Case for Repealing Investment Income Tax

Let Me Count the Whys


Foreword by Paula Calimafde, SBCA Chair:

Read this excellent article by Al Lurie, SBCA Special Counsel, former Assistant Commissioner of Internal Revenue and renown speaker and writer, on why the new IRS Tax Code Section 1411 (adding a tax on net investment income – NIIT) should be repealed. Mr. Lurie makes the case that this new code section is the most complex tax provision in our already complex tax code. He contends that the NIIT is a second income tax which will require a separate determination of taxable income and its own federal tax return (Form 8960). He also believes that the prospects for repeal of the NIIT stand on much firmer ground than the two Supreme Court cases in which the narrowest possible majority has declined to rule the ACA in its entirety unconstitutional. In contrast the NIIT, as just a part of the ACA, bears the fatal constitutional flaw of failing to satisfy the Origination Clause of the Constitution. That argument is developed in the article, and at least on technical grounds seems very persuasive.

Mr. Lurie:

President, Alvin D. Lurie, P.C. (New York); practicing tax attorney; Chairman and Editor, 1999-2015, of NYU Review of Employee Benefits and Executive Compensation; first statutory Assistant Commissioner of Internal Revenue (Employee Plans and Exempt Organizations), post established in ERISA to administer ERISA national program; recipient of IRS Commissioner’s Award for outstanding and significant service in the public interest; first recipient of Lifetime Employee Benefits Achievement Award conferred by American Bar Association Employee Benefits Committee Tax Section; General Editor of Bender’s Federal Income Taxation of Retirement Plans (LexisNexis); author of Lurie’s Commentaries on Pension Design (Corbel), and other technical treatises and materials.


.01 Introductory Background

02 A Giant Among Giants

.03 A Time to Reconsider

.04 Misrepresented Title, Misleading Budget Projections

.05 Sparing the Middle Class?

.06 Like Plucking Goose Feathers

.07 Brevity with Breadth

.08 Hesse’s Analagous Mandarins

.09 Snares for the Unwary

.10 Who Did It?

.11 What Is To Be Done About It?

.12 The Constitution May Have the Last Word: “Origination”

.13 Could Repeal Stop Appeal?

.14 The Lesson of Section 89

.15 Second Thoughts?

.16 On Further Reflection Can One Ignore the Complexity?

.17 A Second Income Tax!

.18 First, Other and Last Words

.19 Coda


Introductory Background

“ We believe that section 1411 [of the Internal Revenue Code, adding a tax on net investment income] . . . is now          one of the most complex provisions of the Code, even though the complexities may be relevant only to certain taxpayers. The amount of resources that have been and will, we anticipate, continue to be spent on interpreting, applying and auditing compliance with section 1411 is daunting when one considers it in the context of the Code and the U.S. federal income tax as a whole. We doubt that Congress intended this.” Report 1284 on the Regulations Proposed Under Section 1411 of the Internal Revenue Code on December 3, 2012. New York State Bar Association Tax Section (May 15, 2013)

The author would differ slightly from the view of the New York State Bar Association as stated in the preceding extract from its Tax Section report. IRC Section 1411 is not just one of the most complex income tax provisions of the Code ever enacted to impose a tax on individuals, trusts and estates, who are its targets, but rather it is the most complex provision. Its reach, though limited to a single income category called “net investment income”, is extraordinarily difficult to apply because it attaches to its components varying conditions depending, in some cases, on whether the income is derived in the ordinary course of business, in other cases on the source — not the character — of the income, in still other cases on whether the source is a business in which the taxpayer is actively or passively involved (a test borrowed from the basic income tax law, where it has its own difficulties, to which an additional layer of complexity is added by its adaptation to the net investment income tax)”. Other special rules apply to gains from the disposition of property — even gains from the sale of one’s primary residence. Gains from the sale of active interests in a partnership or S corporation are subject to their own special rule.

All of this and more is contained in an amendment of the Internal Revenue Code made in a section of the Affordable Care Act headed “Unearned Income Medicare Contribution,” which the author hopes to demonstrate is completely lacking in any connection with Medicare other than, presumably, to give the section the appearance, but not the substance, of a nexus with the health care reform legislation.

This article proposes that Section 1411 be repealed during the two-year “window period” while the Republicans are in control of the Congress, and states the author’s reasons for and likelihood of repeal, and the prospects of a presidential veto and of override of the veto should it occur. The author’s proposal is not to be confused with what is presumably a Republican agenda during this window period of their dominance of the leadership positions in the Congress, during which it is expected they will attempt to follow through on their long-standing promise to repeal the Affordable Care Act at large. That is not the author’s proposal; but were it to occur, Section 1411 would fall with it.

Section 1411 of the Internal Revenue Code was inserted into the income tax system unannounced as an income tax. On the contrary, it was named as if it were a part of Medicare, and placed within the second of the two distinct acts which together have come to be called, colloquially (i.e. not officially), the Affordable Care Act.. That term was derived from the official title of the first of the two acts, “Patient Protection and Affordable Care Act,” as a short-hand way to refer to the two separate acts which were actually passed one week apart in March of 2010.

