By Anthony Diosdi
Federal law imposes a transfer tax upon the privilege of transferring property by gift, bequest or inheritance. This transfer tax takes the form of a gift tax in the case of completed lifetime gifts and an estate tax in the case of property owned by the decedent at the time of death. Gift and estate taxes are computed on the progressive unified rate schedule set forth in Section 2001 of the Internal Revenue Code with rates as high as 40 percent. As of 2022, the lifetime estate and gift tax exemption for U.S. domiciled single filers is $12.06 million and $24.12 million for married couples U.S. domiciliaries filing jointly. For nonresident aliens not domiciled in the United States, there is only a credit equivalent to $60,000 against the estate tax, unless an applicable treaty allows a greater credit.
With recent economic growth in the United States, absent a comprehensive estate tax plan, many U.S. citizens and nonresidents (that have U.S. based assets) will be subject to the U.S. estate and gift tax. A basic goal of estate tax planning is to transfer as much property to designated beneficiaries with as little taxation as possible. One way to transfer property to designated beneficiaries would be through a self-cancelling installment note or “SCIN.” If done correctly, a SCIN may be used as a vehicle to transfer property to loved ones without triggering the estate and gift tax. This article discusses how a SCIN may be a feasible estate planning tool.
Introduction to Self-Canceling Installment Notes
A SCIN is a technique that is sometimes used to avoid the inclusion of a note receivable in the holder’s estate.
For example, Mom sells Blueacre to Son for a note. Son’s note is for a period of ten years or Mom’s life, whichever is shorter. If Mom dies before the note is fully paid, the note is not technically canceled- rather, it has been satisfied, because all payments required pursuant to its terms have been made. Therefore, there is nothing to include in Mom’s estate. However, in order for Mom not to have made a gift to Son at the outset, the consideration for Blueacre would have had to be more than would have received under a straight 10-year note, to reflect the fact that Son would not have had to pay the whole price if Mom died during the period. In addition, in a case where Mom’s life expectancy is less than the term of the note, the Internal REvenue Service (“IRS”) has taken the position that the transaction will be taxed for income tax purposes as a private annuity.
A SCIN is an installment obligation that terminates on the occurrence of a certain event (often the seller’s death) before it is otherwise due. The SCIN may be treated as a private annuity or an installment sale. If there is a stated maximum payment that will be made within the seller’s life expectancy, based on Table V of Treasury Regulation Section 1.72-9, the transaction will be treated as an installment sale. See GCM 39503 (June 28, 1985). If not, the Internal Revenue Service (“IRS”) may tax the transaction as a private annuity. A private annuity is a transaction in which one individual sells another individual an item of property in exchange for an annuity, often measured by the seller’s lifetime. The actuarial tables issued under Section 7520 of the Internal Revenue Code are used in ordinary circumstances to determine the value of the annuity for estate and gift tax purposes.
Because the seller may die before receiving payments equal to the property’s value, the IRS may assert that the SCIN is not full and adequate consideration for the property being transferred, thus triggering adverse tax consequences for the seller or the seller’s estate. For the SCIN to constitute full and adequate consideration, the payment terms must reflect not only the value of the property transferred, but also a premium. The premium compensates for the risk that a premature death may result in the seller receiving less than the value of the property transferred. The buyer must pay a premium for the property to be sure that the original sale is not a partial gift for gift tax purposes. See IRC Section 7822. The premium can be reflected in a higher interest rate or a higher purchase price. A SCIN is not generally includable in the seller’s estate. See Estate of Moss v. Commission, 74 T.C. 1239 (1980). That is, unless the SCIN were to be recharacterized as a retained interest in the property. In such a case, the property would be included in the seller’s estate.
Below is a discussion of two Tax Court court cases that have authorized the use of SCINs for estate and gift tax purposes.
Estate of Moss
In Estate of Moss v. Commissioner, 74 TC 1239 (1980), the decedent sold his stock in a funeral home for a SCIN calling for monthly payments of principal and income for a set term. The note also provided for the cancellation of the remaining payments should the decedent fail to survive the term of the note. In this case, the decedent was in good health when he entered into the transaction. Even though the decedent was in good health when he executed the SCIN, he failed to survive the term stated on the SCIN. The IRS took the position SCIN in this case was either one of the following: 1) the decedent retained control of the debt until death and forgave it by will; or 2) the decedent made an assignment of the note to be effective on his death. The IRS further argued that in either case, the stock transferred through the SCIN should be recharacterized as a retained interest in the property and be included in the decedent’s estate for estate tax purposes. The Tax Court disagreed with the IRS position and determined that the SCIN did not represent anything of value to the decedent at death and as a result, the SCIN was drawn back the decedent’s estate for purposes of the estate tax.
Estate of Costanza
In Estate of Costanza v. Commissioner, TCM 2001-128, 81 TCM (CCH) 1693 (2001), rev’d and remanded, 320 F.3d 595 (6th Cir. 2003), the decedent sold his interest in a restaurant and commercial real estate to his son in exchange for a SCIN. The SCIN provided for monthly installments over an eleven-year period and included a cancellation on death provision. The son made the first three monthly payments by backdating checks and made no further payments during the decedent’s lifetime. The decedent died five months after the SCIN was issued. The SCIN provided for an initial interest rate of 6.25%, increasing every two years, until it reached 8.75% for the final 12 months of the term. In January 1993, the first month of the SCIN, the Applicable Federal Rate was 7.63%.
