The IRS Needs to Fix their Proposed Regulations for the Net Investment Tax

April 30, 2013

By Robert A. Green, CPA with assistance on tax research from Mark Feldman, JD

Traders, get ready to pay thousands of dollars in new Medicare taxes on phantom unearned income in 2013. The IRS doesn't care if you lost money on trading and investments; its new proposed regulations (REG–130507–11) will tax you anyway.

The proposed regulations are wrong in our view, and we need to work together to ask Treasury to fix them before they become final.

ObamaCare taxes
ObamaCare created an entire new and complex parallel tax code which I refer to as “ObamaCode.” There are new taxes in ObamaCare. An ObamaCare Medicare 3.8% surtax on unearned income (including investments), starting in 2013, which applies to upper income taxpayers making over $250,000 (married) and $200,000 (single). Plus a 0.9% Medicare surtax on earned income is assessed over the same AGI thresholds. The 0.9% surtax brings the Medicare rate on earned income to the same 3.8% as on unearned income.

Also, an ObamaCare Individual Mandate Non-Compliance Tax — to purchase health insurance — starts in 2014, which applies to middle-class taxpayers, as we assume most upper-income taxpayers already have health insurance. Other ObamaCare taxes include a Medical Device Tax, High Medical Bills Tax, and Flexible Spending Account Tax.

Proposed regulations for the Medicare tax on unearned income
In December 2012, Treasury released its proposed regulations, including detailed tax rules for ObamaCode's 3.8% Medicare surtax on unearned income. It's also referred to as the net investment tax (NIT) on net investment income (NII).

When we first read the fairly short ObamaCode section (excerpted below) covering the Medicare surtax on unearned income, we found it pretty straightforward and clear. We assumed all unearned income, loss and expense would be summarized and taxed just like the self-employment tax on earned income is summarized and taxed, now. There are no separate buckets or loss limitations in SE taxation on earned income.

But that's not what the tax attorneys from Treasury did with ObamaCare's NIT. They took the short ObamaCode and turned it into a monster of ObamaCare proposed regulations. In my view, they made some unintentional errors.

Our biggest problem is the end result of the proposed tax regulations causes serious damage to traders and other taxpayers in limiting various types of losses and expenses from their NII calculations, and this is a significant and material effect. For something that significant and material, ObamaCode should specifically state that losses will be limited in this fashion, but it doesn't.

A layman, child, taxpayer and even tax pro will read ObamaCode to show there is no loss limitation at all. The terms say “net” in net investment income. The Code says “sum of” all the items listed below.

Many tax professionals have written about problems in the proposed regulations; you can read some of them in the published comments from the hearing on April 2, 2013. We focus our attention on our trader clients. Others raised great inconsistencies for rental properties, passive loss activities, trusts and more. This new law is a nightmare and if you thought you could prepare a tax return before, you can't now.

How did this happen?
Treasury attorneys and officials admitted to some of these problems pointed out by tax professionals at their recent April 2, 2013 hearing and at other conferences, and promised to fix some of the problems. But we want all the problems fixed; otherwise they damage our trader clients' taxpaying interests.

Here is my take on how things got lost in translation. In a nutshell, ObamaCode calls for the “sum of” all types of NII less properly allocable deductions.

ObamaCode doesn't set up three different types of NII buckets: 1) or (i) portfolio income, 2) or (ii) unearned-income trade or business income and 3) or (iii) capital gains income. ObamaCode doesn't limit each bucket to zero when computing the sum of all the parts (buckets). We think Treasury's tax attorneys are stretching tax terms.

Excerpt of ObamaCode
(1) In general.
The term “net investment income” means the excess (if any) of—
(A) the sum of—
(i) gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in paragraph (2),
(ii) other gross income derived from a trade or business described in paragraph (2), and
(iii) net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not described in paragraph (2), over
(B) the deductions allowed by this subtitle which are properly allocable to such gross income or net gain.

