IRS targets in-kind redemption tactics used by crypto-holding ETFs

• The IRS issued a notice and Revenue Ruling 2026-20 on Monday (September 28, 2026), targeting ETF strategies that defer or eliminate tax on appreciated assets.
• The notice targets in-kind redemptions where ETFs hand rising digital assets to Wall Street firms without booking taxable gains, a tactic used by crypto-holding funds.
• Spot Bitcoin ETFs structured as grantor trusts like BlackRock’s iShares Bitcoin Trust appear largely protected, while regular funds holding crypto assets face heightened audit risk.

• October 28 Deadline for public comment on IRS guidance affecting multiple tax-deferred ETF transaction structures

The Treasury Department and Internal Revenue Service coordinated Revenue Ruling 2026-20 and Notice 2026-62 to address what regulators call “novel investment fund strategies that purport to produce tax results inconsistent with the purpose and proper application of relevant federal tax rules.” The enforcement initiative targets a specific pattern: funds holding appreciated cryptocurrency or securities transfer them to authorized trading participants through redemptions structured to avoid gain recognition under Section 852(b)(6) of the tax code, which normally shields regulated investment companies (RICs) from reporting gains on distributed portfolio property.

The same day, the IRS killed the Section 351 conversion, a tax-free stock swap that wealthy investors used to diversify concentrated positions.

IRS Rejects In-Kind Redemption Shelters for Crypto ETFs

The core mechanism targeted by the notice works as follows: an investor holds appreciated assets and wants to avoid immediate tax liability. They transfer those assets to an ETF structured as a regulated investment company.

The ETF then issues creation unit shares (large blocks) to an authorized participant, an institutional broker-dealer or financial firm, which contributes cash or matching securities. Shortly after, the ETF redeems those creation units by distributing the original appreciated securities back to the authorized participant.

Under historical Section 852(b)(6) practice, the fund would not recognize a gain on this distribution.

The IRS now applies step-transaction and substance-over-form doctrine to recharacterize these exchanges as direct taxable asset sales under Section 1001. This reversal strikes at a common practice among funds holding digital assets. According to the IRS notice, the strategy works whether the fund owns crypto directly or through a trust, and the language of Notice 2026-62 is deliberately broad, flagging multiple specific uses including 351 exchanges, box spread strategies, straddles and other derivatives designed to defer tax outcomes.

Comments on the proposed guidance are due October 28. The IRS warned that any final ruling could apply retroactively to transactions already executed, creating potential liability for funds and their investors on past redemptions and conversions.

Spot Bitcoin ETFs Face Lower Risk Than Regular Crypto Funds

The notice names no funds, but the structural difference between trust and RIC vehicles creates material protection gaps.

Spot Bitcoin ETFs structured as grantor trusts, including BlackRock’s iShares Bitcoin Trust, pass their tax attributes directly to shareholders and operate outside the scope of Section 852(b)(6). The trust structure, inherited from traditional commodity ETFs, was designed before crypto’s institutional adoption and sidesteps the redemption mechanics the IRS is now policing. The trust reported $1.47 billion in realized gains over nine months through September 2025, demonstrating the scale of appreciation flowing through such vehicles.

Regular mutual funds holding crypto assets or shares of crypto-holding trusts remain exposed. Any fund using in-kind redemptions to avoid reporting gains on digital asset distributions now faces direct examination risk and potential transaction-of-interest designations.

Funds that hold crypto through offshore subsidiaries fall outside the immediate notice scope, but the IRS’s language hints at broader authority to challenge similar structures.

What Changes for Crypto Fund Managers and Advisers

Tax advisers and fund counsel face an immediate obligation to review past client transactions. Ed Zollars, a CPA writing on federal tax developments, told advisers to audit whether prior conversion transactions qualify for grandfather relief or trigger retroactive liability.

The Investment Company Institute, the main US fund trade group, has argued to Treasury that conversion strategies offer genuine diversification and fee benefits to retail investors, not pure tax avoidance. That defense carries little weight under the IRS’s current substance-over-form analysis.

The ruling leaves unresolved whether funds can restructure redemptions to comply prospectively or whether existing gains remain permanently unreported.

For crypto funds specifically, the enforcement action creates pressure to either abandon in-kind redemption tactics altogether or recharacterize fund structures to qualify for the grantor trust exemption. The former option increases tax drag for shareholders. The latter requires rebuilding the fund as a trust rather than an RIC, a costly and operationally complex transition.

Funds with substantial unrealized gains now face a timing question: realize gains under the old rules before guidance finalizes, or risk retroactive assessment under the new ones.

The CCS read. Spot Bitcoin ETF holders in grantor trusts face no immediate threat, but this ruling pressures the broader crypto fund ecosystem toward greater tax transparency. Institutional investors evaluating new crypto fund vehicles should verify whether their manager uses in-kind redemptions and whether the fund structure qualifies for trust or RIC status, that choice now determines tax liability and audit exposure.

The October 28 comment deadline will test whether the fund industry can convince Treasury to carve out crypto-holding structures or limit retroactive application. If the final guidance stands as proposed, expect material revisions to how crypto funds distribute shares and price redemptions, and potential amended returns and penalties for funds that relied on 852(b)(6) shelters through 2026.