Revenue Ruling 2026-20 and Notice 2026-62 address certain exchange-traded fund (ETF) and tax-aware investment fund strategies, including transactions involving Section 351 contributions. The ruling addresses an investor that, as part of a plan, contributes a diversified portfolio of appreciated securities to a newly formed ETF in an exchange intended to qualify under Section 351. Under the same plan, an authorized participant (AP) acquires ETF shares for securities consistent with the ETF’s investment thesis, or cash the ETF can use to acquire them. Shortly thereafter the ETF redeems those shares in a redemption intended to qualify under Section 852(b)(6), using securities the investor contributed.
Applying substance-over-form and step-transaction principles, the IRS treats the ETF as a conduit and the investor as making a taxable exchange with the AP under Section 1001 with respect to the contributed securities used in the redemption.
Importantly, the ruling does not say that ordinary ETF contributions followed by ordinary-course redemptions are taxable. Instead, its conclusion depends heavily on the integrated facts: a common plan, an AP transaction followed shortly thereafter by a redemption, and a materially different resulting portfolio. This is consistent with the IRS’s accompanying focus on transactions using traditional tax rules to achieve results it believes are disconnected from their underlying economics.
The ruling answers how the IRS will treat the specific transaction before it, but it leaves several important practical questions unanswered for taxpayers evaluating other Section 351 ETF conversions. In particular, it provides no clear standard for determining when portfolios are “materially different,” what facts establish a common “plan,” how much time can separate otherwise related transactions, or how a partial redemption affects the tax treatment of the investor’s remaining contribution.
The facts of the ruling state that, upon completion of the planned transactions, the ETF holds a portfolio of securities that is consistent with its investment thesis and “materially different” from the one transferred by the investor. In its analysis, the IRS viewed the transactions as enabling the investor to exchange its appreciated securities for a materially different portfolio that aligns with the ETF’s investment thesis.
While the facts of the ruling are important, portfolio rebalancing alone does not appear to be the IRS’s concern. Rather, the IRS focuses on a planned series of transactions through which securities contributed by the investor are transferred to the AP and the ETF ultimately holds a materially different portfolio. Other relevant facts include the common plan and the close timing between the AP’s contribution and redemption.
What the ruling does not provide is a numerical standard for determining when the difference becomes material. There is no stated percentage of securities that must change, no turnover threshold, and no specified test based on value, number of positions, industry exposure, investment characteristics, or economic risk. That omission matters and leaves considerable uncertainty as to where the IRS would draw the line.
Notice 2026-62 offers some indication of what the government has in mind. In describing the Section 351 conversion transaction, it notes that some or all of the contributed securities do not align with the ETF’s contemplated portfolio or investment thesis, or that the contributed portfolio may be overconcentrated in one or more securities relative to that contemplated portfolio. That description suggests the relevant comparison is between what the investor contributed and the portfolio the ETF planned to hold from the outset. The holding also uses the Section 1001 realization standard, treating the investor as disposing of securities for property “differing materially in kind or extent.” Under Cottage Savings Association v. Commissioner, that threshold is generally a low one, which may mean that the existence of a common plan carries greater significance in the analysis than the degree of portfolio change alone.
Consider an investor contributing a diversified portfolio of 100 securities. If the ETF ultimately retains 95 of them and replaces five, the resulting portfolio is certainly different, but is it materially different? What if the five replaced positions represent 40% of the portfolio’s value? Conversely, what if 50 positions change but those positions account for only 10% of value? Revenue Ruling 2026-20 is silent on these matters.
Virtually every critical step in Revenue Ruling 2026-20 is tied together by a single factual premise: the transactions occur as part of the same plan. The investor’s contribution, the AP’s acquisition of ETF shares and the ETF’s subsequent redemption are all described as planned components of the transaction. The IRS then relies on authorities permitting separate steps undertaken under an integrated arrangement to be analyzed according to their substance.
Revenue Ruling 71-336, which the new ruling expressly amplifies, likewise involved appreciated stock contributed to a corporation followed, under a prearranged plan, by the corporation’s redemption of another shareholder using that stock. The ruling also relies on Kuper v. Commissioner, a Fifth Circuit decision reaching a similar result where the contributed stock was distributed in redemption the following day.
