Key Takeaways
- • The IRS issued a formal notice Monday warning crypto ETFs and regulated investment companies about in-kind redemption strategies that defer recognition of gains on appreciated digital assets, signaling enforcement activity ahead for the industry.
- • The advisory targets funds holding cryptocurrencies, commodities, or interests in trusts owning such assets that use in-kind transfers to avoid triggering taxable gains when redeeming ETF shares, a strategy previously permitted under existing tax rules.
- • Spot Bitcoin products structured as grantor trusts, including BlackRock's iShares Bitcoin Trust, operate under a different tax framework where tax attributes pass through to shareholders and appear unaffected by the notice.
- • The IRS warned that future guidance could apply retroactively to transactions already completed, creating potential liability exposure for funds and investors who have utilized these strategies.
- • A separate Revenue Ruling 2026-20 targeted Section 351 ETF conversions, another strategy allowing investors to contribute highly appreciated stocks to newly formed ETFs without immediately triggering capital gains taxes; public comment period closes October 28.
Summary
The Internal Revenue Service has issued a warning to crypto ETFs and other regulated investment companies regarding tax avoidance strategies centered on in-kind redemptions, signaling heightened regulatory scrutiny of the digital asset fund industry. The notice, released Monday, specifically addresses how certain investment funds holding cryptocurrencies, commodities, or interests in trusts owning such assets have structured transactions to defer gain recognition on appreciated holdings.
The core issue involves the tax treatment of regulated investment companies that must derive at least 90% of their income from qualifying sources—typically dividends, interest, and securities gains—to receive favorable tax classification. Cryptocurrency and commodity profits generally do not qualify as eligible income under these rules. To manage this constraint, some ETFs have employed in-kind redemption strategies in which appreciated digital assets are transferred directly to trading firms redeeming ETF shares, allowing funds to avoid immediately recognizing taxable gains on the transactions.
The IRS clarified that its concerns apply to funds holding crypto assets directly or through certain trust structures. However, spot Bitcoin products structured as grantor trusts, such as BlackRock's iShares Bitcoin Trust, operate under a distinct tax framework in which tax attributes flow through to shareholders and appear outside the scope of the current notice. The agency also indicated that structures utilizing offshore subsidiaries may fall outside the regulatory focus, though future guidance could potentially apply retroactively to previously completed transactions, creating significant compliance and liability considerations.
In a parallel action, the IRS released Revenue Ruling 2026-20 addressing Section 351 ETF conversions, a strategy that permitted investors to contribute highly appreciated securities to newly formed ETFs and receive diversified fund shares without triggering immediate capital gains taxes. Public comments on both regulatory actions are due October 28, providing stakeholders an opportunity to present technical and practical concerns before final guidance is issued.
The core issue involves the tax treatment of regulated investment companies that must derive at least 90% of their income from qualifying sources—typically dividends, interest, and securities gains—to receive favorable tax classification. Cryptocurrency and commodity profits generally do not qualify as eligible income under these rules. To manage this constraint, some ETFs have employed in-kind redemption strategies in which appreciated digital assets are transferred directly to trading firms redeeming ETF shares, allowing funds to avoid immediately recognizing taxable gains on the transactions.
The IRS clarified that its concerns apply to funds holding crypto assets directly or through certain trust structures. However, spot Bitcoin products structured as grantor trusts, such as BlackRock's iShares Bitcoin Trust, operate under a distinct tax framework in which tax attributes flow through to shareholders and appear outside the scope of the current notice. The agency also indicated that structures utilizing offshore subsidiaries may fall outside the regulatory focus, though future guidance could potentially apply retroactively to previously completed transactions, creating significant compliance and liability considerations.
In a parallel action, the IRS released Revenue Ruling 2026-20 addressing Section 351 ETF conversions, a strategy that permitted investors to contribute highly appreciated securities to newly formed ETFs and receive diversified fund shares without triggering immediate capital gains taxes. Public comments on both regulatory actions are due October 28, providing stakeholders an opportunity to present technical and practical concerns before final guidance is issued.
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