Lost in translation
Treasury seems to interpret “other gross income” to mean trading gains — not trading losses, too. Treasury carves out trading losses from bucket 2 or and places them in bucket 3. This creates a huge problem! CPAs know that “gross income” always includes trading and capital gains and losses. Only “net income” is calculated after deducting expenses, and there's no cost of goods sold in trading activities. Trading proceeds minus cost basis equals trading gains and losses which equates to “other gross income derived from a trading business.”

Treasury seems to interpret “net gain” in investment income (bucket 3) to include capital losses, since it says “net.” I think that's why it carves out trading losses from bucket 2 and places them in bucket 3.

Treasury seems to interpret Code (B) “deductions allowed for each subtitle” to allocate all Section 165 loss deductions into bucket 3.

I think Treasury saw the phrase “the excess of,” and after combining that with its other logic on “other gross income” and “net gain,” Treasury figured it could limit each bucket to zero. But in the Code, “excess of” refers to the entire “sum of” all types of NII. I think the Code (B) allocates deductions to each type of income and then there's the sum of all that remains in Code (A). It's certainly a huge stretch for Treasury to come up with what they did in the proposed regulations limiting losses.

The end result is very different
The important end result: The proposed regulations stack the deck with all losses (Section 165) in the third bucket. That unfairly ties one hand behind the taxpayer's back.

With the worst-case interpretation of putting all bucket 2 trading business losses into bucket 3, active traders will have huge NII in every instance, because bucket 2 will be very high and counted in NII, but bucket 3 losses will be a similar amount but excluded from NII.

The Code states to take the sum of all unearned income and loss, and it clearly does not state that losses should be carved out or limited in any way. This is far too significant and the Code should have specifically mentioned loss limitations and not left it to tax attorneys stretching definitions. These loss limitations are not in the legislative history. Congress did not intend to disenfranchise taxpayers from their unearned losses.

We can see how Treasury made inadvertent errors with putting all Section 165 losses into bucket 3, and there's no harm if they fix it quickly.

Double taxation
See an example of the havoc these proposed regulations can cause in the Side Bar below.

The proposed regulations have NIT in the example of $7,600, whereas our reading of Obama Code has zero NIT. The taxpayers in our example wind up paying Medicare tax twice on the same income — “double taxation” in our view.

The executive spouse already paid Medicare tax on her earned income of $450,000. The proposed regulations are causing the taxpayers to pay Medicare tax on phantom unearned income. The married couple is being charged both the 3.8% tax on unearned income and the 3.8% tax on earned income on the same income. Clearly, Congress did not intend to do that!

Do away with all loss limitations and buckets
While Treasury seems to have unofficially conceded the fix to stop carving out bucket 2 losing business trades and placing them into bucket 3 investments, we don't think that goes far enough for traders. We want to do away with all buckets, and we don't want buckets or items limited to zero. Losses should be allowed in full.

The Managed Futures Association (MFA) sent a letter to Treasury with its suggested fixes to these proposed regulations. It pointed out some of the same problems we have, and asked for the fix of losses carved out of bucket 2, along with other fixes, too. The goal is to combine all trading and capital gains and losses between buckets 2 and 3, so you don't have a trader business loss isolated and lost in case you have investment capital gains. The MFA made a good point about this with hedge funds. It also asked for bucket losses not included in NII to be carried over to the subsequent year's NII calculations.

We go a big step further. We want all items summed up as we read the Code. We agree all losses not used in the current year's NII calculations should be carried over to the subsequent year's NII calculation, on par with capital losses which are carried over. Capital loss limitations exist to pay for lower long-term capital gains rates. How can anyone justify loss limitations with NII and NIT?

Keep in mind a trader views his entire trading and investment activities with one overall investment and business plan and uses asset allocation methodology accordingly. For example, a trader may invest in Apple stock and in a related strategy, actively trade Apple options in a trading business around the investment in Apple stock.

