Historically low interest rates have made self-canceling installment notes (SCIN) an attractive estate-planning tool and a viable alternative to life insurance.

Real property is one asset that, as we know, has declined in value during recent months and may be a prime candidate for an intra-family transfer. The asset can be given or sold at its seemingly depressed value allowing its post-transfer appreciation to escape gift and estate tax.

If a client already has used his $1 million gift tax exemption, he should consider selling the asset to an irrevocable grantor trust (IGT) created for the benefit of his family. For income tax purposes, the grantor of an IGT is treated as the owner of the trust assets.1 As a result, a sale of property to the IGT by the grantor will not be treated as a sale or exchange for income tax purposes,2 and no gain or loss will be recognized as a result of the sale. The grantor's tax basis in the property would carryover to the IGT.

For example: a 50-year-old client sells rental real estate having a fair market value (FMV) of $10 million to an IGT. In return, the IGT gives the client a $10 million promissory note that provides for annual interest-only payments and a balloon payment of principal at the end of nine years. Current interest rates make this technique particularly attractive because a note with a nine-year term would require an interest rate of just 1.65 percent using the February 2009 mid-term applicable federal rate. The interest payments received by the client are not treated as interest income to the client.

You can think of a sale to an IGT as a “freeze” technique. That is, the client has transformed a $10 million asset with unlimited growth potential into an asset with a frozen growth rate of 1.65 percent for a period of nine years. The sale will be successful for estate-planning purposes if the real estate's average annual rate of return is greater than 1.65 percent.

Now, here's the complication: If the client dies during the term of the note, its value will be included in the client's estate for estate tax purposes. This would result in an estate tax liability of $5 million assuming a 50 percent combined federal and state estate tax rate. To fund this liability, you may recommend to the client that the IGT also purchase a $5 million insurance policy on the client's life. The client could make annual gifts to the IGT or the IGT could use rental income from the real estate to fund the premium payments.

Now here comes a further complication: The client's health may be such that acquiring life insurance on his life may be impossible or cost prohibitive.

Then, you may want to consider what I refer to as “SCINsurance.”

SCIN Now

Another way to fund the client's estate tax liability with respect to the note is to structure the note as a SCIN. Simply put, the note contains a clause saying that if the seller (the client) dies before the note is paid in full, any unpaid amounts are canceled and no further payments are due. The client's death during the term of the note creates a windfall for the IGT, because it won't have to pay the unpaid balance of the note. Also, the value of the note is now zero for estate tax purposes, resulting in an estate tax savings of $5 million in the seller's (client's) estate.

I like to think of the SCIN premium as an insurance premium, or “SCINsurance,” because the cancellation feature of a SCIN acts like term life insurance on the client's life. The beneficiary of this insurance is the IGT. Rather than receiving insurance proceeds in the event of the client's death, the IGT's indebtedness to the client is canceled. In effect, the client's estate tax liability with respect to the note is “insured” by the SCIN premium.

To avoid being treated as a private annuity, the term of a SCIN cannot be longer than the client's life expectancy determined using the Internal Revenue Service mortality tables.3 The IRS mortality tables can be used to calculate the client's life expectancy as long as the client is not terminally ill at the time of the sale. An individual is considered terminally ill if there is at least a 50 percent probability of death within one year. If the client survives for 18 months or longer after the sale, he will be presumed to have not been terminally ill at the time of the sale unless there is clear and convincing evidence to the contrary.4

The IGT's potential windfall in the event of the client's death is not without cost. The IGT must adequately compensate the client for his mortality risk. This means that the IGT must pay a premium in the form of an increased purchase price (principal premium), a higher-than-market interest rate (interest rate premium) or a combination of both. (See “Playing It Close to the Edge,” this page.)