The first act is fifteen times the length of the second act, which bears its own title, “Health Care and Education Reconciliation Act.” The bulk and essence of the health care reform enacted in 2010 is contained in the first act. The second act contains only one section (of six lines) relating to health care, with the sole function of amending a few numbers appearing in health care sections of the first act. The amendment of the IRC adding Section 1411 was placed in the second act to establish a new chapter added to the “Income Taxes” ” subtitle of the Internal Revenue Code, called “Unearned Income Medicare Contribution.” That new chapter, as presently constituted, consists of only one section, numbered “1411”, which imposes the new tax. That section states, in its introductory sentences at 1411(a)(1) and (a)(2), that it adds a “tax” and that the tax is “in addition to any other tax imposed by this subtitle” (the subtitle reference being to the “Income Taxes” subtitle of the Internal Revenue Code). So the standing of Section 1411 as a taxation measure is beyond dispute, which may have far-reaching consequences for its constitutionality, as will be discussed later in this article.

Th article will demonstrate that none of the proceeds of the tax are dedicated to the purposes of the so-called Affordable Care Act, none of those revenues flows into the Medicare funds or contributes to Medicare in any way (its nomenclature as a “Medicare contribution” notwithstanding), nor would Section 1411 in any way impact the heath care provisions of the ACA were the tax to be repealed or ruled unconstitutional.

A Giant Among Giants

When I was a newly minted lawyer (over six decades ago), having then only recently been hired by the boutique tax law firm of Jacob Rabkin and Mark Johnson (two celebrities in private tax practice under the firm name of Rabkin law firm of Rabkin & Johnson) — noted for their tax practice, but more especially as authors of two widely respected tax treatises, Federal Income, Gift and Estate Taxation, and Current Legal Forms with Tax Analysis — I became immersed in the tax universe and, familiar with the names of some of the then-distinguished pantheon of tax giants, none more luminary than Henry Simons, an esteemed economist, professor at the University of Chicago, member of the Chicago school of economics, expert in cognate disciplines of public finance and income tax policy, consultant to the Committee for Economic Development, fierce advocate for tax simplicity, and writer extraordinaire whose pen was as sharp as his wit. I mention him here for a remarkable passage in his gem of a book, Federal Tax Reform, written in the mid-1940’s, hence predating by over 65 years the enactment of IRC Section 1411, but bearing directly on the argument of this paper:

“Simplicity in modern taxation is a problem of basic architectural design. Present legislation is insufferably complicated and nearly unintelligible. If it is not simplified, half of the population may have to become tax lawyers and tax accountants. Present laws are marvelously well built. But they are abominable architecturally. They lack structure or sound foundational plan.

“Some taxes defy elegant basic design. A retail sales tax, for example, cannot be simple or structurally elegant, for no one can state, in simple general terms, what transactions this tax should or should not cover. The same is true of the excess-profits tax, which on careful examination turns out to represent no more definite principle of levy than ‘soak the (corporate) profiteer.’ . . . Anyone who has ever prepared or audited a return under the excess-profits tax actually or vicariously) must recognize that simplicity and stability alone argue decisively . . . for one specific amendment, namely removal of its enacting clause!” (Simons, Federal Tax Reform, at pp. 28-29, U. Chicago Press, 1950)

Were I not to have just cited the source and date of the preceding quote — and were I to have made just a very few word substitutions (principally the references to the excess profits tax, which was much in the forefront of U.S. taxpayers’ and tax professionals’ concerns in the 1940’s, because of its role in the financing of World War II) — many readers of this piece who are acquainted with the net investment income tax imposed by Section 1411 (which I’ll refer to as “NIIT”) might assume the subject of the above Simons quote was the NIIT, especially because I have coupled it with the above extract from the New York State Bar Association Tax Section report on that tax.

One might have wished that Professor Simons were alive today to give us his insights on this controversial new tax, because of the rare combination of scholarship, powerful pen, nonpartisanship and straight talk that shines through his writing on the topic of federal tax policy and reform, and also, not least, because of the high regard in which he was held by his contemporaries. The NIIT is badly in need of such an unvarnished critique by a respected nonpolitical commentator, because so much of the commentary relating to anything connected with the Affordable Care Act (the legislation in which the NIIT was enacted) is tainted by charges — some justified, some not — of partisanship by those with whom one disagrees. As Simons has been quoted as saying of an important topic of his time, “[T]he important literature would take up very little space,” to which a colleague of his observed that Simons’ work in the field “would occupy a considerable part of that space.”

So it might be said if such a one as Simons were around today to bring erudition, restraint and objectivity to the dialogue that I expect may soon occur concerning, as the New York State Bar Association Tax Section called it, “one of the most complex provisions of the Code.” My only quarrel with that quote is I would have begun those words without “one of.”

A Time to Reconsider

The time may now be propitious for an in-depth reconsideration of the NIIT. As I am writing these words, we have just entered a relatively rare two-year period of a lame-duck and much diminished Democratic president and an about-to-be newly puissant and reinvigorated Republican party in full control of the Congress, each with diametrically opposed stakes in the survival of the Affordable Care Act (the former’s signature legislative achievement) — much or all of which the Republicans have been ardently bent on dismantling since its enactment in 2010.

I hasten to add that this paper is not about the Affordable Care Act. As its title is meant to convey, it is about Section 1411 of the Internal Revenue Code, which is an unlikely part of the Affordable Care Act. As noted in the Introductory Background above, technically speaking there is no statute so named, rather two separate enactments passed in March 2010 one week apart — reportedly as a parliamentary strategic tactic by the managers of the legislation, but possibly also to insulate the key health care provisions of the law from constitutional challenge, as discussed below. The two separate acts, each with its own title, have only colloquially come to be called, collectively, the Affordable Care Act.

