I haven't looked at the Code in regards to this yet, but Worksheet B in the Instructions definitely seems to indicate the loss needs to be factored in as Earned Income (as Lacerte did).

Lines 1 would show the profit, and Lines 2 shows the loss.  Both are used for calculating the Earned Income on Lines 4.

https://www.irs.gov/pub/irs-pdf/i1040gi.pdf#page=44

My first thought is to fill out the Worksheet B and submit that as a reply to the IRS notice.  But before you do that, you may want to double-check that is actually what the IRS is disallowing.