IRS may target crypto ETFs that use tax-free asset transfers

The IRS issued a notice on Monday that flags funds holding digital assets and using transfers to avoid booking taxable gains. Most US funds pay no tax themselves if at least 90% of their income comes from dividends, interest and stock gains. Profits on crypto and commodities do not count toward that threshold. Too much income from those assets puts the tax break at risk. The IRS says some ETFs avoid booking taxable gains by handing rising digital assets to Wall Street trading firms that cash in fund shares. A rule allows ETFs to make these transfers without booking a taxable gain. The notice says the rule applies whether a fund holds the assets directly or through a trust. The notice names no funds. Spot Bitcoin ETFs such as BlackRock's Bitcoin ETF are built differently. The iShares Bitcoin Trust is a grantor trust that passes its tax attributes to shareholders, according to its SEC filing. The exposure instead involves regular funds that hold crypto or shares of such trusts. Funds that hold these assets through an offshore subsidiary fall outside the notice. The IRS warned that future guidance could apply prospectively only or retroactively to transactions that have already taken place. Comments are due October 28. The IRS also shut down a tax-free stock swap used by wealthy investors. The warning came with Revenue Ruling 2026-20. The ruling ends the Section 351 conversion, which let wealthy investors trade soaring stock for a diversified fund tax-free. The IRS now calls the transaction a taxable sale when an investor puts stock into a new ETF and the fund passes that stock to a trading firm. The IRS notice and the ruling target the same ETF rule. ETF expert Eric Balchunas said the move sounded like a crackdown on funds that break from the spirit of the law. CPA Ed Zollars, who writes Current Federal Tax Developments, told advisers to review clients' past conversions. Law firm Liskow said the Investment Company Institute told Treasury that the conversions offer diversification and lower fees.