Section 1411 was positioned in the second of the two acts, entitled the “Health Care and Education Reconciliation Act.” It was not properly placed in either of the acts, because it is not actually a part of the health reform legislation. Rather it is a section that was included in the HCERA to amend the Internal Revenue Code, notwithstanding the title of Section 1411, “Unearned Income Medicare Contribution,” that seems far removed from an income tax. But it is in every respect a full-fledged income tax — actually a second complete income tax, separate and distinct from the long-standing basic income tax contained in Subtitle A of the Internal Revenue Code.

None of its revenues are dedicated to Medicare. Its entire collections are placed directly in the General Fund of the United States Treasury to pay the bills of our government for all its disparate expenditures, from repairing the dome of the U.S. Capitol, to paying the salaries of the Congressmen and others who work under that dome or any place else in the world where the U.S. flag flies, to station troops in Iraq, or to pay for state dinners in the White House, as in the case of federal income tax revenues generally. But as widely varied as are the uses to which the income tax revenues are put, one of the few destinations to which they are not put is the Medicare trust fund. The initial set of proposed regulations on Section 1411 spells that out very clearly. (See the preamble to those proposed regulations, under the “Background” heading, which cites the General Explanation of Tax Legislation Enacted in the 111th Congress [JCS-2-11, March 24, 2011, at pp. 363-365], written by Congress’ Joint Committee on Taxation — the authoritative “Blue Book,” as it is called in the trade.)

Misrepresented Title, Misleading Budget Projections

The incontrovertible fact is that Section 1411 has no connection whatsoever with Medicare or with any other aspect of the health care reform legislation. The name assigned to the IRC section, “Medicare Contribution,” is a complete misnomer, and has, understandably, misled even some tax experts, who, in talks at tax conferences and in their written comments, have called it a “Medicare surtax.” Whether this ingenuous naming of the section was calculated to mislead the public and even the Members of Congress to induce their passing it, in the belief it was an integral part of the health care reform legislative package, I cannot say.

Let me modify somewhat my assertion that the Section 1411 has no connection with health care reform. The very fact of its inclusion in the ACA means that the revenues projected to be derived from it are included in the pricing of the cost of the ACA by the Congressional Budget Office, which the CBO is required to provide to Congress as part of the process of passing legislation. Such projections are made over a 10-year horizon. The 1411 tax, together with a companion 0.9% boost in the employee share of the health insurance tax (a legitimately considered payroll tax, which was effected by way of an ACA provision) were projected to deliver $300 billion over the 10-year horizon, the great bulk from Section 1411’s tax. I am not familiar with the budgeting accounting routine; but, as I believe it to work, the entire figure is credited against the government costs projected for administering the ACA in its entirety, thereby reducing the purported cost of its enactment supplied by CBO to Congress. That is certainly a substantial “connection” with the ACA for political purposes, if for no other.

I have characterized Section 1411, in a recent piece, as a “Trojan horse,” which some of its readers have taken as a political comment. I will unapologetically affirm that is my honest, apolitical view of its naming and placement in the ACA. It would be difficult not to believe it was a deliberate ploy to deceive and disarm the political opposition by giving the section the outward appearance of a Medicare contribution. I realize that is a serious charge and I do not make it lightly. It appears to have had its desired effect.

I have not polled the potential congressional opposition to validate my suspicion, but I recently received a call from one Member of Congress, unknown to me, who had voted on the bill in 2010. He had seen my article and called to ask whether I was absolutely sure that the 1411 tax collections are not transferred to the Medicare Trust Fund. I told him that I was, and cited him to the Blue Book and other sources on which I relied for my view. The Congressman was incredulous and not a little angered by the deception played on him. If, as I strongly suspect, the tax was deliberately coated in a kind of camouflage by giving it the appearance of a Medicare tax, such calculating misrepresentation, albeit understandable in the messy business of politics, is not a pretty picture and should not be condoned.

Sparing the Middle Class?

Perhaps the very high priority of the Administration to get the health care legislation enacted is also at the root of the decision to insulate the “Medicare contribution” against resistance from the general public by limiting it to individual taxpayers whose adjusted gross income exceeds certain relatively high threshold amounts. The tax is also imposed on estates and trusts, but limited to their undistributed net investment income in the tax year, and further limited to the excess of their AGIs over the dollar amount in any year that the highest tax bracket for estates and trusts begins.

As with the tax on individuals, the tax on estates and trusts is designed to assure that the tax will reach only the upper brackets of estates and trusts. On the face of it, the threshold number for estates and trusts is in the extremely low $13k to $14k range, as contrasted with the $200k to $250k range for individual taxpayers. However, this disparity is not nearly as large as it seems at first blush, because the investment income of estates and trusts is divided between the trust or estate and its beneficiaries in receipt of investment income from that source; and the component of distributions to the income beneficiaries in any year is taxable to the beneficiaries under Section 1411 the same as other investment income received by them directly from other sources, subject to the $200k or $250k thresholds.

So the tax is only meant to fall “on the rich,” in the incantation of political-speak, which — not accidentally — is designed to assure the middle class voters, where most of the votes are harvested, that their representatives in Congress are not raising taxes on them. The difference for many members of Congress in winning or losing their races depends largely on how the respective rivals stack up on that single criterion.

Like Plucking Goose Feathers

Calculatingly or not, there is nothing inherently wrong, I would submit, with confining the NIIT impact to “high bracket” taxpayers. That is the precept on which many forms of taxation are designed, and the reader should look for no argument to the contrary in this paper; although the proper placement of the breakpoint between taxed and untaxed investment income can be problematic. The calculus for designing the NIIT obviously drew on many factors, on which wide disagreement was possible. But there can be no reasonable disagreement that it is the over-the-top complexity of the tax that is most objectionable, unacceptable and wholly unnecessary to achieve the revenues that presumably underlaid its conception.

