The Latest Installment

I’ve been asked: Can the new 3.8% Medicare tax be deferred by using an installment sale? The answer is clearly yes, and here’s why that is so.

The general rule is stated in Section 453(a) as follows: "Except as otherwise provided in this section, income from an installment sale shall be taken into account for purposes of this title under the installment method." For purposes of our analysis now, we can state the general rule this way: "Income from an installment sale shall be taken into account for purposes of this title under the installment method."

That means that when a sale is an installment sale, the measure of the income that can be taxed is that income which is taken into account under the installment method.

So, the question becomes this: For purposes of the 3.8% Medicare tax, is the amount of the income that can be taxed the same as the amount of income that is calculated under the installment method?

Look again at the rule: "Income from an installment sale shall be taken into account for purposes of this title under the installment method."

Therefore, the place to begin to answer the question is to determine whether the the Medicare tax is within the same "title" of the United States Code as the one containing the capital gains tax, because "for purposes of this title", the section says, income from installment sales will be taken into account "under the installment method".

Both Section 453 (the installment-reporting section) and Section 1411 (which provides for the new Medicare tax) are contained in Title 26, which, indeed, contains the entire Internal Revenue Code. So, according to Section 453, for purposes of Title 26 (including Section 1411) all taxation of income from installment sales will be on income that is taken into account "under the installment method".

According to Section 453(c), income from installment sales will be "recognized for any taxable year" pro rata as principal payments are received. If no principal payments are received in a given year, no part of the gain from the sale is recognized for that year. Under the general rule as stated in Section 453(a), that is necessarily true for both the capital-gains tax and the new Medicare tax.

This conclusion is further suppported by the text of Section 1411 itself. Section 1411(c)(1)(A)(iii) defines "net investment income" for purposes of the 3.8% tax, as it relates to sales of capital assets, as meaning "net gain (to the extent taken into account in computing taxable income) attributable to the disposition". The phrase, "to the extent taken into account in computing taxable income", is an obvious reference to Section 453’s test, "taken into account for purposes of this title under the installment method". Section 453’s installment-reporting method tells what amount is taken into account in a given year, and that amount is used by Section 1411 for purposes of calculating the "net investment income" to which the 3.8% tax applies.

Therefore, when income from a sale is deferred and not recognized because of an installment sale, it is deferred and not recognized as "net investment income" which would otherwise be taxed at 3.8%.

I should note, also, that what I’ve referred to here as the "Medicare tax" is only called that because the revenue which the Internal Revenue Service collects from it is said to be dedicated to support Medicare. The name of the tax, though, as actually stated in Section 1411, is a tax on "net investment income".

Please note: Deferral of the "Medicare tax" will be addressed in my CPE course for CPAs next week. See last week’s post, below, for details.—Stan Crow