A self-cancelling installment note (SCIN) is a technique used by estate planners to transfer value out of the estate of an individual at no gift tax cost.1 The transaction works by having a client sell an asset to a family member or trust in exchange for a promissory note that includes a self-cancellation feature, which terminates the note and cancels the outstanding balance if the client dies during the term of the note. In addition to interest on the promissory note, a SCIN includes a risk premium for the self-cancellation provision. If the client survives, he’s wholly repaid on the note with the additional consideration of the risk premium. If he doesn’t survive, the asset and the remaining note balance are removed from the client’s estate, and value has been shifted transfer-tax free to the buyer without any additional obligation on the note.
This technique can produce a significant upside, because the generally accepted benchmark to value the risk premium on the self-cancellation feature was the Internal Revenue Service-published mortality tables – tables that only take a client’s health into account if he has a “terminal condition” and not if the client’s health is poor, but not terminal. However, in CCA 201330033, published on July 26, 2013, the IRS stated that the mortality tables didn’t apply to value the SCIN; rather the transferor’s life expectancy had to be considered in light of his particular medical history as of the date of the gift to determine the value of the SCIN. In doing so, the IRS appears to upend a widely accepted practice for calculating the risk premium.
Use of SCINs in Estate Planning
An intra-family installment sale, when a transferor sells an asset in exchange for a promissory note, is a commonly-used estate planning technique, which is especially advantageous in the current low-interest rate environment. By transferring an asset in an installment sale, the asset and its future appreciation are removed from the transferor’s estate and replaced with a low-interest promissory note. The minimum interest rate is determined using the IRS applicable federal rate (AFR) given the term of the note and may be interest-only with a balloon-payment or fully or partially amortized. If the asset’s income and appreciation are greater than the AFR (the so-called “hurdle rate”), this effectively leverages value outside of the transferor’s estate at no gift-tax cost. If the transferor dies before the note is fully repaid, the remaining value of the note is included in the transferor’s gross estate. A SCIN is a variation of the installment sale technique. The unique feature of a SCIN is that the promissory note contains a self-cancelling provision that cancels any outstanding balance on the note if the transferor (the payee on the note) dies during its term. As a result, the SCIN has no value in the transferor’s estate, and the entire value is transferred to the buyer free of transfer taxes. SCINs are often used as a wealth transfer technique by related parties when the transferor isn’t expected to live past his life expectancy because of this potential to transfer significant value out of the transferor’s estate with no gift or estate tax cost.
Estate Tax Consequences
The IRS initially argued that the outstanding balance of the SCIN at the time of the transferor’s death was includible in his estate because the cancellation feature was no different from a transferor who forgave the remaining payments on a note through a testamentary forgiveness of debt. However, in Estate of Moss, the Tax Court rejected the IRS’ position.2 In Moss, a taxpayer sold his company’s stock to his employees in exchange for a SCIN. The principal to be paid under the SCIN was a higher price than the book value of the stock at the time of transfer. Given the increased price, the Tax Court found that the “cancellation provision was part of the bargained for consideration provided by decedent for the purchase price of the stock. As such, it was an integral provision of the note.3 Therefore, the Tax Court concluded, the cancellation feature wasn’t the same as a testamentary forgiveness of debt, and the outstanding balance wasn’t includible in the taxpayer’s gross estate. The IRS ultimately acquiesced to the result of this ruling4 and has continued to recognize this principle.
