CPA Firm Offers Suggestions on Proposed Net Investment Income Tax Regs

Enclosed for your consideration are comments on the above-referenced proposed regulations, submitted by McGladrey LLP. McGladrey LLP, a licensed CPA firm, is the fifth largest U.S. provider of assurance, tax and consulting services, with nearly 6,500 professionals and associates in more than 70 offices nationwide. Our comments were prepared by our Washington National Tax office with the participation of technical specialists from a number of disciplines and industries across the country.

We have focused our comments on what we believe to be the areas of most immediate concern to our clients, and we respectfully offer the following four suggestions regarding the proposed regulations.

• Eliminate the proposed general regulatory ban on deducting section 165 losses,

• Consider allowing income tax deductions to be deferred, solely for purposes of Section 1411,

• Address the problem of self-rental income by allowing income tax deductions for the amount of rent paid by the taxpayer to the taxpayer, albeit through two distinct entities, to be subtracted from the taxpayer's gross rental income in determining the amount of the taxpayer's net investment income, where such deductions are incurred by a non-trading business in which the taxpayer materially participates, and

• Consider liberalizing the capital loss rules for net investment income purposes.

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Section 1411 is a brief statute, taking close to a page to establish an entirely new tax on the investment income of millions of Americans. Its brevity is deceptive, however, because it presents very difficult technical and conceptual issues. Foremost among these is the practical need to integrate the operation of this new tax with the regular income tax.

The IRS is to be commended for identifying a host of technical issues where the policies, structure, and operational rules of the regular income tax appear to conflict with the apparent policies of Section 1411. In our view, the proposed regulations would resolve too many of those conflicts in a manner that would frustrate what we believe was the intent of Congress and unduly interfere with the private economy.

We have identified four issues, among many others, whose expeditious resolution we believe is of primary importance. We would respectfully urge the IRS to consider our comments and suggestions on those four issues.

Summary of Recommendations

In our view, the final regulations should remove the general prohibition on deducting Section 165 losses in computing net investment income (NII). Such losses should be allowable, at least to the extent allowed for income tax purposes, against any source of gross investment income or gain.

In our view, the final regulations should allow taxpayers to defer or capitalize, solely for purposes of the net investment income tax (NIIT), income tax deductions that are not used against NII in the taxable year in which they are used for income tax purposes because there is insufficient NII in that year. We believe the statutory language referring to deductions "properly allocable" is flexible enough to encompass the concept of deferring or capitalizing an item, solely for NIIT purposes, to better match it with the income to which it economically relates.

In our view, "self-rental" and similar problems should be addressed by clarifying that the income tax deductions of a NIIT-exempt business (i.e., a non-trading business in which the taxpayer materially participates) for payments of rent, interest, or similar amounts, to the extent they are effectively paid by and received by the identical taxpayers, albeit through different entities, should be considered to be "deductions allowed by this subtitle which are properly allocable to" such items of gross income.

Finally, in light of the fact that there is no capital gains preference in the NIIT and thus the policy rationale for limiting capital losses to capital gains may not be applicable, we would respectfully ask the IRS to consider whether the statutory language is flexible enough to allow the final regulations to provide that a capital loss that is "allowed as a deduction" by Section 165(a), but limited by Section 165(f) for income tax purposes, is nevertheless "allowed by this subtitle . . . [and] properly allocable to" net investment income for NIIT purposes.

General Observations on Section 1411

The net investment income tax (NIIT) is imposed at a flat 3.8 percent rate on the taxpayer's net investment income (NII) in any given year, but only to the extent the taxpayer's total income in the year from all sources exceeds $250,000, $200,000, or $125,000, depending on whether the taxpayer is a married couple filing jointly, an unmarried taxpayer, or a married taxpayer filing separately. Technically, the test turns on the taxpayer's modified adjusted gross income (MAGI). These threshold amounts are not indexed for inflation, and the MAGI threshold is near zero for the undistributed income of a non-grantor trust or estate. Accordingly, it can be expected -- absent legislative action -- that many more taxpayers will eventually be subject to the new 3.8 percent tax on their first dollar of NII. For example, after 20 years of 6 percent inflation, a married couple with $75,000 of wage income in today's dollars will have a nominal MAGI in excess of the $250,000 threshold for imposition of the NIIT. That is why "getting it right" now is so important.

