The IRS is examining tax arrangements used by some cryptocurrency ETFs, raising questions about how certain funds account for gains when digital assets are transferred to Wall Street trading firms. In a notice issued September 28, the agency said some structures may allow funds to avoid recognizing gains on their books. A separate tax ruling rejected a strategy that let wealthy investors exchange appreciated stock for diversified fund shares without immediately recognizing taxable gains.
Both actions focus on ETF tax rules. Any change in how these gains are classified could affect a fund’s tax status, structure and investors’ tax bills. The IRS has not named specific funds or said that all crypto ETFs are covered.
How in-kind redemptions may affect fund income
Most U.S. investment funds can receive favorable tax treatment if they meet certain conditions, including deriving at least 90% of their income from dividends, interest and gains from stock trading. Income from cryptocurrency and commodities does not qualify for this calculation. A fund with too much non-qualifying income could put its tax status at risk.
The IRS notice says some ETFs may use in-kind redemptions to handle appreciated digital assets. Rather than sell the assets and record a capital gain, a fund transfers them to a trading firm, which redeems or monetizes the fund shares. If the transaction does not result in a recorded sale gain at the fund level, the income may avoid classification in a less favorable category.
The agency said the arrangements under review could involve funds holding digital assets directly or through trusts. ETF analyst James Seyffart said the notice is broad in scope, covering in-kind redemptions, transactions under Section 351, box spread strategies and straddle transactions—arrangements that could be used to create or defer tax outcomes.
Spot bitcoin trusts may be treated differently
The notice does not identify any affected funds. Spot bitcoin products such as BlackRock’s iShares Bitcoin Trust use a different legal and tax structure. It is a grantor trust, meaning its tax treatment passes through to shareholders rather than being handled entirely like that of a conventional fund.
The more immediate focus appears to be on conventional funds that hold crypto assets directly or own interests in related trusts. Funds holding these assets through offshore subsidiaries are not expressly covered by the notice. Given the differences among product structures, the label “crypto ETF” alone does not establish whether a fund could be affected; investors would need to examine its registration documents and tax arrangements.
The IRS also left open the possibility of retroactive application. Future guidance could apply only to transactions conducted after its release, or to transactions already completed. The deadline for public comments is October 28. The final scope and effective date remain unclear pending further guidance.
IRS rejects a Section 351 stock-swap strategy
Tax Ruling 2026-20, also issued that day, further limits another ETF transaction structure. Under the strategy, an investor could contribute substantially appreciated stock to a newly formed ETF. The fund would then transfer the stock to a trading firm, with the aim of obtaining a more diversified portfolio without immediately recognizing capital gains.
The IRS determined that, in the circumstances addressed, transferring the stock to the trading firm was a taxable sale—not a tax-free exchange eligible for treatment under Section 351. ETF analyst Eric Balchunas said the ruling appeared aimed at specific practices that depart from the intent of the tax law, rather than rejecting all ETF structures.
Accountant Ed Zollars also analyzed the ruling. For fund managers and institutional investors, key questions are how the IRS will draw the lines between in-kind redemptions, trust holdings and Section 351 transactions, and whether any new rules will reach asset transfers that have already taken place.