Self-Canceling Installment Notes

An additional family wealth transfer vehicles is a self-canceling installment note (SNIN), frequently referred to as a death-terminating installment note that has characteristic of both a private annuity and an installment sale. This vehicle is primarily an estate tax planning device.

Say, for example, that parents who are likely to be subject to estate tax have a piece of highly appreciated investment real estate that they wish to transfer to their children. To do so via a testamentary transfer would incur significant estate tax, but give their children a step-up in basis for income tax purposes. To do so as a lifetime gift would subject the date-of transfer value of the gift to the highest transfer tax rates at the time of the parents' death under the current unified transfer tax system, and would also give the children the parents' historical tax basis for purposes of determining gain or loss when the children sold the property. Heads you lose, tails you lose.

An alternative is to sell the property to the children at an arm's length fair market value during the parents' lifetimes in exchange for an installment note carrying the minimum interest rate that the Internal Service will permit. The children should make at least annual payments on the note at which time the parents recognize a proportionate share of the gain as taxable income at favorable capital gains rates for investment property. The note would contain a provision that upon the death of the seller (one or both of the parents), the balance of the note is cancelled.

Since the transfer was for full and adequate consideration in a sale, the property is removed from the sellers' federal gross estate. Therefore, the date-of-death fair market value of the property is not subject to federal transfer tax. Likewise, since the transfer was for full and adequate consideration in a sale no portion of the transaction is a gift to the children, and not subject to the gift tax provisions of the law. In addition, the children's basis for income tax purposes is the price they actually paid for the property (the face amount of the note plus any down payment).

Upon the sellers' death, cancellation of the note is treated as the disposition of an installment obligation to a related party. The remaining unrecognized gain on the note is included in the final income tax return of the sellers (or the first income tax return of their estate) and taxed at capital gains rates. In a variation of this scheme, the parents can forgive receipt of annual installments, thereby creating a taxable gift to the children of the installment amount foregone. Since this is a gift of a present interest, the forgiveness qualifies for the annual gift tax exclusion. The parents still recognize their proportionate share of the installment gain, just as if they had received payment from the children and made a cash gift back to them.

Self-canceling installment notes are not for every family. Nor should they be undertaken without review and approval of legal and tax counsel working together. SCINs represent a play on the time the capital gains tax is paid, and the difference in higher estate tax rates and lower capital gains rates. If the sellers outlive the term of the note, they will have recognized (and paid capital gains tax) on the full amount of the inherent gain in the property as they received those payments. From the standpoint of the time value of money, the present value of the tax payments may be significantly less than having to pay it all in the year of sale. One caveat should be mentioned; planners must carefully understand the character of the gain to be realized by the sellers on the sale of the property. To the extent the sale would generate ordinary income; all such income is treated as having been receiving in the first installment payment, even if no payment is made. The event can distort the desired present value of the tax objectives as to the timing of gain recognition if it is not recognize and planned for. In a similar manner, this technique may not work well at all of the property being sold is ordinary income property (inventory, for example), or has a high degree of ordinary recapture from depreciation.

When the need is present and the proper assets are available, a self-canceling note may be an effective tool to move wealth from one generation to another with minimal tax impact to the buyer or the seller.

©2008 Ronnie C. McClure, PhD, CPA