In addition, we note that the American Taxpayer Relief Act of 2012 includes various tax burdens that also apply only to the extent the taxpayer's adjusted gross income (AGI) exceeds comparable levels. All of these new rules will undoubtedly add substantial tax complexity to the investment process. Analyzing a decision to recognize a capital gain, for example, is no longer a simple question of applying a capital gains tax rate determined by the nature of the asset and its holding period. Taxpayers and their advisors must now also consider the amount of other sources of MAGI or AGI in the taxable year. That is because the actual marginal tax rate on such a sale can now vary between 15% and roughly 25% for long-term capital gains and between 35% and roughly 45% for short-term gains. To avoid imposing undue hindrances on private investment and the economy, the regulations under Section 1411 should endeavor to minimize any harsh or untoward effects that are not strictly required by the statutory language.

In our view, the most significant problems integrating the NIIT and the regular income tax would arise even if the MAGI threshold for the NIIT were zero. That is because the determination of what constitutes NII is not simple, except in the most basic fact patterns.

For example, in the case of a cash sale of a share of publicly traded stock purchased for cash, gross income or "gain" is the excess of amount realized over adjusted basis, and net income generally equals gross income. In many other situations, however, not all of the costs, expenses or other amounts "invested" in an income-producing endeavor are capitalized into the basis of a specific asset for income tax purposes. Instead, such items are incurred and taken into account as deductions, often in taxable years before or after the year in which the related gross receipts or gross income are taken into account. For example, investment interest incurred in the taxable year to acquire a specific investment asset that has not yet generated any income may be allowed as a deduction against investment income realized in the same year from an entirely different asset.

The income tax deals with such problems reasonably well, generally by allowing such expenses as currently deductible expenses -- subject to a few sensible rules intended to protect the revenues by isolating certain types of income in three major categories. In the main, those rules consist of (1) the limitation on deducting capital losses against non-capital income, (2) the limitation on deducting investment interest or expenses against non-investment income, and (3) the deferral of aggregate, net passive losses, except to the extent that any particular passive investment responsible for such a loss is sold or otherwise disposed of.

This approach does not integrate easily with a tax, like the NIIT, that is imposed only on certain types of income and only in certain years, with no explicit provision for carryovers, carrybacks, or the like. In addition, the three "buckets" that comprise NII do not conform to the three categories of regular income.

For income tax purposes, the three major categories of investment income are:

Finally, under the statutory language of Section 1411 the three buckets of "gross" investment income are not separately reduced by their associated deductions. Instead, the three buckets are added together and the resulting sum is then offset by deductions "properly allocable to such gross income or net gains." We believe that the statute would have been drafted differently if the drafters had intended any required "matching" of such deductions with income from particular buckets.

The IRS has done an excellent job of identifying the issues created by these and related differences between the structure of the income tax and the NIIT. We hope that the suggestions described below will be taken into account in crafting final regulations to address these structural problems.

Specific Suggestions for IRS Consideration

1. Eliminate the proposed general regulatory ban on deducting Section 165 losses

The income tax imposes severe constraints on deducting capital losses against non-capital income, generally prohibits carrybacks of such losses for individuals, and imposes a variety of limitations on deducting ordinary losses under Section 165, including losses that become Section 165 deductions through the operation of other provisions such as Sections 475, 988, or 1231. There does not appear to be any reason to impose additional limitations on those deductions for NIIT purposes, as the proposed regulations would do. Indeed, in our view, the statute does not authorize such limitations.