If the promissory note is structured as an interest-only SCIN with an interest rate premium (INT-SCIN), the note would require an interest rate premium of 0.724 percent.5 Therefore, the interest rate on the note would be 2.374 percent (1.65 percent plus 0.724 percent). SCINsurance will cost the IGT an additional $72,400 per year in interest. Assuming the client is in good health, that premium is expensive — the equivalent of a $5 million nine-year term life insurance policy on the client's life. But keep in mind that the premium is not being paid to an insurance company. Rather, the premium is being paid to the client and it will be returned to the client's family upon his death, after estate tax. So, the net after-tax cost of the SCINsurance is just $36,200.

If the promissory note is structured as an interest-only SCIN with a principal premium (PRIN-SCIN), the principal premium would be $621,306. Therefore, the face amount of the note under the PRIN-SCIN would be $10,621,306. In actuality, a PRIN-SCIN has both a principal premium and an interest premium. The principal premium is paid at the end of the note term when the balloon payment is made while the interest premium is paid annually due to the larger face amount of the note. But if the client dies during the term of the PRIN-SCIN, the SCINsurance will cost less than it otherwise would have using an INT-SCIN. First, since the principal of the note will be forgiven upon the client's death, the PRIN-SCIN's principal premium will never be paid. Second, interest payments made under a PRIN-SCIN during the client's life are generally less than those made under an INT-SCIN.

PRIN-SCIN vs. INT-SCIN

When using an interest-only SCIN, the better estate-planning play is to use a PRIN-SCIN rather than an INT-SCIN if you have reason to believe that your client is likely to die during the note term. If the client dies during the term of a PRIN-SCIN, the IGT will never pay the principal premium because the entire principal, including the premium, will be forgiven. In contrast, if the client dies during the term of an INT-SCIN, the IGT will pay the interest premium at least up until the client's death.

In other words, the PRIN-SCIN has smaller interest payments during the client's life and larger debt forgiveness upon the client's death. Thus, if the client dies during the term of the SCIN, the IGT will be better off if the SCIN is structured as a PRIN-SCIN rather than an INT-SCIN. (See “If Client Dies During SCIN Term,” p. 34.)

The potential estate tax savings become even more dramatic when the term of the note is lengthened. (See “Longer SCIN Terms Are Better,” p. 35.)

As Interest Rates Rise

The mortality risk premium associated with a SCIN is tied to interest rates. As interest rates rise, the cost of SCINsurance will increase and at some point will become cost prohibitive. However, when dealing with a client with a shorter-than-normal life expectancy, a SCIN will remain an attractive estate planning tool and a viable alternative to life insurance.
The author thanks his partner, David A. Handler, for his contributions to this article.

Endnotes

  1. Internal Revenue Code Section 671.
  2. Revenue Ruling 85-13, 1985-1 C.B. 184.
  3. See General Counsel Memorandum 39503 (June 28, 1985).
  4. Treasury Regulations Section 25.7520-3(b)(3).
  5. Assumes client is age 50, a mid-term applicable federal rate of 1.65 percent and a nine-year note term.

Angelo F. Tiesi is a partner in the Chicago office of Kirkland & Ellis

PLAYING IT CLOSE TO THE EDGE

Longer SCIN term means larger risk premiums

To maximize the mortality leverage of a self-canceling installment note (SCIN), you can increase the term up to the client's life expectancy. But increasing the term also increases the probability that the client will die during that time. This, in turn, results in a higher interest rate premium or principal premium to be applied to the note.

Compare a 50-year-old client with a 60-year-old client. Here's the principal premium and interest rate premium applicable to a $10 million interest-only SCIN using the February 2009 applicable federal rate of 1.65 percent:

Age 50
Note Term (in years) Principal Premium Total Principal Interest Rate Premium Total Interest Rate Note Term (in years) Principal Premium Total Principal Interest Rate Premium Total Interest Rate
9 $621,306 $10,621,306 0.724% 2.374 % 9 $1,538,944 $11,538,944 1.716% 3.366%
15 1,210,788 11,210,788 0.951 3.911 15 2,988,269 12,988,269 2.171 5.131
20 1,917,680 11,917,680 1.167 4.127 204,787,63514,787,6352.596 5.566
25 2,854,132 12,854,132 1.422 4.381 25 exceeds life expectancy
Angelo F. Tiesi

IF CLIENT DIES DURING SCIN TERM

The IGT will be better off if the SCIN were structured as a PRIN-SCIN rather than an INT-SCIN

Compare an irrevocable grantor trust (IGT) of a client who dies on the eighth anniversary of the nine-year interest-only self-cancelling installment note (INT-SCIN), with a client who dies on the eighth anniversary of a nine-year interest-only SCIN with a principal premium (PRIN-SCIN). A PRIN-SCIN saves the IGT $497,188 — that translates into an estate tax savings of $248,594.