Gift Tax Consequences
A SCIN shouldn’t result in gift tax, provided the transaction is bona fide and the terms of the note reflect full and adequate consideration (that is, the value of the transferred property with interest plus the risk premium). To be a bona fide transaction, a transferor holding a SCIN should have a reasonable expectation of repayment and an intent to enforce the collection of indebtedness at the time of the transaction. In addition to the indicia of genuine debt, such as seed equity and an ability to repay, the self-cancellation feature also looks to the transferor’s life expectancy with regard to the parties’ expectations of repayment. For example, a transaction may be found to not be bona fide if the transferor’s death is so imminent that neither party reasonably expects that payments will be made under the note. Transactions between family members are subject to a higher level of scrutiny on these considerations. For example, the IRS was able to successfully challenge a SCIN transaction as not bona fide in Estate of Musgrove, as the note was unsecured, the parties failed to schedule regular payments, the note provided for no interest and the evidence showed no expectation of repayment.5 The SCIN should provide for a risk premium for the self-cancellation feature in addition to the AFR to qualify as full and adequate consideration. The purpose of the risk premium is to provide consideration for the transferor to account for the risk that he won’t be paid on the note and to charge the transferor for the benefit he would obtain by the early death of the transferor. The risk premium can be paid in one of two ways: increasing either the principal amount of the note or the interest rate. Determining the appropriate risk premium presents a struggle between protecting against the gift tax risk, while maintaining the estate planning benefits. Every additional dollar due on the SCIN that’s attributable to the risk premium is an additional dollar needed to clear the hurdle rate for an effective leveraged sale transaction. However, if the risk premium is too low, the transaction won’t be for full and adequate consideration and under IRC Section 2512, the difference between the fair market value (FMV) of the property transferred and the value attributed to the SCIN will be deemed a gift.
How to Calculate the Risk Premium
Calculating the risk premium has been a source of uncertainty because there’s a dearth of Treasury regulations, court decisions or IRS guidance that explicitly applies to SCIN transactions. A common practice by estate planners has been to use the IRC Section 7520 or Section 7872 tables to calculate the risk premium. These methods are also used in popular estate planning software. Some commentators have recommended using the actual life expectancy determined by an actuary as a conservative approach. The IRS calculated the risk premium of a SCIN in Dallas v. Commissioner, a 2006 Tax Court Memorandum opinion. In that case, the taxpayer transferred stock to a trust he created in exchange for an upfront cash payment and a promissory note with a face value of $2.232 million, which represented the proportionate value of the stock transferred with no risk premium added.6 The taxpayer took the position that the note wasn’t a SCIN, and therefore, a risk premium wasn’t appropriate.7 The Tax Court sided with the IRS in finding that the note was a SCIN and that its FMV was reduced from $2,232,000 to $1,687,704 to account for the self-cancellation provision, resulting in a gift of $544,296.
Neither the IRS nor the Tax Court explained how the IRS arrived at the risk premium in Dallas; however, commentary analyzing the value suggests that the IRS relied upon the mortality table in IRS Publication 1457 with the Section 7872 rate to calculate the risk premium to account for the possibility that the transferor wouldn’t outlive the term of the note.8 In reference to SCINs, the IRS noted in a 1986 General Counsel Memorandum that, because there’s no requirement that the actuarial tables be used in determining the gift taxation of an installment sale, there was more room to establish that the terms of a sale are reasonable, though they didn’t indicate that such tables shouldn’t be employed in the calculation.9 With limited guidance and IRS mortality tables that had been used by both practitioners and the IRS to value SCINs, relying on this method of calculation became a generally accepted practice.
In addition to using IRS mortality tables to calculate the risk premium for a SCIN, estate planners relied on the safe harbor provisions in the Treasury regulations under Section 7520. Under the regulations, taxpayers could rely on the mortality tables, as long as the taxpayer didn’t have a “terminal illness.” The regulations consider an individual to be terminally ill if he’s known to have an incurable illness or other deteriorating physical condition and “there is at least a 50 percent probability that the individual will die within 1 year.10 Additionally, if the individual survives more than 18 months after the transaction, “that individual is presumed to have not been terminally ill at the date of death unless the contrary is established by clear and convincing evidence.”11 These safe harbors allow taxpayers who aren’t terminally ill, but have health concerns, to take advantage of the mortality tables.
CCA 201330033
This Chief Counsel Advice involved a taxpayer who entered into two transactions in which he sold stock in exchange for a SCIN. The first transaction involved an interest-only note with a face value of nearly double the value of the stock to account for the risk premium. The second transaction was similarly an interest-only note, but the risk premium was incorporated into the interest rate on the note. In each instance, the note matured near the taxpayer’s life expectancy, had a self-cancelling feature and the risk premium was calculated using Section 7520 and related mortality tables. Shortly after the transaction, the taxpayer was diagnosed with an illness and passed away within six months, having never received an interest or principal payment on either SCIN.