The Tax Court held that assets sold in exchange for a SCIN were included in the decedent’s estate because there was no bona fide transaction for full and adequate consideration. The Tax Court focused on the parties’ failure to follow the terms of the agreement as evidence that the transaction was not made at arm’s length or for adequate consideration. The Sixth Circuit Court of Appeals reversed, holding that the discrepancies were adequately explained, and that the parties could not have known that the decedent would die during the note term. More importantly, the Sixth Circuit specifically rejected an argument by the IRS that would invalidate all SCINs- namely, that a sale in exchange for a SCIN is not bona fide because the only reason to enter into such a transaction is the expectation that the decedent will die during the term of the note. The Sixth Circuit also ruled that the testimony of medical experts that the decedent had a five to 13 1/2 year life expectancy was sufficient to show that, at the time the transaction was entered into, the decedent had a real expectation of repayment.
We will next discuss considerations regarding the structuring of a SCIN.
Structuring the SCIN So as Not to Trigger the Estate and Gift Tax
In order to avoid the estate and gift tax consequences of transferring property using a SCIN, the instrument must contain a self-cancellation provision. At a minimum, the self-cancellation provision should state that SCIN is bargained for as part of the consideration for the sale of the property. The purchase price of the property must reflect a principal risk premium either in the form of a above market sale price or an interest rate premium (above market interest rate). Finally, the seller of the property should not maintain any control of the property transferred.
Failure to follow these rules may result in the IRS treating the transfer as a taxable gift or the transfer being included in the decedent’s gross estate for estate tax purposes. . The gift or estate tax may be assessed on the entire value of the property sold, less the consideration actually paid. The probability of the IRS recharacterizing the transfer may be avoided by structuring the SCIN as much as possible like a traditional mortgage. However, unlike a traditional mortgage, the property sold should not be used as collateral for the note. Using the transferred property as collateral may result in the IRS taking the position that the seller maintains control over that asset.
What Interest Rate or Discount Rate Should be Used in a SCIN
Selecting the appropriate market rate of interest is one of the most difficult steps in the process of SCIN planning. For income tax purposes, SCINs are subject to the installment sales rules. Section 483 of the Internal Revenue Code applies to installment sales. The general rule under Section 483 is that the interest rate on an installment sale note must equal the appropriate applicable federal rate (“AFR”) with semiannual compounding. The AFR is a federally determined rate. It is published monthly, and a different rate is determined for short-term (three years or less), mid-term (more than three years but not more than nine years), and long-term (more than nine years) obligations. See IRC Section 1274(d)(1). These rates are based on the average market yield, during any one-month period ending in the calendar month in which the determination is made, on outstanding marketable obligations of the United States with remaining periods of maturity of three years or less (for short-term obligations), and corresponding periods for mid and long term obligations. Options to renew or extend are taken into account in determining the length of the term. See IRC Section 1274(d)(3). The AFR is determined based on semiannual compounding, and rates are published each month which convert the AFR to interest rates which are compounded at different time periods.
The Maximum Allowable Term of a SCIN
The term of a SCIN should not exceed the seller’s actuarial life expectancy. If the term of the note extends beyond the seller’s life expectancy, the IRS is likely to recharacterize the note as a private annuity for income tax purposes. This may result in the IRS treating the transaction as a private annuity. In such a case, if the seller dies before the note is paid and the note/property is not included in his or her estate, the purchaser’s basis will be adjusted to reflect the unpaid amount of the note, or, if the purchased asset has been disposed of, deferred gain will be recognized. See GCM 39503 (june 28, 2005).
The IRS’s position is that the seller’s unrecognized gain on the date of death is taxable to the seller’s estate as income in respect of a decedent. This position has been litigated. See Frane v. Commissioner, 998 F.2d 567 (8th Cir. 1993). It may be possible to avoid this problem area be disposing of the note before the seller’s death and thereby accelerating the gain (thus getting the income tax out of the estate) if death during the term appears likely, although the other consequence of the disposition (e.g., a taxable gift of an asset which is not included in the estate) must always be considered.
The Type of Repayment Schedules That Can be Used in SCINs
Installment notes may be designated with virtually any schedule of payments, but they most frequently conform to one of two basic payment schedules level-principal notes equal periodic payments of principal on the note together with accrued with accrued interest. Level payment self-amortizing notes are the second most frequently used type of installment note. This type of note is similar to the standard home with level annual payments. With this type of note, the principal portion of each payment starts low but increases with each payment. Conversely, the interest component starts high but declines as a greater portion of the principal on the note is paid off.
In either case, the term of the installment note may be less than the amortization or principal recovery period of the note. If the amortization or principal-recovery period of the note is greater than the term of the note, the last payment in the term of the note, called a balloon payment, is larger than the rest of the payments. It is equal to the remaining principal balance of the note plus the normal payment.
In summary, a SCIN may be a feasible estate-planning tool, but it must be used carefully and the note must be properly drafted.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.