For example, where a landlord owns four beachfront rental properties in New Jersey, one is partially destroyed by a devastating hurricane, and another is thereupon sold at a loss, there is no reason to disallow the landlord's losses against the rental income generated by his remaining properties (assuming they are treated as distinct activities) or against other portfolio income generated with the proceeds of a sale. It is burdensome enough, in some cases, that such losses may not be carried back to prior years for NIIT purposes. There is no need to impose added burdens that do not exist in the income tax rules.

Similarly, the regulations should not prevent an investor in a "trader" hedge fund -- incurring a capital loss, say, from the sale of GM stock by the fund -- from deducting or netting that loss against a gain, say, from the sale of Google stock by the identical fund, by another fund, or by the taxpayer in its individual trading activities (including any investor funds). That appears to be the result required by the proposed regulations. Specifically, if a trader hedge fund (or other passive or trading business) incurs a Section 165 loss and a Section 61 gain on separate transactions, the proposed regulations appear to preclude the deduction of the Section 165 loss against the Section 61 gain from the same fund, or from any other fund, or from Section 61 gains realized by an individual outside of any trading or passive business.

The regulations also should not preclude the deduction of individual capital losses (i.e., losses incurred outside of any trading or passive business) against capital gains recognized through a trader hedge fund or other trading or passive business. That also appears to be the effect of excluding Section 165 from the deductions "allowed by this subtitle which are properly allocable to such gross income or net gain."

Again, we see no statutory or policy argument for the view that our hypothetical landlord's Section 165 losses (rendered ordinary by Section 1231) are not "properly allocable" to his rental income or, for that matter, to other types of portfolio income if he were to replace one of his rental properties with a bond, annuity, or royalty trust. Furthermore, we see no statutory or policy argument for the view that a capital loss from a taxpayer's individual investment portfolio should not be allowable against capital gains derived from an investment in a trader hedge fund or other trading or passive business.

If there is a concern with deducting capital losses against non-capital income (about which we comment more specifically below), the existing income tax rules of Section 165(f) are adequate to that task. There is no need for, or statutory support for, any additional limitations.

We do note that certain Section 165 losses may be taken into account in the determination of "net gain" from the disposition of property in an individual investment portfolio. That could include both capital gains and ordinary gains, such as the gain from the sale of certain foreign currency instruments or the gains arising under Section 475 for an electing trader. However, the fact that some of those Section 165 losses are used up in the determination of "net gain" does not mean that any remaining Section 165 losses from the portfolio are not also deductions "allowed by this subtitle" and properly allocable to other investment income -- such as the rental income of our hypothetical New Jersey landlord (if the losses are ordinary losses that can be used against rental income) or the gains he may have from a trader hedge fund (if the losses are capital losses).

Certainly, the same Section 165 loss should not be used twice. Yet, if it is not used even once in the determination of "net gain," there is no reason it would not qualify as a deduction "allowed by this subtitle" and properly allocable to gross investment income from whatever bucket derived, subject only to the limitations on deducting capital losses against non-capital income (about which we have additional comments below).

2. Consider allowing income tax deductions to be deferred solely for NIIT purposes

The case of the landlord and his beachfront properties highlights another problem that may arise when losses are allowed and utilized for income tax purposes, but not usable for NIIT purposes because they exceed the amount of the taxpayer's gross income from investments in the year the loss is incurred. If the landlord's Section 1231 loss is fully allowed for income tax purposes but far exceeds his net investment income in that year, his rents in future years are being overtaxed under the NIIT (assuming the properties are not aggregated or grouped for passive loss purposes). The landlord's future rental income should be reduced, for NIIT purposes, by the Section 165 or Section 1231 losses realized and recognized in earlier years (for income tax purposes but not for NIIT purposes) at the time the two rental properties were damaged or disposed of.

Although there is no explicit provision allowing for a carryover or carryback under the NIIT (in situations where there is no carryover or carryback¹ for income tax purposes), the statute does provide for the subtraction, from gross NII, of deductions that are "properly allocable" to such amounts. We see no reason why the concept of "properly allocable" could not recognize that an income tax deduction allowed for income tax purposes, in a year in which there is no NII, is "properly allocable" for NIIT purposes to NII taken into account in a subsequent year. The general concept of an amount being "properly allocable" to an item of income or gain encompasses timing as well as other considerations. In effect, it would be like capitalizing an amount for NIIT purposes even though it is expensed for purposes of the income tax.

