On September 28th, the IRS issued Rev. Rul. 2026-20 and Notice 2026-52, with the latter pronouncement entitled “Guidance and Other Actions Being Considered Regarding Certain Potentially Abusive Investment Fund Strategies Involving Financial Products.” The Notice describes a bevy of transactions designed to (1) defer gain recognition while allowing for diversification of assets containing unrealized gain or (2) create an ordinary loss/capital gain conversion. If the IRS wanted to scare taxpayers, mission accomplished. Only one such transaction is specifically knocked out using substance-over-form and step-transaction-principles (in Rev. Rul. 2026-20), with the IRS indicating that it is looking at these other transactions and not expressing any view on their tax consequences, but at the same time indicating that guidance may be issued in the future, which “could apply prospectively only or retroactively to transactions that already have taken place at the time the guidance is issued.”

Let’s take a look at the transaction in the revenue ruling, which is not terribly difficult to understand (contrary to some of the other transactions in the Notice that the IRS is “examining”). In the ruling, a taxpayer, in a transaction that meets the technical requirements of §351, transfers a “diversified” portfolio (i.e., no more than 25% of the total value of the contributed securities is in any one issuer and no more than 50% of the total value of the contributed securities is in five or fewer issuers) to an exchange traded fund (“ETF”) that intends to qualify under §851 as a regulated investment company (“RIC”). These contributed securities are not part of the investment philosophy of the ETF. As part of the contemplated transaction, the ETF issues shares to a person serving as an “authorized participant” (“AP”) in exchange for securities that are consistent with the ETF’s investment philosophy or cash that ETF intends to use to acquire such securities. Shortly thereafter, the ETF redeems the shares of the AP in a transaction intended to qualify under §852(b)(6), in exchange for the securities transferred to the ETF by the taxpayer. Upon completion of the planned transactions, the ETF holds a portfolio of securities that is consistent with its investment philosophy, but materially different from the portfolio transferred by the taxpayer.

Code §852(b)(6) essentially provides that the distribution by the ETF/RIC is not subject to tax under §311(b) (i.e., which taxes a corporation on the distribution of appreciated property to a shareholder). When the dust clears, the goal of the transaction is that the taxpayer essentially will have swapped his contributed portfolio of appreciated securities for an interest in an ETF containing other securities that are in keeping with the investment philosophy of the ETF (and, no doubt, the desired investment philosophy of the taxpayer). While not discussed in the ruling, presumably the AP is amenable to participating in the transaction, because it has contributed either securities with no unrealized gain or has contributed cash, so that when it receives the distribution of the appreciated securities from the ETF/RIC, AP will take a substituted basis in those securities and can sell them without recognition of gain or loss. Of course, the taxpayer’s basis in the ETF shares will have unrealized gain; however, the taxpayer will not recognize that gain until disposition of the ETF shares. In the ruling, the IRS concludes that the transaction is not in keeping with the purposes of §351 and that the taxpayer has engaged in a taxable swap of securities.

It also is of interest that the Notice indicates that the IRS is looking at “partnership exchange funds” where a taxpayer contributes to a partnership a non-diversified portfolio of securities where the partnership has other assets that are not stock or securities with a value of at least 20% of the value of partnership assets after the contribution of the securities (so as not to be an investment company under §721(b) by reference to §351(e)). As part of the same plan, the partnership engages in the ETF strategy described above (referred to in the Notice as a “partnership variation” strategy).

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