Self-Cancelling Installment Note

The use of a Self-Cancelling Installment Note (SCIN) can be a very tax efficient method for transferring business interests to succeeding generations.

A SCIN is nothing more than a promissory note which includes a self-cancellation feature in the event the seller should die during the note term. This self-cancelling feature alleviates the borrower from any future payment obligations upon the death of the seller. From an estate valuation standpoint, upon death the note results in a zero value for estate tax purposes. The IRS has taken a position that if the SCIN’s cancellation, due to the seller’s death, will result in the seller’s estate recognizing deferred gain from the sale on the estate’s first income tax return. This will offset some of the estate tax benefits provided by the SCIN. One way of avoiding this income tax is to have the seller sell to his grantor trust.

Since the SCIN is nothing more than an installment note with a term contingent on the earlier of the seller’s life expectancy or a number of years, the SCIN valuation often relies on actuarial tables under IRC Section 7520 in determining the fair market value of the note. The fair market value of the SCIN must equal or exceed the fair market value of the property sold in order to avoid making a gift. The valuation of the SCIN must account for the risk of an early cancellation in the event of the seller’s death, commonly known as “Risk Premium”. This can be accomplished by increasing the purchase price or using a higher interest rate or maybe a combination of both.

SCINs can be an attractive strategy for transferring assets from one generation to the next, especially where a family business is involved. By way of illustration, a parent could structure an installment sale to his children or trusts for their benefit using a SCIN. If the parent were to die during the term of the SCIN, the self-cancellation provision may remove a significant amount of the fair market value from the seller’s estate in addition to relieving the buyer from on-going payment obligations.

The buyer may receive a stepped-up tax basis in the assets and possibly a deduction for interest payments, subject to typical limitations on interest deductibility. The sale will be a taxable event for the seller, usually reportable under the installment sale method if elected, unless the transaction involves the seller’s grantor trust which would then make the transaction income tax neutral.

Naturally, there is more wealth transfer if the seller should die earlier in the SCIN term; thus, these types of transactions work best for individuals between the ages of 60 to 80, who may anticipate shorter than actuarially projected life expectancies.

The use of life insurance can be used as a complement to the transaction to hedge its risks, i.e. IRS adjustments to valuation of the note resulting in gift tax liability, can equalize other heirs of the seller who may not be participating in the sale.

The IRS has renewed its interest in Self-Cancelling Installment Notes thus causing reluctance by many estate planning professionals to implement. A recent CCA issued by the IRS, CCA 201330033, considered how much of the decedent’s sale of stock in a closely held company to his grantor trust in exchange for a SCIN resulted in gifts subject to Federal gift tax as well as any attendant estate tax consequences due to the cancellation of payments under the SCIN upon the death of the decedent. In the end, the IRS determined that a gift resulted from the SCIN transaction due to the value of the stock exceeding the value of the consideration provided for in the note. Due to the position taken by the IRS in the CCA, SCIN transactions will most likely come under greater scrutiny by the IRS. One way of minimizing the burden of unexpected gift or estate tax liability may be incorporating life insurance into the estate plan. Providing additional revenue upon a decedent’s death can ease any liquidity concerns if a Federal tax payment arises.

For the right client, a SCIN can serve as a very tax efficient tool in passing appreciated assets to future generations.