In short, we request that the IRS consider final regulations allowing losses or deductions in such a case to be deferred or capitalized, solely for NIIT purposes, and recovered to the extent there is NII in later years. This is no more cumbersome or complex than similar computations done for alternative minimum tax purposes, at-risk purposes, passive loss purposes or the like.² In addition, it seems well within the authority of the IRS under the statute to determine that a deduction taken into account for income tax purposes in one year may be "properly allocable" for NIIT purposes to investment income realized in a later year. It should be remembered that the deduction is being deferred for NIIT purposes because there is no NII, not accelerated.

3. Clarify the Treatment of Self-Rental Income and Similar Items

Section 1411 does not apply to rental income, interest income or similar income derived in the ordinary course of a non-trading business in which the taxpayer materially participates, within the meaning of Section 469. In many cases, there are substantial, non-tax business reasons to conduct business through multiple entities -- including entities whose activities might not rise to the level of a "trade or business" if they were viewed in isolation.

Ideally, the final regulations would clarify that rents, interest or similar items that are incurred by a taxpayer in the course of a non-trading business in which the taxpayer material participates are excluded from that taxpayer's gross investment income under Section 1411 to the extent they are received by the same taxpayer, regardless of whether such amounts are received directly in the taxpayer's individual capacity or received through an entity that may or may not constitute a "trade or business" viewed in isolation.³

Whether or not such an approach is possible, we would respectfully suggest that another very practical solution to the problem of "self-rental activities" (and similar issues arising with interest, royalties, or other items) under Section 1411 be adopted. We recommend that the final regulations resolve this problem by clarifying the rules allowing the subtraction, from gross investment income, of deductions that are "properly allocable" to such income. Simply put, the income tax deductions of an exempt business (i.e., a non-trading business in which the taxpayer materially participates) for payments of rent, interest, or similar amounts -- that are effectively paid by and received by the identical taxpayers, albeit through different entities -- should be considered to be "deductions allowed by this subtitle which are properly allocable to" such items of gross income.

Our suggestion can best be explained with an example.

As a matter of Congressional intent, it does not appear that a 3.8 percent tax should be imposed on "gross rental income" that is fully offset by an economically allocable expense in the identical amount, attributable to the identical payment, and made and received by the same taxpayer, albeit through different entities. In our view, a clearer case of an expense that is "properly allocable" to a particular item of investment income would be difficult to find. For a similar application of this approach to "matching" income and deductions, see Regulation Section 1.469-7(a)(1)(i) and (ii), and (d).

In sum, this approach -- relying on a sensible and economically reasonable interpretation of the term "properly allocable" -- would appear to be well-suited to the issues arising under Section 1411, even if the IRS cannot completely reconcile the complex and potentially conflicting rules and authorities related to aggregating or disaggregating activities, entities or businesses in Sections 1411, 469, 465, 166, 162, and other provisions.

4. Consider Liberalizing the Capital Loss Rules for NIIT Purposes

As described above, there is no reason for imposing a stricter rule for Section 165 deductions under the NIIT than the rule applicable for income tax purposes. In our view, there is actually a policy argument for a more liberal rule, and there may also be sufficient flexibility in the statutory language to accommodate such a rule. At a minimum, we would respectfully ask the IRS to consider the issue.

The original goal of the predecessor to Section 165(f) was to prevent the harvesting and use of capital losses against ordinary income in certain years, while capital gains were recognized in other years and taxed at preferential rates. That concern does not appear to apply to a "flat" net investment income tax with no preference for capital gains. Thus, there is certainly a strong policy argument that a capital loss "allowed" under Section 165, but limited for income tax purposes to capital gains, should be treated under Section 1411 as a deduction that is "allowed by this subtitle and properly allocable" to any type of investment income -- without regard to the income tax rule allowing such losses only against capital gains.