But an important question remains: whose plan must it be?
Revenue Ruling 2026-20 states as a fact that the investor, ETF and AP transactions are undertaken pursuant to the same plan. It does not establish a separate test for how much knowledge, agreement or participation each party must have before separate transactions become components of that plan. In many transactions, the investor will have no direct relationship or communications with the AP. If the investor has no agreement or communication with the AP, whose knowledge or intent is sufficient to establish the common “plan” on which the ruling depends: the investor’s, the ETF sponsor’s, the AP’s or some combination of them? Revenue Ruling 2026-20 does not say.
Two features of the guidance bear on that question. First, the ruling states that the result would be the same if multiple investors engaged in the transaction, so its analysis does not depend on a single investor orchestrating every step. Second, Notice 2026-62 frames the arrangement from the investors’ perspective: as a result of the planned transactions, investors expect to avoid recognizing their built-in gains while effectively exchanging their securities for an interest in an ETF with a materially different portfolio. That framing suggests the IRS may focus on what the investor understood about the post-contribution repositioning, even where the investor never deals with the AP directly. The absence of investor-AP communication therefore may not, by itself, be determinative.
Suppose an investor contributes securities to an ETF with the understanding that the ETF will reposition the portfolio, but has no agreement with the ETF regarding how that repositioning will occur and no agreement with an AP concerning a particular contribution or redemption. Or suppose the ETF knows that a redemption is expected but the contributing investor neither directs nor controls which assets will satisfy it. At what point do those independent decisions become part of an integrated plan?
The ruling does not answer those questions. It also does not appear to treat the possibility or mere foreseeability of a subsequent redemption as sufficient, standing alone, to establish a “plan.” The authorities cited in the ruling involve integrated or prearranged transactions, and the ruling itself repeatedly anchors its conclusion in transactions undertaken pursuant to the same plan.
Accordingly, documentation and actual conduct matter. Agreements, communications, timing, investment mandates and the degree to which subsequent steps were fixed or effectively committed when the Section 351 contribution occurred could become important evidence if the IRS argues that nominally separate transactions were really elements of one transaction.
The third ambiguity is deceptively simple: time. But there are actually two timing questions embedded in the transaction. Revenue Ruling 2026-20 states that, after the AP receives ETF shares, the ETF redeems those shares “shortly thereafter.” Thus, read literally, the phrase measures the period between the AP’s contribution and the AP’s redemption. The ruling does not specify how much time may elapse between the investor’s original Section 351 contribution and the subsequent AP transaction and redemption. That distinction is important because the latter period could be considerably longer.
Notice 2026-62, issued contemporaneously with the ruling, raises an additional timing question. In discussing the transaction that is the subject of the ruling, the notice states that in many cases the redemption occurs shortly after the investor’s original contribution, while the ruling itself attaches “shortly thereafter” only to the interval between the AP’s acquisition of shares and its redemption. The difference may be significant. By declining to identify a specific period between the investor’s contribution and the later redemption, the guidance leaves taxpayers without a bright-line timing rule and makes it difficult to rely on a prescribed waiting period as a safe harbor.
If plan integration is controlling, simply having the redemption occur a prescribed number of days after the investor’s contribution may offer limited assurance. A redemption occurring much later could arguably remain subject to the ruling if it was contemplated as part of the original plan. Conversely, an unplanned redemption occurring relatively soon after the contribution presents a meaningfully different set of facts. The authorities the ruling relies on offer limited help: in Kuper the redemption occurred the following day, and Revenue Ruling 71-336 describes a redemption occurring “shortly thereafter.”
An important limitation appears in Notice 2026-62. Treasury and the IRS expressly leave open the treatment of a Section 351 seeding transaction where the securities contributed to a new ETF are consistent with its investment thesis and are intended and expected to be retained absent a substantial change in circumstances, including an unexpected change in market or business conditions. That fact pattern provides a useful counterpoint to Revenue Ruling 2026-20. At one end is a contribution of securities that are consistent with the ETF’s investment thesis and are expected to remain; at the other is a planned transaction in which contributed securities move through the ETF to an AP while the ETF emerges with a materially different portfolio. Because the notice expresses no view on that fact pattern, it is a reference point rather than a safe harbor, and the difficult cases will fall between those two poles.