Or, use Google options to avoid “substantially identical positions” for purposes of avoiding wash sale loss deferrals, or to respect Section 475 MTM segregation rules. It's bad public policy for Treasury to put in place negative tax incentives to alter proper investment methodology.

Special concerns for business traders using Section 475 MTM
We're concerned Treasury will only make the bucket 2 loss carve out fix, which means we will still be left with disenfranchisement from using many unearned losses. In the big picture, that causes the most damage. That potential outcome is unacceptable for business traders using Section 475 MTM ordinary gain or loss treatment, because they likely won't get a chance to deduct their potentially very large net trading losses from NII.

An investor or business trader using the cash method may not be as concerned over capital losses because the capital loss limitation already limits current year losses to $3,000 against ordinary income. All a taxpayer loses in NII is deducting a net $3,000 capital loss limitation, as no net losses are allowed in buckets 2 and 3. Capital loss carryovers move to the subsequent years for both regular tax and NII purposes. While there are many confusing inconsistencies between regular tax and NIT, there isn't much for capital losses.

But, there are significant and hurtful inconsistencies between regular tax and NII in the case of Section 475 MTM losses. The proposed regulations won't count Form 4797 ordinary losses in NII, unless you find other passive-activity income items to soak them up.

Plus, one of the best tax features of Section 475 MTM losses is they are counted in net operating losses (NOLs), which generate huge refunds for business traders by deducting the losses for regular tax purposes in the prior two and/or subsequent 20 years. The problem is that NOLs are not counted in NII calculations, and NOL carryforwards don't reduce NII.

Nevertheless, NOLs reduce AGI and that can prevent NIT in the first place!

Use SE tax on earned income as a precedent
When we first read the ObamaCode, we figured it mimicked the self-employment (SE) tax rules on earned income, as SE tax includes Medicare taxes. With SE tax, all items of earned income, loss and expense are tagged as such in tax preparation software and automatically entered on an SE worksheet which is part of Form 1040 SE.

That SE tax form then summarizes all items of gain, loss or expense and the total is subject to SE tax. The Medicare tax component of SE tax applies to all SE income. The surtax rate applies over the Medicare/AGI threshold amounts (recapped above).

Tax pros face a nightmare on 2013 tax compliance work
These regulations will significantly increase time spent on annual tax compliance. Not just for clients that may obviously owe the Medicare tax on unearned income, but all clients since they may have carryovers items to deal with like capital loss carryovers. It reminds me of the second tax regime AMT, where we must account for all AMT preference items even for clients that don't pay AMT, which also has income thresholds. Having to deal with a complicated third tax regime NII and NIT is going to be a real costly mess, especially in the first few years. We wonder if the tax revenue raised is going to be greater than the additional tax compliance costs to the economy.

We expect the IRS will probably release the necessary tax form(s) late — like it did with the cost-basis reporting Form 8949 — and that will cause additional confusion. The proposed regs apply to 2014, but ObamaCode applies to 2013, so can we do our own interpretation of ObamaCode for 2013?

All taxpayers and professionals will surely get lost in reconciling inconsistencies with these proposed regulations, with regular income tax regulations and AMT regulations. We now have three different tax regimes to deal with, and we were hoping to narrow it down with tax reform to one. Aren't we going the opposite way from tax reform and simplification?

My suggested fixes make life simpler for tax publishers, professionals and self-preparing taxpayers. I suggest to simply have a UE form for unearned income like the SE form for earned income.

This story reminds me of the cost-basis reporting mess, which our firm is a leading voice on. Congress wanted to rein in tax cheats and the IRS went overboard with regulations that caused tremendous confusion with brokers and taxpayers. It's still unresolved.

Bottom Line
Congress and President Obama promised taxpayers “tax reform,” “tax simplification” and “tax fairness.” The advocates of ObamaCare have good intentions, and ObamaCode may be true to those intentions. But these ObamaCare proposed regulations don't match these goals.

