Bloomberg Businessweek recently reported on comments from Kevin Salinger, deputy assistant secretary for tax policy at Treasury, and Erika Nijenhuis, senior counsel, speaking at a Wall Street Tax Association seminar. Their message was blunt: Treasury is not looking to be disruptive, but it is not going to ignore a market that has grown up around transactions producing results Congress likely never intended.
That market is often called "tax alpha," a catch all term for strategies that use financial engineering to reduce or defer the taxes wealthy investors owe, mostly on capital gains, but in a few cases on ordinary income too. Below is a breakdown of the specific strategies Treasury named, what they mean, and how each one actually works under the tax code.
This is the strategy Treasury has been watching longest. Section 351 of the Internal Revenue Code says that if you contribute property to a corporation solely in exchange for stock, and you control that corporation right after, no gain gets recognized on the contribution.
Applied to ETFs, this means an investor or an authorized participant can hand a basket of appreciated stock to an ETF and receive fund shares back without triggering the capital gains tax that a sale on the open market would have caused. The fund inherits the same low cost basis in those shares under Section 362, so the built in gain does not disappear. It just moves.
Where it gets more aggressive is the exit side. Under Section 852(b)(6), a regulated investment company does not recognize gain when it distributes appreciated securities in kind to a shareholder who is redeeming shares. So the same appreciated stock that came in tax free under Section 351 can go back out tax free under 852(b)(6), often to a different investor entirely. Run enough of these paired transactions and a fund can effectively wash embedded gains out of its portfolio without a taxable event ever occurring at the fund level.
Treasury's concern is not the everyday version of this. It is engineered "heartbeat" style transactions, where large amounts of capital are moved in and back out in a short window specifically to manufacture a redemption event large enough to flush appreciated stock. That starts to look like a transaction built for tax results rather than investment purposes, which is exactly the kind of fact pattern Section 351(e) was written to police, since it denies tax free treatment when a contribution is really a way to diversify a portfolio through an investment company.
A box spread combines a bull call spread with a bear put spread on the same underlying index. Because the payoff at expiration is locked in from day one, the difference between what you pay to enter and what you collect at expiration behaves like a fixed, risk free interest rate.
Normally, interest income is taxed at ordinary rates, up to 37 percent federally. Box spread ETFs try to avoid that by using nonequity index options, which fall under Section 1256 of the code. Section 1256 contracts get two special treatments: they are marked to market every year end, and any gain or loss is automatically split 60 percent long term and 40 percent short term, regardless of how long the position was actually held.
The result is that a return which functions exactly like interest gets taxed at a blended rate closer to 27 percent for a top bracket taxpayer, instead of 37 percent. That is the entire pitch of a fund like the Alpha Architect 1 to 3 Month Box ETF, which is built to track T Bill like returns while claiming primarily capital gain treatment.
The friction point is Section 1258, the conversion transaction rule. It says that if substantially all of your expected return from a position is really just the time value of money, the IRS can recharacterize what would have been capital gain as ordinary income up to the amount of that imputed interest. Treasury has not issued a clear safe harbor confirming that box spread ETFs fall outside Section 1258, which is exactly why this strategy made the list.
A notional principal contract, more commonly called a swap, is an agreement to exchange payments over time based on a reference rate or index applied to a notional amount. The tax code treats two kinds of swap payments very differently.
Periodic payments, the ongoing exchanges made throughout the life of the swap, are ordinary income or ordinary expense under the Treasury regulations governing Section 446. Termination payments, made when a party exits the swap early, are treated as capital gain or loss under Section 1234A.
That asymmetry creates an opportunity. A fund can structure a swap so the regular periodic cash flows generate large ordinary losses, deductible against income taxed at the highest rates, while the eventual termination or sale of a profitable position produces a capital gain taxed at a much lower rate. This is the mechanism behind funds like the AQR TA Delphi Plus Fund, which Treasury officials cited as having booked ordinary losses equal to roughly 28 percent of invested capital in a single year, and behind pitch decks Treasury says have advertised a million dollar investment potentially generating a 300,000 dollar ordinary loss.
A straddle exists when a taxpayer holds offsetting positions in personal property such that the risk of loss on one is substantially reduced by holding the other. Under the general straddle rules in Section 1092, losses on one leg get deferred to the extent there is unrecognized gain in the offsetting position.
An identified straddle is a specific election. If a taxpayer clearly identifies the straddle on their books before the close of the day it is entered into, any loss on one leg is not deducted immediately. Instead it is added to the basis of the remaining offsetting position. This gives more certainty than the general loss deferral rule, but it also gives a taxpayer a tool to control exactly when and how a loss shows up, which is why Treasury flagged it alongside the swap strategies above.
Under Section 988, foreign currency gains and losses are ordinary by default. But Section 988(a)(1)(B) lets a taxpayer elect capital treatment instead for certain forward contracts, futures, and options, as long as the position is a capital asset in the taxpayer's hands and is not part of a straddle.
The catch is timing. The election has to be made, and the position identified, before the close of the day the transaction is entered into. That means a sophisticated trader can effectively choose the character of a currency position in advance based on which way they expect it to move, locking in capital treatment ahead of an anticipated gain while letting ordinary treatment apply by default to positions expected to produce losses.
Section 6011 and its regulations require taxpayers to disclose certain reportable transactions that carry potential for tax avoidance. A transaction of interest, or TOI, is one specific category. It is Treasury's way of saying "we think this might be a problem, but we do not yet have enough information to call it a listed transaction," which is the formal label for a transaction Treasury has already concluded is abusive.
Once something is designated a TOI, participants must file Form 8886 with their return, and any advisor who was paid above a threshold, generally 50,000 dollars for individuals or 250,000 dollars for other clients, must file Form 8918 and keep a list of participating clients. Failing to disclose triggers penalties under Section 6707A that can run from 10,000 dollars up to 200,000 dollars per violation, independent of whether the underlying tax position turns out to be correct.
At the seminar, Salinger confirmed that labeling certain Section 351 conversions a transaction of interest is actively on the table, along with every other strategy discussed above. That designation alone would not shut anything down, but it would force disclosure into the open, which is often the first step before more formal guidance follows.
None of these strategies are illegal on their face. Each one is built on a real, current provision of the Internal Revenue Code. What Treasury is signaling is that the aggregate effect, several provisions stacked together to produce a result Congress did not intend, is now squarely on its radar. For practitioners advising clients who use or are considering these structures, the practical takeaway is simple: document the business purpose, watch for formal TOI guidance, and do not assume the absence of a rule against something means it is safe indefinitely.
Research and citations for this piece were pulled using Bizora, our AI powered tax research platform built for CPAs, enrolled agents, and in house tax teams.
Reporting on the Wall Street Tax Association seminar comments referenced in this piece is credited to Bloomberg Businessweek.
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