There really is no reason why a second income tax had to be established, even if a legitimate revenue source to support the ACA were deemed necessary by the Administration. The existing income tax scheme can accommodate any appropriate revenue needs. It already has many additional tax-raising features, like an alternative minimum tax, capital gains tax, and itemized deduction restriction. Even for the sudden gargantuan needs of fighting World War II on two fronts, an extremely high-rate excess profits tax for the duration of the conflict was employed.

There are many ways to raise revenue without raising the hackles of the taxpayers. Tax collectors for many millennia have practiced that art (“plucking the feathers of the goose with the least squeals” is how it has sometimes been colorfully described). A simple rate increase at the highest brackets could accomplish as much revenue, or more, as the NIIT, without so violent an assault on the long-standing architecture of the income tax system. The enormous costs and burdens of compliance it imposes on taxpayers and their professional advisers (and, one might add, on the Treasury Department and its tax enforcing agency, the IRS) are, in effect, a third income tax that must now be paid.

Brevity with Breadth

The statute is not quite two pages long. But in those two pages vast swaths of the Internal Revenue Code have been imported into the law by reference to provisions affecting individuals, partnerships, corporations (C and S), self-employed individuals, estates, trusts, charitable remainder trusts, grantor trusts, controlled foreign corporations, passive foreign investment companies, and pension trusts and other tax exempt entities. The list goes on and on. Even U.S. citizens earning income abroad have made the list.

In addition, there is an overlay of special rules geared to specific activities, most notably the “passive activities” test. It is an enormously complex rule adopted from the income tax, where it acts as a potent limitation on deduction of losses from passive activities against other income, but adapted to perform an entirely different function that cuts across and interacts with the net investment income tax in ways that can drastically affect the tax outcome, even as between partners and fellow shareholders, who, as a result of slight differences in their respective activities vis-à-vis their company — as identified in exacting criteria spelled out for passive versus active conduct in lengthy regulations under IRC Section 469 — that, with modifications for purposes of the NIIT that are contained in the regulations under Section 1411, can cause greatly dissimilar tax results among related taxpayers.

Probably no more need be said to indicate the enormous problems of compliance posed by 1411 than to mention that this less-than-2-page statute has resulted, at my last count almost four years after 1411’s enactment, in 463 pages of initially proposed, final and then further proposed regulations ( issued simultaneously with the “final” regulations). These 463 pages do not include over 100 pages of Section 469 regulations, and the copious regulations under other IRC sections that are incorporated by reference in Section 1411 (e.g., the sections covering distributions of income by estates and trusts and by charitable remainder trusts, which must be considered in determining a trust distributee’s NIIT liability).

Other problems arise from the fact that, while the NIIT generally uses the terms, definitions, rules and principles of the regular income tax as a template for determining the tax under Section 1411, we are told in the preamble to the proposed regulations that “except as otherwise provided” (italics added), chapter 1 “principles and rules” of the IRC “apply in determining the tax under section 1411” — but then cautions the reader that there is “no indication in the legislative history of section 1411 that Congress intended, in every event, that a term used in section 1411 would have the same meaning ascribed to it for other Federal income tax purposes.” The preamble amplifies this by stating that the proposed regulations “modify the chapter 1 rules in certain respects in order to prevent circumvention of the purposes of the statute.”

Had Gilbert and Sullivan worked such a double-talking statute for the little town of Titipu into the libretto for their opera on the story of the free-wheeling authority that Pooh-Bah, as the Lord High Everything Else of that little town of Titipu claimed, they probably would not have needed to add another song. The refrain in the lyrics of one of the existing songs, “Here’s a pretty mess,” would seem a good fit.

I do not mean this as criticism of the IRS regulation drafters or the others who had input in the development of the regulations. I believe they did a masterful job of shaping and composing those several hundreds of pages of regulations. The criticism must be directed at the enactment of a statute that requires such extended explication and tortuous amplification.

I truly believe only a relatively small handful of tax lawyers and accountants will be able to cope with it, and, even for them, not without the expenditure of vast amounts of time, which will reasonably translate into commensurate high fees that will, for many taxpayers, rival the tax revenues the government will realize from the taxpayers’ NII tax returns. This is not meant as a commentary on the fees of skilled professionals, but as a means of illuminating to readers, even to those who will never have to deal personally with 1411, the enormity of the costs of this tax to the U.S. economy in time spent and dollars expended, far beyond the actual taxes paid by those on whom the tax is imposed.

In evaluating the true costs of this loss of time and money to our economy, one must consider how this diversion of time and money might better have served the U.S. economy at large. Consider also whether the taxes raised from this tax could be put to better use by the Federal Government than in paying for the increased budgets of the administrative agencies involved in administering the NIIT. The Test of Unintended Consequences can be ignored only to the detriment of this country.

Hesse’s Analogous Mandarins

I am put in mind of the exquisitely brilliant performance of the mandarins whom Herman Hesse invents in his masterpiece, The Glass Bead Game, a novel where he describes a super class of mathematical and musicological geniuses who engage each other in games for which they develop their own rules and language, that require a knowledge of everything that was ever known by mankind, just in order to qualify as a contestant in the games. Hesse’s own words in the novel express his ingenious construct much better than I can hope to put it:

“The only way to learn the rules of this Game of games is to take the usual prescribed course, which requires many years; and none of the initiates could ever possibly have any interest in making these rules easier to learn.