I remind all that ObamaCare was highly contentious between Democrats and Republicans and it passed by one simple majority vote in the Senate through after-the-fact reconciliation in the middle of the night. Congress didn't have time to read the fine print of ObamaCare and they didn't see these proposed regulations until December 2012. Many congressional leaders will tell you that “the devil is in the details” (regulations) when it comes to new laws.

We are respectfully asking Treasury to fix all inadvertent errors. We think its interpretations stray too far from the Code.

We are assuming that Treasury won't provide all this necessary relief, so we plan to publish a Petition on RallyCongress.com for traders to send to their congressmen and women and President Obama. Hopefully these groups can also speak with Treasury about these important problems.

Should business traders continue to use Section 475 MTM?
The clear answer is yes. The income tax savings from using Section 475 MTM ordinary business loss treatment far exceeds potential NIT cost, plus NIT is only triggered if you are over the AGI threshold of $250,000 married and $200,000 single.

It's important to remember the power of Section 475 MTM losses. They will probably lower your AGI to well under the AGI threshold, so you won't owe NIT. Section 475 MTM trading gains will provide income that your trading business expenses can be offset against in bucket 2.

Definitely don't back off using trader tax status and Section 475 MTM. GreenTraderTax strategies will stand up to these new ObamaCare taxes and we will make tweaks as needed.

[SIDE BAR]
An example of the havoc these proposed regulations can cause
Suppose a securities trader is married to an executive with a W-2 in the amount of $450,000. The trader has a trading business loss of $100,000, comprised of a Section 475 MTM ordinary trading loss of $75,000 (reported on Form 4797), and trading business expenses of $25,000 (reported on Schedule C). It doesn't matter if the trading business is a sole proprietorship or a pass-through entity.

The couple also has an investment long-term capital gain of $90,000, and interest and dividend income of $10,000. They have no investment expenses or investment interest expenses. Their married/filing joint AGI is $450,000, which represents the wife's W-2 income, since all unearned income activity was at breakeven.

Based on our interpretation of ObamaCode, in this example all unearned income, loss and expense is zero, and NII matches unearned income or loss calculated in gross income. Per our understanding of ObamaCode, NII is zero, and even though the couple is over the $250,000 AGI limitation by $200,000, there is no NIT since there is no NII.

But based on the proposed regulations, there's a large Medicare tax on phantom unearned income.

• Regulation bucket 1 for portfolio income is $10,000, corresponding to “i” in the Code.

• Regulation bucket 2 is “other gross income from a trading business,” corresponding to “ii” in the Code. A strict interpretation of the proposed regulation shows the bucket 2 total is in the millions of income, because individual trading losses are carved out and placed into bucket 3. This happens whether the business trader uses Section 475 MTM or the cash method.

• Regulation bucket 3, corresponding to “iii” in the Code, is an investment capital gain of $90,000. But, after trading losses are moved from bucket 2, the loss is in the millions.

Do the math with the current proposed regulations. Bucket 1 would be $10,000. Bucket 2 would be $9,975,000, assuming there are $10 million of trading gains on individual trades, less $25,000 of trading business expenses. Bucket 3 would be limited to zero since the $90,000 investment capital gain is offset with the business trading losses $10.075 million. Total NII would be $9,985,000.

We expect Treasury to fix the proposed regulations. If they make this fix, bucket 1 would be $10,000, bucket 2 would be a revised loss of $100,000 and bucket 3 would be a revised gain of $90,000 from the investment capital gain. Revised NII would be $100,000 since only bucket 1 and 3 are positive and can be counted in NII.

3.8% Medicare surtax calculations
With the proposed regulations, NII would be over $9 million, so we use the lower amount of AGI over the AGI threshold: $200,000 times the 3.8% rate equals a NIT of $7,600. But if Treasury makes the bucket 2 loss-carve-out fix, revised NII will be $100,000 and it's less than the excess of AGI over the threshold. NII of $100,000 times 3.8% equals $3,800 of NIT.