The Internal Revenue Service (IRS) issued a notice on September 28, 2026, targeting cryptocurrency exchange-traded funds (ETFs) that use in-kind redemption mechanics to keep digital asset gains off their taxable balance sheets. Alongside the notice, the agency published Revenue Ruling 2026-20, officially ending Section 351 tax-free stock conversions previously used by high-net-worth investors.
IRS Targets In-Kind Redemption Tactics
Under U.S. tax regulations, investment funds retain tax-exempt status if at least 90% of their gross income derives from qualifying sources such as stock dividends, interest, and capital gains. Direct profits from digital assets and commodities do not count toward this statutory threshold, creating tax risks for funds holding crypto.
To manage this requirement, certain funds hand off appreciating digital assets to Wall Street trading firms during share redemptions. Using special in-kind redemption rules, ETFs avoid booking taxable gains on these transfers. The IRS highlighted that this strategy applies whether assets are owned directly or through trusts, though funds utilizing offshore subsidiaries fall outside the notice's scope.
Key takeaways from the regulatory update include:
- Tax Rule Enforcement: The IRS is scrutinizing fund in-kind redemptions designed to maintain the 90% qualifying income test.
- End of Section 351 Swaps: Revenue Ruling 2026-20 eliminates tax-free stock-for-ETF diversification conversions.
- Spot Bitcoin Exemption: Grantor trust structures like the iShares Bitcoin Trust pass tax attributes directly to investors and avoid this mechanism.
- Retroactive Enforcement Risk: The IRS warned future rules may apply retroactively, with public comments due by October 28.
Impact on Spot Bitcoin ETFs and Fund Structures
Bloomberg ETF analyst James Seyffart noted that the IRS notice covers broad ground, targeting straddles, box spreads, and Section 351 exchanges. ETF expert Eric Balchunas observed that regulators are cracking down on transactions that break the spirit of existing tax law.
The impact varies significantly by fund architecture. Spot products organized as grantor trusts—such as BlackRock’s iShares Bitcoin Trust—pass tax attributes directly to shareholders according to SEC filings, shielding them from this specific rule setup. However, standard funds holding digital assets face potential compliance adjustments. Ed Zollars, a CPA writing for Current Federal Tax Developments, advised financial advisors to audit prior client conversions immediately. Meanwhile, the Investment Company Institute (ICI) advocated to Treasury that conversion rules provide investors with diversification and lower fees.
This tax enforcement arrives as crypto asset products face evolving macroeconomic conditions, including shifting Bitcoin ETF inflows and broader state actions like California's crypto legislation.
Why It Matters
This IRS notice represents a major regulatory shift against sophisticated tax-deferral strategies used in crypto-adjacent fund management. By threatening prospective and retroactive changes to in-kind redemptions, federal authorities are signaling tighter tax compliance across non-standard ETF holdings. Asset managers utilizing conventional corporate fund structures to hold digital assets may be forced to reorganize into grantor trusts or offshore vehicles to mitigate potential tax liabilities.
