Net Investment Income Adds Complexity

Opponents of tax law simplification have nothing to fear after the enactment of the additional Medicare Contribution Tax on unearned income known as the Net Investment Income (NII) Tax.  It creates levels of complexities that require us to understand not only the exact components of NII, but also creates some interesting variances for the hedge fund industry and brings to light additional distinctions between a trader fund and an investor fund for tax purposes.

Issued on November 30, 2012, proposed regulations provide guidance for the NII tax that becomes effective for tax years after December 31, 2012.  The tax is a non-deductible item assessed at a rate of 3.8% on the lesser of the individual’s net investment income or the amount by which modified adjusted gross income exceeds $250,000 for married taxpayers or $200,000 for single taxpayers. 

NII consists of three broad categories of income: 

Category One   Gross income from interest, dividends, annuities, rents, substitute interest and substitute dividends, unless excluded by the ordinary course of trade or business exception, 

Category Two   Gross Income from passive activities where the taxpayer does not materially participate and income from a trade or business of trading in financial instruments or commodities, and 

Category Three   Net gain attributable to the disposition of property other than property held in a trade or business. 

To the extent allowable for regular income tax purposes, deductions properly allocable to these gross income items are deducted to arrive at NII.

Expressly excluded from these categories are any items of income already taken into account in determining self-employment tax, as well as certain qualified employee pension and annuity plans.

“Trader” funds, as distinguished from “investor” funds, enter into the activity of buying and selling securities for their own account to primarily generate profit from daily market swings; the consistent high levels of trading would afford it a trade or business status and the expenses of the fund would be deductible “above-the-line,” not subject to itemized deduction limitations. Investment interest expense would also not be subject to investment income limitations for GPs. 

Investor funds, on the other hand, employ a buy-and-hold strategy and mainly seek capital appreciation or the receipt of interest and dividend income.  Expenses attributable to this activity are typically portfolio deductions subject to the 2% adjusted gross income limitation and interest expense is subject to investment income limitations.

Even though trader funds rise to the level of a trade or business, the income from this activity is subject to NII tax under category two above.

The odd result affecting trader fund expenses under these regulations is the manner in which they are allowed for NII tax.  Trader fund expenses are not subject to limitations as mentioned above. Because of these special rules for trader funds, the regulations stipulate that, to the extent an individual (i.e., GP of the fund) has self-employment income, regardless of source, these trader expenses will first reduce self-employment income; any remaining expenses will then be allowed to offset NII.  The disparity is the spread between the deductible self-employment tax and the non-deductible NII tax.  This means that any GP with a profitable management company will see reduced tax benefit from their trader fund expenses because those expenses will first reduce management company self-employment income.

Working capital of an operating business is generally considered operational capital and not investment capital.  Under these regulations, category one income includes interest or dividends generated from working capital.  This means that the interest being earned on the excess cash of a management company will be subject to the NII tax even if the cash is used in the ordinary course of a trade or business that is excluded from the NII definition. 

Category one income also specifically includes any substitute interest and dividends as a mechanism to prevent circumvention of the intent of the rules.  However, a curious result occurs when one looks at income received under a notional principal contract (NPC), commonly referred to as a swap.  By including income from a trade or business of trading in financial instruments as part of the investment income definition, income received under a notional principal contract is pulled into the NII calculation for trader funds while this same income generated by investor funds is excluded.  

Whether intended or not, the exclusion of the income from NPCs for an investor fund alleviates some angst of the investor fund members who are generally unable to benefit from the portfolio deductions that are allocated to them, either due to AMT or itemized deduction limitations.  It is worthwhile to note at this point that any properly allocable expenses that are eligible to be deducted against gross income to arrive at NII hinge on amounts deducted for regular income tax purposes.  For example, if an investor has portfolio deductions that do not exceed the 2% threshold, the investor receives no tax deduction for these expenses under regular income tax and, therefore, no deduction is available for NII tax purposes.

Continuing with our NPC example, any gain on the disposition of the NPC will be considered as category three, net gain attributable to the disposition of property not from a trade or business for investor funds.  For trader funds, the gain falls into the all-encompassing category two, income from a trade or business of trading in financial instruments and commodities. 

For illustration purposes, if the disposition represents the only disposition activity for the year and results in a loss, the net gain clause would cause the investor fund to reflect net gain for the year under category three of zero and not a loss.  Alternatively, this loss for a trader fund could be captured in category two.  The regulations for category two type trading income reference only gross income.  One can only presume that the intent is to allow losses to the extent of gains but that is not clear from the current proposed regulations.

PFIC QEF income and CFC Subpart F income are other areas of income where there appear to be an anomaly in the new rules and, perhaps, some possible planning opportunities for investor funds.  Because of technicalities in the code sections, these forms of income are recognized by a taxpayer under the QEF and subpart F regimes for income tax purposes.  However, these items of income do not fall within the umbrella of the NII, at least not until the cash is distributed.  For domestic investors who are not anxious for cash, investing through these vehicles can offer deferral opportunities.

The regulations do provide an opportunity for individual investors to make a lifetime election with respect to all PFIC and CFC investments to recognize for NII purposes the same QEF income and Subpart F income that are recognized for regular income tax purposes.  This is meant to alleviate the need for separate tracking of basis regimes for income tax purposes and NII purposes.

Trader funds will not have this disparity because of the same catch-all provision that pulls all income from trading into category two.  This may not be disadvantageous if one considers the record keeping requirements that will be necessary to track the income flows and cash distributions of each PFIC or CFC investment as necessary for investor funds.

A grid is provided below to highlight some of the items discussed above.  As we come near tax season, one of the things on the minds of many managers is the preparation of their annual K1s.  In light of the nuances of these new rules, managers and tax preparers will need to focus more of their attention during the 2014 tax season on the proper disclosure of income and expense items from fund K1s than they ever have before.

The IRS is seeking comment on the proposed regulations; deadline for written or electronic comments will be March 5, 2013.

 NII Categories At-a-Glance 

1Gross losses for traders are presumed to be allowed to be netted against gains until zero in the spirit of the rules.

2 Election available for individual members of investor funds to include Subpart F and QEF income in NII