Analyzing Hedging under Obamacare’s Net Investment Income Tax Final Regulations

In general

The net investment income tax (NIIT) is a 3.8% additional tax for individuals with adjusted gross income (AGI) greater than $200,000 ($250,000 for married couples filing jointly). Net investment income for this purpose includes interest, dividends, annuities, rents and royalties, plus passive income from a trade or business activity, and income from the trade or business of trading in financial instruments and income from the trade or business of trading in commodities.  Also included in NIIT are gains from the sales of assets (unless associated with materially participating trade or business income). 

Final regulations (along with new proposed regulations) were issued in late November of 2013.

Trading in Commodities

The regulations specify that the NIIT applies to a trade or business that constitutes a passive activity as defined under I.R.C. §469 or involves the trade or business of trading in financial instruments or the trade or business of trading in commodities.  Treas. Reg. §1.1411-5(a)(2).  The regulations specify that the definition of “commodities” for purposes of the NIIT refers to items described in I.R.C. §475(e)(2).  That definition includes any commodity that is actively traded within the meaning of I.R.C. §1092(d)(1) which is personal property that is actively traded.  Also included is any option, forward contract, futures contract, short position and any similar instrument in a covered commodity. I.R.C. §475(e)(2)(C).  The definition of “commodity” also includes “a hedge with respect to such commodity.”  But, as noted above, to be subject to the NIIT, the taxpayer must be engaged in the trade or business of trading in commodities.  Under the regulations, for taxpayers that own interests in pass-through entities, that determination is made at the entity level.  Treas. Reg. §1.1411-4(2)(b)(2)(ii).  For taxpayers that are engaged directly in a trade or business, the determination of whether the taxpayer is engaged in the trade or business of trading in commodities is determined at the owner level.  Treas. Reg. §1.1411-4(2)(b)(1). Thus, the status of income in terms of whether it is derived from a trade or business is always determined at the entity level.  Therefore, a sole proprietor farmer’s income from hedging activity, or hedging income of a farming entity structured as pass-through entity is not subject to the NIIT, because the farmer or entity is engaged in the trade or business of farming and not the trade or business of trading in commodities. 

Hedging gains and losses for a farmer are, therefore, not subject to the NIIT.  However, if the farmer’s commodity trading activity doesn’t satisfy the definition of “hedging” the resulting income or loss is speculative in nature.  Speculative income from trading in commodities is subject to the NIIT under a different provision – I.R.C. §1411(c)(1)(A)(iii).  That provision says that the NIIT applies to net gains attributable to the disposition of property other than property held in a trade or business in which the taxpayer materially participates.  The speculative gains and losses get the standard 60 percent long-term capital gain (or loss) and 40 percent short-term capital gain (or loss) treatment by virtue of I.R.C. §1256, but the additional 3.8 percent NIIT also applies. 

CALT does not provide legal advice. Any information provided on this website is not intended to be a substitute for legal services from a competent professional. CALT's work is supported by fee-based seminars and generous private gifts. Any opinions, findings, conclusions or recommendations expressed in the material contained on this website do not necessarily reflect the views of Iowa State University.

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