In considering how the FMV should be determined for the above transactions, the IRS stated that it didn’t believe that the Section7520 tables applied to value notes and that those tables applied “only to value an annuity, any interest for life or term of years, or any remainder.”12 The IRS further stated, “these notes should be valued based on a method that takes into account the willing-buyer willing-seller standing in §25.2512-8. In this regard, the decedent’s life expectancy, taking into consideration decedent’s medical history on the date of the gift, should be taken into account.”13 The IRS concluded that “because of the decedent’s health, it was unlikely that the full amount of the note would ever be paid. Thus, the note was worth significantly less than its stated amount, and the difference between the note’s fair market value and its stated amount constitutes a taxable gift.”14
The facts in the CCA don’t indicate that the taxpayer had any known illness at the time of the transaction. Further, in stating that the Section 7520 tables weren’t applicable, the IRS disregarded a generally accepted practice of calculating the risk premium on a SCIN, similar to the method employed by IRS itself in Dallas. More importantly, the IRS didn’t state what the appropriate method is to calculate a risk premium. The IRS noted certain bad facts that were present in this situation that may have affected its decision or may affect future decisions, including the fact that the notes didn’t pay principal until the end of the term, and the IRS didn’t think the taxpayer had a reason to enter into the transaction (for example, to receive to a steady stream of income in retirement). The IRS reasoned that “the arrangement in this case was nothing more than a device to transfer the stock to other family members at a substantially lower value than fair market value of the stock.”15
SCIN Planning After CCA 201330033
This new position taken by the IRS in CCA 201330033 casts serious doubt over the widely accepted practice of calculating the risk premium on a SCIN. The standard applied by the IRS in this CCA creates uncertainty for all other SCIN transactions in determining the appropriate risk premium, particularly if an analysis of the client’s medical history at the time of the transfer is required. Further, this CCA may open the floodgates to challenging every SCIN in which the estate planner relied upon the Section 7520 or Section 7872 mortality tables, even if no medical condition was known at the time of the transfer.
This CCA has the potential to significantly reduce the number of SCIN transactions. To continue using this technique, practitioners should consider obtaining an actuarial valuation of the client’s life expectancy to calculate the risk premium to avoid gift tax exposure. However, this may substantially increase the cost of the transaction, and a client may find it overly intrusive given the potential need for a medical examination and family history. Additionally, the use of the Section 7520 or Section 7872 tables is a significant aspect of what made the SCIN a popular planning technique, because of the potential upside for a client whose health suggests he wouldn’t live to average life expectancy. As a result, CCA 201330033 is likely to breathe new life into other planning techniques, such as private annuities, that have received less attention in light of the popularity of SCINs.
Endnotes
1. The income tax consequences of a SCIN transaction will vary depending on the specific facts and are beyond the scope of this Article.
2.Estate of Moss v. Commissioner, 74 T.C. 1239 (1980), acq. in result, 1981-2 C.B. 1.
3.Ibid. at 1246-1247.
4. 1981-1 C.B. 2.
5.Estate of Musgrove v. United States, 33 Fed. Cl. 657 (1995).
6.Dallas v. Comm’r, T.C. Memo. 2006-212.
7. The taxpayer didn’t offer an alternative method of calculating the risk premium.
8. Edward P. Wojnaroski, Jr, 805-3rd., “Private Annuities and Self-Canceling Installment Notes,” Tax Mgmt. Est., Gifts & Tr. (BNA) at A-96, n.1104 (2010).
9. Internal Revenue Service Gen. Couns. Mem. 39503 (May 19, 1986).
10. Treasury Regulations Section 1.7520-3(b)(3).
11.Ibid.
12. CCA 201330033 (July 26, 2013).
13. CCA 201330033 (July 26, 2013), citing I.R.S. Gen. Couns. Mem. 39503.
14. CCA 201330033 (July 26, 2013).
15. Ibid.