“These rules, the sign language and grammar of the Game, constitute a kind of highly developed secret language drawing upon several sciences and arts, but especially mathematics and music (and/or musicology), and capable of expressing and establishing interrelationships between the content and conclusions of nearly all scholarly disciplines. The Glass Bead Game is thus a mode of playing with the total contents and values of our culture . . . All the insights, noble thoughts and works of art that the human race has produced in its creative eras, all that subsequent periods of scholarly study have reduced to concepts and converted into intellectual property — on all this immense body of intellectual values the Glass Bead Game player plays like the organist on an organ.”

It makes for great reading, which is very rewarding in a novel. But Hesse’s game is not an acceptable model for coping with a tax statute that will affect not just the many multimillionaires who can afford to pay dearly for the extraordinary feats of a select cadre of tax experts, but also the multitudes of so-called high bracket taxpayers whose AGIs pierce the levels of the $200-250k thresholds relatively modestly (hence financially comfortable certainly, but far from the strata which the political usage of “rich” is intended to connote), that will draw them into the net of Section 1411.

Snares for the Unwary

Little has been said in the legal literature, let alone in the broad press, op-ed commentary or public print generally, of the enormous complexity that this new statute has injected into the tax law of the Nation, and the inevitably resultant errors that will abound in all the places where its application will occur. As I had cast about for a way to draw a sharp image of the morass of complexity that courses deeply through nearly every layer of this statute with such error-prone consequences, I hit upon an example in an unlikely place, that I am almost too embarrassed to own up to — my preparation of my own NII tax return for calendar year 2013 (the first year the new law became effective). In the many items of investment income reportable, probably among the simplest to identify is dividends, because Section 1411 states unequivocally at the head of the list that “The term ‘net investment income’ means gross income from interest, dividends, annuities, royalties and rents.”

For one in receipt of dividends or other types of income items on that list, that should be a simple enough figure to determine, except for an important provision of the statute coupled with the preceding quoted words that necessitates preliminary determinations whether the income was derived by the taxpayer from a business, and, if so, whether the business is a “passive activity” with respect to the taxpayer (one of the most difficult complexities of the statute, as briefly noted above).

Once having gotten past that difficulty, one might suppose, the dividend figure can be pulled directly from the 1040 form. But even that has its complications, as I discovered to my embarrassment. Dividend income has for several years past been divided between two classes, designated in the federal tax law as “ordinary” and “qualified.” They are shown on lines 9a and 9b, respectively; but a favored tax rate is accorded to those required to use the Qualified Dividend and Capital Gains Tax Worksheet in calculating their ordinary income tax and who report “qualified dividends” on line 9b of Form 1040. In that case, the line 9b qualified dividend amount, not the ordinary dividend amount on line 9a, is employed in calculating one’s tax liability for the regular tax. The assumption one might logically draw from that is that the qualified dividend amount is also proper for calculating the NIIT. At least, that was the assumption I made in determining my NIIT for 2013 and in entering that figure on line 60 of Form 1040, to comprise part of “total taxes.” In a notice to me relating to my calculation of my net investment income tax, the IRS has disagreed with my assumption and substituted the ordinary dividend amount, which is invariably the larger of the two dividend amounts.

I have since paid the tax cost of my error. But I consider it well paid as part of the price I have had to pay in composing this paper, insofar as it substantiates the charge I make in the paper of the increased potentiality for error that inheres in the net investment income tax, due largely to the necessity to distinguish and differentiate the treatment of the same item of investment income under the ordinary income tax from its treatment under the NIIT. I must confess to some perverse gratification I have derived from this experience, notwithstanding the price I have had to pay. I am referring not to the additional tax, but the embarrassment of public disclosure of my mistake to demonstrate the point I have made of the deeply layered “morass of complexity” baked into this new income tax.

It turned out, after I submitted to the editor my final draft of this paper, that I could have made my point by citing an article in the Wall Street Journal on the top ten “Tax Traps” (the term used by its author to identify “hidden hazards that can cost taxpayers money or get them in trouble with the IRS”) — but for a little detail, namely, the article was not in print when I finished this paper. Of course, I could have begged leave of the editor to permit me to substitute the WSJ story for my self-confession. But by doing so I would have missed this opportunity to exemplify how something as commonplace as a dividend caught even a relatively informed taxpayer in the net of the net investment income tax!

Who Did It?

A question that one may wish to know is: from whose head sprang Section 1411? It is not as interesting to classicists as the myth of Athena having sprung from the head of Zeus, which has fascinated scholars for perhaps 25 or more centuries, but, for persons in the U.S. in this early part of the 21st century A.D., it is of more immediate relevance. There are no telltale fingerprints on the legislation, and I have not heard anyone claim authorship.

I have seen a comment by one person in a position to know that the 1411 concept arose in a White House paper circulated following the defeat of a Senate bill to raise the individual income tax rate by 1 percent during its campaign for enactment of the ACA. I pass this along with no personal knowledge of the accuracy of the claim. But it is not beyond belief that someone in the West Wing may have played a role in the evolution of 1411. If it is true, one can expect see it confirmed in time in the memoir of one who no longer feels constrained to preserve the confidentiality befitting one who has been close to power and enjoyed its perquisites.

What Is To Be Done About It?

The more important issue now is what is to be done about Section 1411 in the 114th Congress, 1st Session, that began January 3, 2015, when the Republicans, who have promised repeatedly to repeal Obamacare when they lacked the power to pull the strings on Capitol Hill, now are positioned to put their money where their mouth is, in the brief window period of the next two years of Republicans ascending and Democrats descending. As I stated above, repealing the Affordable Care Act is not the argument of this paper, and Section 1411 is but one provision of the ACA, and in no way connected to the health care reform provisions of the law. Not even one iota of those provisions is dependent on the NIIT. Its repeal would do no damage to the portions of the law that bear on its beneficial claims.

