Treasury targets ETF tax loopholes with new IRS ruling

Key points

• The IRS issued Revenue Ruling 2026-20 and Notice 2026-62, targeting the '351 conversion' strategy that allows investors to rebalance portfolios without incurring taxable gains.
• Treasury Secretary Scott Bessent declared that these conversions 'don't work under existing law' and that the department is serious about cracking down on tax-dodging transactions.
• The 'tax alpha' industry, which focuses on minimizing tax liabilities, has surged in popularity; hedge funds offering these strategies accrued over $90 billion between early 2025 and April 2026.
• ETFs created using 351 conversions have raised at least $21 billion since 2021, according to Tax Alpha Insider.
• Shares of Affiliated Managers Group, which owns AQR (a pioneer in tax-aware investing), fell up to 2% following the announcement.

Background

This crackdown follows a July 2026 industry event where Treasury officials signaled interest in probing aggressive tax planning strategies. The move aligns with broader efforts to address tax avoidance, as seen in earlier discussions about corporate tax receipts dropping due to AI-driven capital spending incentives. The current focus on ETFs and 'tax alpha' strategies represents a shift towards targeting individual and institutional investor behaviors that exploit favorable tax treatments of ETFs, such as in-kind trading to avoid capital gains tax.

How outlets are covering it

The Financial Times emphasizes the broader crackdown on 'potentially abusive' tactics and the impact on the 'tax alpha' industry, noting the surge in popularity of these strategies. GuruFocus focuses on the implications for asset managers like AllianceBernstein, highlighting concerns about dividend sustainability and the potential increase in tax liabilities for those using ETFs to manage appreciated assets. Current Federal Tax Developments provides a detailed technical analysis of the ruling, explaining how the IRS uses step-transaction and substance-over-form doctrines to recharacterize 351 conversion transactions as taxable exchanges, and identifies other potentially abusive strategies in Notice 2026-62, such as partnership exchange funds and box spread option funds.

Why it matters

The ruling could significantly impact the 'tax alpha' industry, which has grown rapidly in recent years. It may lead to increased tax liabilities for wealthy investors and asset managers who have relied on these strategies to minimize their tax bills. The move also signals a broader shift in the US government's approach to tax enforcement, potentially affecting other areas of tax planning and investment strategies.

What to watch

The Treasury indicated it is 'also considering issuing additional guidance or taking other action to address the transactions described in this notice' and that such guidance could apply 'retroactively.' This suggests potential further enforcement actions and regulatory changes in the coming months. Investors and asset managers may need to reassess their tax strategies in light of the new ruling and potential future guidance.