IRS Challenges Custom Basket ETF Tax Strategy

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  Stocks and Investing on Thu, Oct 29th, 2026 by The Motley Fool
      Locale: UNITED STATES

The Mechanics of the Strategy

At the core of this strategy is the use of "custom baskets" and "in-kind" transfers. Traditionally, when an investor sells a stock that has increased in value, they are liable for capital gains tax on the profit. To avoid this, some investors have utilized customized ETF structures. In this arrangement, an investor transfers a specific basket of stocks—often highly appreciated positions—directly to an ETF provider.

In exchange for these stocks, the ETF provider issues shares of the ETF to the investor. Because the transaction is structured as an "in-kind" exchange rather than a sale for cash, practitioners of this strategy argue that no taxable event has occurred. This allows the investor to move from a concentrated, risky position in a few stocks to a diversified holding in an ETF without paying the federal capital gains tax, which can be as high as 20%, plus the 3.8% Net Investment Income Tax (NIIT) for those meeting certain income thresholds.

The IRS Position: "Disguised Sales"

The IRS is now challenging the legitimacy of these transactions, viewing them not as genuine investments but as "disguised sales." Under tax law, a transaction is considered a sale if the taxpayer receives something of value in exchange for the property. The IRS contends that receiving liquid ETF shares—which can be easily sold on the open market for cash—is economically equivalent to receiving cash for the original stock portfolio.

By reclassifying these in-kind swaps as taxable sales, the IRS aims to close a loophole that has allowed wealthy individuals to defer or entirely avoid taxes on massive gains. The agency is focusing on the "substance over form" doctrine, asserting that the economic reality of the trade outweighs the technical structure used to execute it.

Broader Implications for Asset Management

This regulatory shift places significant pressure on asset managers and ETF providers who have facilitated these custom baskets. For years, the ETF industry has leaned on the inherent tax efficiency of the ETF structure—specifically the ability to create and redeem shares in-kind to avoid triggering capital gains within the fund itself. However, the IRS is now drawing a sharp distinction between the operational efficiency of the fund and the personal tax avoidance of the individual investor.

If the IRS successfully implements a broader crackdown, it could lead to a surge in audits for high-net-worth individuals who have employed this strategy over the last several years. Furthermore, it may force a redesign of how customized portfolios are managed for institutional and private clients, as the risk of retroactive tax liabilities and penalties increases.

The Legal Battle Ahead

As the IRS tightens its grip, a legal confrontation is expected. Proponents of the strategy will likely argue that they are following existing tax codes regarding in-kind contributions to partnerships or investment vehicles. The resolution of this conflict will likely depend on how courts define the "liquidity" of the ETF shares received. If the shares are deemed sufficiently liquid to act as a cash substitute, the IRS's position that these are disguised sales will be strengthened.

For the broader market, this move indicates a continuing trend of the IRS utilizing modernized data and increased funding to target complex tax avoidance schemes that were previously too difficult or costly to track. The focus is no longer just on simple under-reporting, but on the structural engineering of portfolios designed to circumvent the spirit of the tax code.