The situation is far different from what obtained when the constitutionality of the ACA was argued in the Supreme Court in 2012 in the landmark case of National Federation of Independent Business v. Sebelius, , 132 S. Ct. 2566 (2012). A chief concern was whether the challenged provision in that case, the penalty imposed on the failure of individuals to obtain health insurance policies required under the ACA, was supportable under the Commerce Clause, and, if not, whether it was severable from the rest of the Act, so that, if the challenged provision were to be ruled unconstitutional, the rest of the law would fall with it.

The Constitution May Have the Last Word: “Origination”

That is obviously not an issue if the NIIT were to be repealed by Congress or stricken by a court if in a lawsuit. There exists a basis for challenging Section 1411 on constitutional grounds, although not one of the grand and lofty provisions of congressional power in the Constitution, like the Commerce Clause or the Taxing Power, but rather on the so-called “origination” requirement of Article I, Section 7, Clause 1, that “All Bills for raising Revenue shall originate in the House of Representatives; but the Senate may propose or concur with Amendments as on other Bills.” The NIIT did not so originate. It was added as a Senate amendment to a House bill that lacked even a scintilla of a provision on which a defense against an origination argument could be grounded.

Two fairly recent cases, Sissell v. HHS, , 760 F. 3d 1 (D.C. Ct. App. 2014), in the D.C. Circuit Court of Appeals, and Hotze v. Sebelius, 891 F. Supp. 2d 864 (S.D. Tex. 2014), decided in the Southern Texas District Court and now pending on appeal in the 5th Circuit Court of Appeals, where the case was orally argued on December 2, 2014, pose origination challenges to a tax enacted as part of the ACA, like Section 1411.

The ACA is in fact what could be called a host statute for many sections establishing taxes and penalties. The NFIB v. Sebelius case, supra, indeed involved such an ACA-hosted tax, but surprisingly none of the parties advanced an origination argument in challenging the constitutionality of the tax that was at bar. With all the numerous ACA-founded cases now in the lower courts, it is all but certain that the constitutionality of the ACA will again be presented to the Supreme Court for decision, but this time at least probably one on the origination requirements of Article I, Section 7. Whether it will involve a challenge to IRC 1411 is less certain.

Irrespective of the particular section of the ACA on which such litigation is initiated, it will involve the rule of law established in a pair of Supreme Court cases decided over 100 years ago, Flint v. Stone Tracey Co., 220 U.S. 107 (1911) and Rainey v. U.S., 232 U.S. 310 (1914), where the Court established a “primary purpose” test that had to be met in determining whether the requirements of Article I, Section 7 were satisfied in a case where the origination requirement of the Constitution was invoked. The case held that the primary purpose test was applicable to the particular section in which the tax was provided, not to what I have called above the host statute as an entirety.

As applied to Section 1411, if it were the statute at issue, that test would not permit putting into question the purpose of the ACA, but only the purpose of 1411. The origination doctrine holds no threat to the ACA as a whole or its sections that have no relation to the raising of taxes. The lower court decisions in Sissel and Hotze erred in applying the primary purpose test to the whole of the ACA. If properly applied to just the revenue-raising sections, it is hard to see how the origination challenge could fail.

Could Repeal Stop Appeal?

It is all but certain that the issue will land on the High Court docket, because, after the Fifth Circuit decides the Hotze appeal, it may be presumed that the D.C. and Fifth Circuit appellate courts, respectively, will have provided the requisite conflict between the circuit courts. The D.C. Circuit Court, considered among the most liberal, rejected the origination challenge, while the Fifth, generally regarded as the most conservative in the country, seems most likely to sustain it. Even judges, no less than ordinary mortals, are usually predictable in their positions on the Constitution. As a wag once said, opinionated people (and judges are certainly honored for their opinions) use the Constitution like a drunk uses a lamppost, more for support than illumination.

The only thing on the horizon that would abort a grant of certiorari by the Court to hear the origination issue as regards Section 1411 would seem to be if Congress were to moot the issue by repealing the section. The mere prospect of adjudication of the fate of 1411 in the Supreme Court might be enough to stir the Republicans to act quickly to repeal it while they have the power, so as to foreclose the risk of a decision by the Court that takes the matter beyond their control.

There, of course, would remain the uncertainty of a presidential veto. But the Republicans might then succeed in winning over enough Democrats who see in the recent elections in November evidence of a disenchantment of a large bloc of the electorate with ACA, and who, looking to the 2016 elections, see the opportunity to win some points among perhaps even a larger bloc of voters who by then will have experienced not just general disenchantment with the overregulation of the ACA and its failure to live up to its promises of lower health costs and higher insurance benefits, but the pain inflicted by this sleeper new income tax that they were told was just a modest Medicare tax increase, and who are now paying stiff fees to accountants and lawyers for compliance with it and/or for planning their way around it — something they never had to do in all the years of paying payroll taxes that were truly “Medicare contributions.”

Some of those Democratic congressmen and women, no longer obligated to show loyalty to their guy in the White House, will vote to override the veto if they think it would help them win their races to return to Congress; and some may even do it because they discovered belatedly what was in the ACA long after they had pressed their buzzers to vote for its passage in 2010.