Revenue Ruling 2026-20 puts certain Section 351 ETF conversion transactions on notice. But it is equally important not to convert a ruling based on a particular integrated transaction into a blanket prohibition on Section 351 ETF contributions. The holding itself is drawn narrowly, even though the doctrines on which it rests are not. The IRS treated the investor as engaging in a taxable exchange with the AP specifically with respect to the securities originally contributed by the investor and that the ETF subsequently used to redeem the AP. In other words, the ruling does not expressly treat the investor’s entire contribution as a taxable exchange merely because some of the contributed securities leave the ETF pursuant to the plan. Rather, the taxable exchange identified by the IRS corresponds to the contributed securities that move through the ETF to the AP.
The scope of the holding becomes particularly important where only a portion of the contributed portfolio is used to redeem the AP. Suppose an investor contributes $100 million of appreciated securities and the ETF later uses $25 million of those securities in the planned AP redemption. Revenue Ruling 2026-20 expressly treats the investor as engaging in a taxable exchange with respect to the contributed securities used in the redemption. The ruling does not expressly extend that treatment to the remaining $75 million merely because it was contributed in the same Section 351 transaction. That does not mean the remaining contribution necessarily qualifies for nonrecognition, and the example should not be read as establishing any quantitative safe harbor. Instead, the example illustrates an important issue left unresolved by the ruling: whether integration of the overall transaction necessarily determines the treatment of the entire contribution, or whether the taxable exchange remains limited to the particular contributed securities that ultimately pass to the AP.
Two further points complicate the analysis. First, the holding begins by recharacterizing “the transfer of securities by Investor to ETF” to reflect the substance of the plan, but then describes a taxable exchange limited to the securities used to redeem the AP. It does not say what follows for the rest of the transfer. Second, the ruling does not identify what the investor is treated as receiving in the deemed exchange with the AP, whether the securities or cash the AP contributed or the ETF shares issued to the AP. That question affects the investor’s amount realized and its basis and holding period in its ETF shares.
Taxpayers should also keep in mind that the ruling does not rely on Section 351(e), which denies nonrecognition for transfers to an investment company that result in diversification of the transferors’ interests. Under the regulations, a transfer that is part of a plan to achieve diversification without recognition of gain is treated as resulting in diversification.
Timing of review also matters. The ruling is not framed solely as a prospective change in the law; the IRS grounds its conclusion in existing judicial doctrines and prior authorities. Revenue rulings generally apply retroactively unless they provide otherwise under Section 7805(b)(8). Revenue Ruling 2026-20 contains no such limitation. Notice 2026-62 adds that future guidance on the transactions it describes could include identifying them as listed transactions or transactions of interest and could apply retroactively. The notice also states that the IRS may challenge these strategies on examination under existing law. Taxpayers therefore should consider not only proposed transactions, but also whether completed Section 351 ETF conversions remain within an open limitations period and share the features emphasized in the ruling. Beyond those general points, the open questions discussed above translate into specific diligence for each participant.
Revenue Ruling 2026-20 should not be read as providing that Section 351 ETF conversions no longer qualify for nonrecognition, but Treasury and the IRS have said they are considering additional guidance on these transactions. The most significant feature of the ruling may therefore be not what it definitively resolves, but what taxpayers now have to prove when their facts fall outside it. In the absence of numerical safe harbors for portfolio change or timing, taxpayers considering Section 351 ETF conversions should be prepared to establish that separate steps are genuinely independent, using the transaction’s actual economics and contemporaneous documentation.
For transactions involving only a partial disposition of contributed securities, taxpayers will also need to consider whether the ruling’s recharacterization applies solely to the securities transferred to the AP or has broader consequences for the Section 351 contribution, an issue the ruling does not expressly resolve.
For more information on this topic, please contact a member of our team.
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