Treasury and IRS Target “Tax Alpha” Strategies, Citing Potential Abuse
Washington D.C. – The U.S. Treasury Department and the Internal Revenue Service (IRS) have identified a range of Wall Street tax avoidance strategies, dubbed “Tax Alpha,” as potentially abusive. In a notice released September 28, the agencies singled out transactions involving “351 conversions,” Box Spread ETFs, and derivative trades by tax-oriented funds, signaling a crackdown on sophisticated tax-saving maneuvers.
While the IRS notice, identified as Notice 2026-62, does not name specific products or issuers, it categorizes these strategies into two main groups. The first leverages the “in-kind redemption” mechanism of Exchange Traded Funds (ETFs), encompassing 351 conversions and Box Spread ETFs. The second involves “tax-oriented funds” that use derivatives to generate artificial losses, which investors can then use to offset other income.
Treasury officials had previously described similar transactions as “too good to be true” at an industry seminar in July, according to Bloomberg.
Specific Rulings and Public Comment
On the same day the notice was issued, the agencies released Revenue Ruling 2026-20, which specifically targets certain 351 conversions, deeming them taxable. This ruling clarifies how existing tax law applies to these transactions and represents the only definitive conclusion reached thus far. Treasury Secretary Scott Bessent stated on X that the notice “makes it clear the Treasury is serious about shutting down transactions designed to evade taxes and abuse federal tax laws.”
A 351 conversion derives its name from Section 351 of the U.S. tax code, which allows investors to transfer assets into a corporation in exchange for stock without immediately recognizing capital gains. Capital gains are typically the difference between a selling price and a cost basis, and recognition triggers tax liability.
The IRS describes a scenario where investors transfer highly appreciated stock into a newly formed ETF in exchange for fund shares. If the transferred portfolio is sufficiently diversified—defined as no single company exceeding 25% and the top five companies not exceeding 50%—no immediate tax is due.
Subsequently, the ETF uses an “in-kind redemption” to exchange these stocks. This means the ETF directly transfers the stocks to participating brokers making redemptions, rather than selling them on the market for cash. Under Section 852(b)(6) of the tax code, ETFs are not required to recognize gains when distributing appreciated stock in this manner. The IRS noted that these steps are often completed shortly after the transfer. This effectively allows investors to exchange their original stock for a substantially different portfolio without incurring immediate taxes.
The tax ruling concludes that such pre-arranged transactions will be recharacterized based on their economic substance. The ETF will be viewed merely as an intermediary, and the investor will be treated as directly exchanging stock with the participating broker, constituting a taxable event. The IRS clarified that contributions of assets intended for long-term investment, consistent with an investment strategy, are not within the scope of this action. Routine ETF creations and redemptions are also not affected by the notice.
The notice also addresses a variation where investors with insufficiently diversified holdings first transfer their stock into a partnership-style “exchange fund,” which then engages in a 351 conversion. The IRS indicated it is still considering how to address these arrangements.
Market Impact and Industry Reactions
Bloomberg reported that 351 conversions have generated approximately $23 billion in business on Wall Street. The publication cited the Twin Oak Active Opportunities ETF (TSPX) as an example, which held about $200 million in unrealized gains within its $450 million in assets upon its launch in February 2025. Within a week of its inception, its holdings in Snowflake and Datadog were reportedly exchanged for an S&P 500 fund.
Wes Gray, CEO of Alpha Architect, suggested that the ruling leaves room for ETFs genuinely intended for holding contributed stocks. He told Bloomberg, “You probably shouldn’t dump 100 U.S. stocks into an ETF and turn it into international bonds a week later.” Jeffrey Hochberg, a partner at Sullivan & Cromwell, noted that the timeframe for how long an ETF can hold contributed stocks, when there is a pre-arranged plan for their disposition, remains highly uncertain.
Box Spread ETFs and Tax Deferral
Box Spreads involve a combination of four options on the same underlying asset, designed to yield a fixed return close to short-term interest rates. The IRS pointed out that some ETFs utilize these to generate returns similar to U.S. Treasury bonds. Before the options expire, the fund distributes profitable positions through in-kind redemptions, thereby claiming to avoid recognizing income.