The Lesson of Section 89

Once before in the Nation’s history, in the 1980s, faced with enactment of well-intentioned benefits legislation that proved too onerous in operation, Congress amended the law to simplify its operation two years later. Within another year, when the law — Section 89 of the Internal Revenue Code — still proved too difficult to administer and required tremendous compliance efforts by employers, the section was amended retroactively and, for all practical purposes, never took effect.

The NIIT has been in effect for almost two years. Substantial revenues have begun to accumulate from it and will continue to flow regularly into the Treasury’s coffers every quarter of a year that passes, since the tax is subject to quarterly estimating requirements along with federal ordinary income tax payments. Significant planning has already been done and implemented presumably, for the purpose of eliminating or delaying 1411 taxes, and that will only grow as more advisers become aware of the planning opportunities. Were repeal to eventuate, how much retroactive redress could occur is problematic. Of course the planning costs and tax compliance expenditures by taxpayers and government already incurred are not reversible.

If repeal of the NIIT is a reasonable prospect, the only class of people to benefit from delay, it would appear, are the tax planners and tax return preparers. Who would be in favor of that besides those planners and preparers?

Second Thoughts?

An extremely complex piece of legislation, enacted 40 years ago, caused an enormous reaction among tax practitioners in the area of benefits and related tax law to which the legislation was addressed (I speak of ERISA), which induced many pension and tax lawyers and other practitioners at the time to give up their specialty in that field. Those that stayed with ERISA in the ensuing decades have since been joined by legions of practitioners in the law, accounting, and actuarial professions, insurance, third-party administration, and cognate disciplines.

There have actually been celebrations of this 40th ERISA anniversary in numerous conferences around the country. Surely none doubt that ERISA has produced an immense improvement in the security of workers’ pensions that is worth celebrating. Most people in the field today do not know that ERISA owes its existence largely to the shock of the bankruptcy of the greatly admired Studebaker auto maker some 50 years ago — not the bankruptcy per se, but that its 4,000 workers lost all, in many cases, or significantly reduced percentages of their pensions, because of the greatly underfunded plan. The long shadow cast by that event was, without any question, the single most potent stimulus to the coterie of senators who initiated the movement toward enactment of the reform legislation which eventuated a decade later and, as much as anything, influenced the major design features of ERISA. Even today the word “Studebaker” resonates in a strange way for old-timers. (I must admit to actually experiencing a chill when I was in South Bend last year and saw that legendary name on a civic building. It wasn’t because I have a thing about civic buildings.)

I mention this to make a point about Section 1411. As I was putting the finishing touches on this article, I wondered whether I was being too hard on the NIIT, objecting to its complexity, its overregulation, its costs of compliance, its over-bureaucracy, its deceptive title, and its lack of justification. Too much pain without the gain. That led me to compare it in my mind to ERISA, about which much the same criticism could be made — and was! Today, of course, ERISA ranks among the major pieces of U.S. social legislation alongside such stand outs as the Social Security Act, the Wagner Act and the Taft-Hartley Act. The endless objective of advancing the goals of ERISA, as expounded in its declaration of policy — “assuring the equitable character of such plans and their financial soundness. . . . establishing standards of conduct . . . for fiduciaries of employee benefit plans . . . requiring [private pension plans] to vest the accrued benefits of employees . . . to meet minimum standards of funding, and by requiring plan termination insurance” — continues to this day in congressional offices on Capitol Hill, in Treasury and Labor cabinet-level suites, in the administrative agencies charged with the care and feeding of the ERISA community (Treasury and IRS, Labor and PBGC principally), and in many other warrens where government workers work. There is also, of course, the entire aggregation of private associations, educational institutions, websites, publishing houses, and many other major participants in the ERISA complex. ERISA is big business and deeply engrained in our society.

It didn’t begin that way. The ERISA acronym enjoyed wide currency all around the country in the immediate wake of the enactment of the statute — but not what its proponents would have wanted — when some unknown critic/humorist said the acronym stood for the phrase “Every Rotten Idea Since Adam.” There was widespread criticism of its overregulation and overburdening system, some of it justified, much of it directed at the dual jurisdiction that ERISA established, requiring IRS and Labor to work the same territory — more a function of politics than policy, with the congressional Labor and Tax committees fighting to preserve their respective turfs as the law worked its way through the legislative process. The dual jurisdiction resolution of this conflict was only a compromise and attracted much opposition.

Today, of course, it’s a very different story. The rooters greatly outnumber the hooters. Will Section 1411 overcome its hostile initial reception and achieve acclaim similar to what ERISA has earned? I think not. ERISA made from the very beginning — and continues to make — a major social contribution to the retirement security of employees. Section 1411 has initiated only a convulsion in the tax scheme of the country, with absolutely no contribution to the health care system (false labeling to the contrary notwithstanding).

The ink of President Ford’s signature on the Employee Retirement Income Security Act was barely dry when IRS and the Labor Department, jointly, removed almost immediately the trustees of the Central States Teamsters pension fund for serious, if not criminal, breaches of their fiduciary obligations; and they quickly set the plan back on the path of providing reliable pensions to the employees of the 11,000 trucking companies then covered by collective bargaining agreements with the Union. That Tax/Labor duet was the first joint administrative action generated by ERISA, and a harbinger that Dual Jurisdiction could work. As one of the early, albeit biased, actors in that drama, I can attest that in its first test, in the full glare of the public spotlight, the new statute performed its intended goal even beyond the expectations of its architects in Congress and their most ardent supporters.

On Further Reflection Can One Ignore the Complexity?

