IRS Warns on Crypto ETF Tax Tactics, Ends "Tax-Free" Stock-to-ETF Swap

The Internal Revenue Service is turning up scrutiny on how some crypto-linked exchange-traded funds manage taxable income. In a notice released Monday, the agency flagged structures that rely on in-kind redemptions to avoid recognizing gains on rising digital-asset positions. On the same day, the IRS also moved to eliminate a separate strategy used by affluent investors to swap concentrated stock positions into diversified funds without current tax. Both actions focus on the same set of ETF tax rules. How the strategy works Most U.S. funds that qualify as regulated investment companies generally avoid entity-level tax if at least 90% of their income comes from dividends, interest and gains from securities. Income tied to crypto and commodities typically does not count toward that threshold, raising the risk that too much non-qualifying income could jeopardize the tax status. According to the IRS notice, some funds have sought to sidestep that issue by transferring appreciated digital assets to Wall Street trading firms (authorized participants) that redeem fund shares. Because ETF rules allow in-kind redemptions without the fund recognizing a taxable gain, the fund may avoid booking gains that could be treated as problematic income. The IRS said the approach can apply whether the fund holds the assets directly or through a trust. Which funds may be affected The notice does not name specific products. Spot Bitcoin ETFs are often structured differently. For example, BlackRock’s iShares Bitcoin Trust is organized as a grantor trust and, as described in its SEC filing, passes its tax attributes through to shareholders. The IRS focus is on conventional funds that hold crypto directly or that hold shares of crypto trusts. The notice indicates that funds holding such assets through an offshore subsidiary are not covered. The agency also signaled that future guidance could have retroactive reach: "Any such guidance could apply prospectively only or retroactively to transactions that already have taken place..." Public comments are due October 28. Revenue Ruling 202620 ends Section 351 "conversion" swap Alongside the notice, the IRS released Revenue Ruling 202620, targeting the Section 351 conversion transaction. The structure had allowed an investor to contribute highly appreciated stock into a newly formed ETF and receive ETF shares in return without immediate tax, effectively exchanging a concentrated position for diversification. Under the ruling, the IRS treats the key step—the fund transferring that stock to a trading firm—as a taxable sale, shutting down what had been marketed as a tax-free swap. ETF analyst Eric Balchunas characterized the move as a crackdown on transactions that stray from the intent of the rules. CPA Ed Zollars, who writes Current Federal Tax Developments, urged advisers to review prior client conversions. The Investment Company Institute (ICI), the main U.S. fund industry trade group, has argued to Treasury that these conversions can provide diversification and lower fees, according to law firm Liskow.