These types of ETFs typically do not pay dividends; their gains are reflected in the net asset value, and investors pay capital gains tax upon selling their shares, based on their holding period. Bloomberg reported that the largest of these is Alpha Architect’s 1-3 Month Box ETF (BOXX), with approximately $15 billion in assets.
A simplified calculation for $1 million in assets with a 5% annual return illustrates the tax advantage. If $50,000 were considered interest from Treasury bonds, it could be subject to a top federal income tax rate of 37% plus a 3.8% Net Investment Income Tax (NIIT), totaling approximately $20,400 in taxes. In contrast, long-term capital gains held for over a year are taxed at 20% plus 3.8%, amounting to about $11,900, a saving of roughly $8,500. Gains held for less than a year are taxed at ordinary income rates. Before selling, this strategy merely defers tax payments, and the example does not include state taxes.
The notice also highlighted two other ETF-related practices. One involves switching to another ETF tracking the same index before the ETF distributes dividends, thereby avoiding dividend income. Another, related to digital assets, involves ETFs directly or through trusts holding commodities or digital assets, and then distributing appreciated positions via in-kind redemption.
U.S. tax law requires ETFs, as “regulated investment companies” (RICs), to derive at least 90% of their gross income from qualified sources such as dividends, interest, and capital gains from securities trading. This is a condition for RICs to benefit from their tax treatment, as they are generally not subject to income tax at the fund level. Profits from selling commodities or digital assets are not considered qualified income. The IRS noted that these ETFs use in-kind redemptions to prevent these gains from being recognized.
Tax-Oriented Funds and Derivative Strategies
The second category, “tax-oriented funds,” typically operates through investment partnerships or private accounts. The notice states that these strategies involve creating offsetting long and short positions, with fund managers selectively choosing which side to close and what tax elections to make. The result is the generation of ordinary income losses, paired with capital gains that are subject to lower tax rates or can be deferred. Ordinary income, such as wages and interest, is taxed at progressive rates, and ordinary income losses can directly offset such income.
The notice outlined three specific practices:
- Using foreign currency forward contracts in conjunction with futures to create an “identified straddle.”
- Deciding after the trading day ends whether to treat profits from foreign currency forward contracts as capital gains, a choice the IRS notes the fund makes with full knowledge of its tax implications.
- Terminating profitable swap contracts early while holding losing positions until their payment date.
Bloomberg reported that such transactions are central to the Delphi Plus strategy at AQR Capital Management. According to documents obtained by Bloomberg, the AQR TA Delphi Plus Fund had approximately $6.6 billion in assets at the end of June, with ordinary income losses recognized in 2025 equivalent to 28% of its invested capital. Kevin Salinger, Deputy Assistant Secretary for Tax Policy at the Treasury, stated in July that he had seen marketing materials claiming investors could “invest $1 million and potentially get $300,000 in ordinary income losses.”
The notice also clarified that long-standing practices, such as selling stocks with unrealized losses at year-end while retaining those with unrealized gains, align with congressional intent. The mere classification of a strategy as “tax-oriented” does not itself raise concerns.
Next Steps and Public Input
The Treasury Department and IRS have requested industry feedback by October 28, including whether the descriptions in the notice are accurate and the economic substance of similar transactions differs. The agencies indicated that subsequent actions could include regulations, notices, or tax rulings. Certain transactions may also be designated as “transactions of interest” or “listed transactions,” which require additional disclosure, according to Bloomberg.
The notice stated that future guidance may apply only to prospective transactions or could be retroactive to transactions completed before its issuance. The IRS also retains the ability to challenge abusive investment strategies under existing law during audits. The agencies emphasized that the guidance will target specific abusive transactions while striving to minimize compliance burdens.
Brent Sullivan, operator of the Tax Alpha Insider blog, told Bloomberg that 351 conversions are the most concrete aspect of the current action, with the Treasury “still gathering information” on other items. Whether other strategies on the list will be formally designated and when such designations would take effect depends on future official guidance, for which the Treasury and IRS have not yet provided a timeline.