For example, assume an elderly investor who has incurred and paid income taxes on her investment portfolio throughout her investing life incurs substantial capital losses in 2008 and decides to shift her portfolio into safer assets that are unlikely to generate capital gains or capital losses, such as bonds, utility stocks, annuities or royalty trusts. Such a taxpayer would be subjected to the NIIT on future portfolio income that is not, in any economic sense, net investment income.

It can certainly be argued that a "solution" to such problems should await a larger solution to the same problems under the income tax. (For example, such a legislative solution might allow capital losses to be utilized without limitation as long as the taxpayer had no built-in gains in any capital assets.) On the other hand, if there is a possibility that this 3.8 percent tax may grow in size and importance due to the lack of indexation of the MAGI threshold, the tax law should arguably "get it right" here, even if the income tax approach to these problems must await Congressional action.

If the IRS agrees with us on the policy point that there is no policy reason to preclude the deduction of capital losses against non-capital items of gross investment income for NIIT purposes, the statutory language may be sufficiently flexible to permit the IRS to conclude that a capital loss that is "allowed as a deduction" by Section 165(a), but limited by Section 165(f) for income tax purposes, is "allowed by this subtitle . . . [and] properly allocable to" net investment income. This is not that different from allowing deductions for NIIT purposes that may be limited for purposes of the alternative minimum tax, if the taxpayer were subject to that tax for the year. In our view, the reference to deductions "allowed by this subtitle" in Section 1411 should not be given an overly mechanistic interpretation, where it would produce a result so clearly contrary, in our view to what Congress likely intended.

² Indeed, we note that a trader or investor as part of its investment activities may sustain losses in connection with IRC Section 1256 contracts. Where those losses exceed any reported capital gains in that year, the Code has provided a remedy which actually allows a taxpayer to recognize a "deferred benefit" associated with this item. Under Section 1212, a non-corporate taxpayer who has a net section 1256 loss for a taxable year may elect to carry-back such loss to each of the 3 preceding taxable years and apply such loss to the extent of net section 1256 gains in each year. Certainly a taxpayer who sustains a net 1256 loss in 2014 and whose only prior 1256 net gains were in 2013, which gains were subject to the NIIT, would be able to avail itself of a tax benefit from those losses for regular income tax purposes. Presumably upon filing the respective carry-back claim, the taxpayer in 2013 would then be permitted to not only adjust his or her reported 1256 net gains but should be able to recompute his or her NIIT and request a refund of same, as this re-computation would be consistent with the intent of the Sec. 1411 provisions. The ability to allow income tax deductions to be deferred solely for NIIT purposes would be even simpler, because it is only a deferral of items of deduction, but similarly within the spirit of the Code and, we believe, within the existing statutory authority of the concept of "properly allowable" deductions.

³ That result could be reached in a variety of ways, including through clarification that a single trade or business, for purposes of the application of Sections 162 and 469 to Section 1411, may extend beyond the boundaries of a single entity. That possibility is implied by Section 465(c)(3)(B), which allows the aggregation in certain cases of separate "activities" that constitute "a" trade or business -- implying that a single business can be conducted through separate entities. Whether or not the requirements for such aggregation under Section 465 are satisfied in any particular case, the underlying premise seems to be that a single trade or business may, in theory, be conducted through multiple entities or conducted by an individual as a proprietor and as an owner of a pass-through entity. The self-rental situation seems to be a perfect illustration of that phenomenon -- whether the landlord is the individual partner leasing property to a partnership in which the landlord is a partner, or one partnership is passively leasing property to another partnership with substantially common ownership.

We recognize, of course, that some case law suggests that the determination of whether a partnership or other entity has commenced a trade or business, for purposes of its deductions, must be determined without regard to whether its partners or owners are already engaged in a similar business. That case law may not be applicable where one is considering amounts paid from one entity to another entity in connection with the simultaneous conduct by the two entities and their owners of a single trade or business, even if one entity, viewed in isolation, would not have sufficient activity to constitute a trade or business.