Can one conceive of any way Section 1411 could make a similar contribution to the good and welfare of this country? It would be one thing if the NIIT did not come with all the baggage I have described, i.e., an enormously complex statute, difficult to interpret, requiring knowledge of the applicability of numerous rules, tests and examples spelled out in the hundreds of pages of regulations of Section 1411 itself, plus more regulations pertaining to sections drawn into 1411 from the regular income tax by reference in the sparsely worded terms of 1411.

All of this scholarship is required just to determine what items of income are captured by the very wide net of 1411, because the statute does not simply take the taxable income of the regular income tax as the starting point to calculate one’s NII tax. As already noted, it requires the identification of a mixture of inclusions and exclusions of Form 1040 items; so these cannot be simply transferred unchanged to tax work papers for calculation of the NII tax. The NIIT requires specific ascertainment of the investment or other characteristics of income items reportable on the 1040 return, because the NII tax applies only to some income items, or portions thereof, received by the taxpayer directly from its source other than in the ordinary course of a trade or business, or as a distributee of a business or other entity with which he or she has a connection that fails to meet criteria specific to the relation of the taxpayer to the conduct of business by the distributor.

Some items of income are explicitly exempt from the NIIT, such as distributions from kinds of qualified plans specifically identified in Section 1411, e.g., qualified retirement plans. A special rule relates to portions of gains from dispositions of active interests in partnerships and S corporations. The application of these standards is dependent on factual determinations meeting tests spelled out in the regulations, which pose their own difficulties.

Income items otherwise exempt are taxable if derived from designated trading businesses. Conversely otherwise taxable income is exempt if treated as taxable for purposes of the taxpayer’s self-employment income tax. In this maze of rules some items of investment income could fall within two conflicting baskets. Presumably somewhere in the regulations there exists a tie-breaker rule that will control the day. If not, a private determination letter or a revenue ruling may provide the answer. Court decisions will ultimately resolve the issue for some confused taxpayer. The hundreds of pages of 1411 regulations already on the books is but the beginning of a body of law that will burgeon to unimaginable lengths.

A Second Income Tax!

The point to be made most emphatically is that the NIIT is not simply a gloss on the ordinary income tax rules. It is a discrete second income tax with its own distinct elements, and necessitates its own separate determinations of taxable income, and preparation of its own federal tax return (Form 8960). It even requires the filing of its own quarterly estimates of NII tax. The fact that it employs terms applicable to the regular income tax (although not always defined the same), and in some cases excludes from tax income also excludable from the regular income tax (for example, a portion of the gain realized on sale of the primary residence), does not facilitate compliance with the NIIT, but, on the contrary, complicates the task because of the necessity of differentiating the distinctive rules governing the taxation under 1411 of some items of 1040 income from those that are not taxable under 1411.

All the above is compounded by the murky language employed in Section 1411 in some critical passages to denote these distinctions, which defy ready comprehension, even after several readings. Thus, an inherently complex statute is made more so by the manner in which these distinctions are expressed.

The price of such complexity is manifold. Errors in compliance will not just be committed by taxpayers (yes, even I). Errors will also abound among the legions of IRS agents. The courts will not be exempt. The cost of compliance will rise commensurate with the difficulty of implementing it — not just for taxpayers, but also for the government. That is not only in counting the dollars that IRS will have to expend on audits, but also the diversion of IRS and Treasury personnel at all levels from other more gainful employment of their time and skills. That in itself will have consequences of great magnitude, albeit unpredictable specifically.

First, Other and Last Words

This article begins with a telling quotation from the report of the Tax Section of the New York State Bar Association strongly critical of Section 1411 of the Internal Revenue Code. It later draws from the work of one of the most eminent and honored economists of his time, Henry Simons, who, writing on federal tax reform 70 years ago, delivered a stinging criticism of legislation of that time that could as well have been written today about Section 1411.

Later in the article the discussion turns to a remarkable novel from roughly the same period by a celebrated writer of the time, Herman Hesse, whose tour de force, while having no relation to taxes or tax reform, describes a game called Das Glasperlenspiel (The Glass Bead Game in English), which required hyper-intellectual skills of the small handful of mandarins able to qualify to play the game and to navigate its rules, which I saw as a metaphor for what is required for coping with the rules of Section 1411. The game had historical authenticity among the intelligentsia throughout Europe for many centuries, requiring of its players total knowledge of the contents and values of the world’s cultures. A better name for it might have been The Game of Everything for its boundless reach, if not quite coextensive with the boundaries that are today ascribed to the Theory of Everything (thanks to a popular movie in the theaters as this is being written).

The common characteristic that binds each of these writings together and, collectively, all to this article is the outsized complexity of their subject matter, of which each of the pieces takes a dim view. I am pleased to be in such good company. At the very time I thought that I had said in this article all that needed to be said on the subject, a tax lawyer and frequent author, Robert W. Wood, wrote in a Forbes magazine article that “maybe the IRS should not have to administer our insanely complex tax law, but it does.” (italics added.) Giving further weight to the Wood quotation, it is noteworthy that the very same phrase, “insanely complex” as a characterization of the tax law, is quoted in a blog on the Internet, called TaxProfBlog, by its highly respected owner, editor and blogger, Professor . Paul Caron, whose blog is widely acknowledged as the best exclusively devoted to tax matters by the elite tax academe community.


Neither the Wood or Caron quote is directed to Section 1411, and obviously that is not the only place in the federal tax law where unwarranted complexity can be faulted. But it is the most egregious in this author’s experience, and their words serve well as the CODA to this piece. The shoe certainly fits.