Nine-Year
INT-SCIN
Note principal: $10 million
Interest rate: 2.374%
Nine-Year
PRIN-SCIN
Note principal: $12,854,132
Interest rate: 1.65%
Year Payment Amount Total Payments Year Payment Amount Total Payments
2010 $237,400 $237,400 2010 175,252 $175,252
2011 237,400 474,800 2011 175,252 350,503
2012 237,400 712,200 2012 175,252 525,755
2013 237,400 949,600 2013 175,252 701,006
2014 237,400 1,187,000 2014 175,252 876,258
2015 237,400 1,424,400 2015 175,252 1,051,509
2016 237,400 1,661,800 2016 175,252 1,226,761
2017 237,400 1,899,200 2017 175,252 1,402,012
2018 10,237,400 12,136,600 2018 10,796,558 12,198,570
Assumptions:
• 50-year-old client
• $10 million sale
• Nine-year interest-only SCIN
• February 2009 long-term applicable federal rates of 2.96 percent
— Angelo F. Tiesi

LONGER SCIN TERMS ARE BETTER

A PRIN-SCIN saves more in estate tax when compared to an INT-SCIN as the SCIN term increases

If client dies at the end of the 24th year (in 2033), the irrevocable grantor trust (IGT) is saved $1,382,832 by using a principal premium self-cancelling installment note (PRIN-SCIN) over an interest-only self-cancelling installment note (INT-SCIN). That translates into an estate tax savings of $691,416.

25-year
INT-SCIN
Note principal: $10 million; Interest rate: 4.381%
25-year
PRIN-SCIN
Note principal: $12,854,132; Interest rate: 2.96%
Year Payment Amount Total Payments Year Payment Amount Total Payments
2010 $438,100 $438,100 2010 $380,482 $380,482
2011 438,100 876,200 2011 380,482 760,964
2012 438,100 1,314,300 2012 380,482 1,141,446
2013 438,100 1,752,400 2013 380,482 1,521,928
2014 438,100 2,190,500 2014 380,482 1,902,410
2015 438,100 2,628,600 2015 380,482 2,282,892
2016 438,100 3,066,700 2016 380,482 2,663,374
2017 438,100 3,504,800 2017 380,482 3,043,856
2018 438,100 3,942,900 2018 380,482 3,424,338
2019 438,100 4,381,000 2019 380,482 3,804,820
2020 438,100 4,819,100 2020 380,482 4,185,302
2021 438,100 5,257,200 2021 380,482 4,565,784
2022 438,100 5,695,300 2022 380,482 4,946,266
2023 438,100 6,133,400 2023 380,482 5,326,748
2024 438,100 6,571,500 2024 380,482 5,707,230
2025 438,100 7,009,600 2025 380,482 6,087,712
2026 438,100 7,447,700 2026 380,482 6,468,194
2027 438,100 7,885,800 2027 380,482 6,848,676
2028 438,100 8,323,900 2028 380,482 7,229,158
2029 438,100 8,762,000 2029 380,482 7,609,640
2030 438,100 9,200,100 2030 380,482 7,990,122
2031 438,100 9,638,200 2031 380,482 8,370,604
2032 438,100 10,076,300 2032 380,482 8,751,086
2033 438,100 10,514,400 2033 380,482 9,131,568
2034 10,438,100 20,952,500 2034 13,234,614 22,366,182
Assumptions:
•50-year-old client
•$10 million sale
•25-year interest-only SCIN
•February 2009 long-term applicable federal rates of 2.96 percent
Angelo F. Tiesi