interest, capital gains on stock/securities). Certain ETFs invest in non-qualifying assets, such as commodities or digital assets (directly or via grantor trusts). When these non-qualifying assets appreciate, the ETF distributes them to APs in Section 852(b)(6) in-kind redemptions, taking the position that realized but unrecognized gains from Section 852(b)(6) distributions are excluded from the Section 851(b)(2) gross income calculation.

Strategies Used by “Tax-Aware” Funds: Notice 2026-62 also targets multi-position derivative strategies executed by investment partnerships and separately managed accounts. These include: (1) Identified Straddles under Section 1092(a)(2) combining Section 988 ordinary foreign currency forwards and Section 1256 capital futures to selectively generate capital gains and ordinary losses; (2) Same-Day Foreign Currency Forward Elections under Section 988(a)(1)(B), where funds use hindsight at the end of the trading day to elect capital treatment for gain positions while leaving loss positions as ordinary under Section 988(a)(1)(A); and (3) Selective Notional Principal Contract (NPC) Terminations under Treasury Regulation § 1.446-3 and Section 1234A, where funds cancel appreciated short-term equity swaps prior to payment dates to claim capital gain while holding loss swaps to maturity to claim ordinary deductions.

Professional Implications for CPAs, EAs, and Tax Advisory Practice

The issuance of Revenue Ruling 2026-20 and Notice 2026-62 carries immediate operational and compliance implications for tax practitioners advising high-net-worth individuals, fund managers, and institutional investors.

First, Revenue Ruling 2026-20 is a binding precedent representing the IRS’s official legal position. CPAs and EAs must review existing client transactions involving recent ETF contributions and in-kind redemptions. Tax return preparers cannot take a nonrecognition reporting position under Section 351 for conversion transactions matching Revenue Ruling 2026-20 without violating tax return accuracy standards and incurring potential disclosure penalties under Section 6662 unless substantial authority or a reasonable basis with adequate disclosure (Form 8275) exists. In light of Revenue Ruling 2026-20, substantial authority for Section 351 conversion nonrecognition arguably no longer exists.

Second, Notice 2026-62 signals that the IRS is actively preparing future regulatory actions under Section 7805(b), including potential retroactive anti-abuse regulations, prospective revenue rulings, and formal designations of certain strategies as “transactions of interest” or “listed transactions” under Treasury Regulation § 1.6011-4. Such designations trigger rigorous reportable transaction disclosure obligations on Form 8886 for taxpayers and Form 8918 for material advisors.

Third, Notice 2026-62 explicitly reserves Treasury’s authority to minimize compliance burdens and “respect market expectations with respect to conventional, long-established tax planning that is consistent with the intent of Congress.” Specifically, the notice excludes traditional ETF seeding arrangements where initial assets align with the fund’s investment thesis and are intended to be retained absent unexpected market changes. CPAs and EAs must meticulously document client intent and fund economics to differentiate legitimate fund seeding and standard in-kind creation/redemptions from prearranged conversion schemes.

Finally, Treasury and the IRS have requested public comments by October 28, 2026, regarding the factual accuracy, economic distinctions, and prospective scope of future guidance addressing these subject transactions. Tax professionals and industry stakeholders have a critical window to submit technical comments to shape forthcoming administrative regulations.

Prepared with assistance from Gemini Notebook.