Main Menu Name: SCIN
Calculates the required principal premium and the interest premium on a self-canceling installment note for gift and estate tax purposes. It also calculates repayment schedules showing interest, principal, basis recovery, and gain for each scheduled payment.
In this article:
An installment note is a promissory note (evidence of debt) usually issued in conjunction with the sale of property where at least one payment is to be received by the seller after the close of the taxable year in which the sale occurs. A self-canceling installment note is an installment note that contains a provision under which the buyer's obligation to pay automatically ceases in the event a specified person, called the measuring or reference life (usually the seller), dies before the end of the term of the note.
When Is It Used?
An installment note is useful when a client owns a highly appreciated asset he would like to sell and wants to spread the recognition of and taxation on the gain over a term of years. (However, any gain attributable to excess depreciation that is subject to recapture under IRS §1245 or §1250 is fully recognized in the year of sale. Also, under installment sale rules, all gain is recognized in the year of sale, even if payments on the note extend over several years, if the subject of the note is publicly traded stock.) Installment notes with a self-canceling provision are especially useful when one family members, typically a parent or grandparent, wishes to transfer property to another family member, typically a child or grandchild, with minimal gift and estate tax consequences.
What Are the Estate and Gift Tax Consequences?
In general, the fair market value of any unpaid installment obligation on the date of death is included in the estate of the seller. However, if the note contains a properly designed self-cancellation provision, the buyer is under no obligation to make any further payments after the seller's premature death, which leaves no unpaid balance to be included in the seller's estate. The self-canceling feature can be an effective means of transferring property to family members without estate or gift tax consequences in the event of the death of the seller-transferor before the last potential payment has been made under the terms of the installment note.
How Should a SCIN Be Structured?
A SCIN will avoid adverse gift and estate tax treatment only if the self-cancellation provision is properly designed. The courts have held that:
- The cancellation provision must be bargained for as part of the consideration for the sale.
- The purchase price must reflect this bargain either with a principal risk premium (above market sales price) or an interest rate premium (above market interest rate).
- The seller may not retain any control over the property being sold after the sale.
If the self-cancellation provision is not properly designed, the seller may be deemed to have made a part-sale part-gift. If any of the transfer of the remainder interest (the canceled payments) is considered a gift, the entire value of the property sold, less the consideration actually paid, will be included in the decedent's gross estate. This problem can be avoided by structuring the note as much like a market note as possible, except for the principal or interest rate premium. Although not all issues of valuation and proper design have been resolved by regulation or by the courts, most authorities feel the debt instrument and the sales contract should both include the self-cancellation clause. To avoid retained controls, the sales contract and/or note cannot place any restrictions on the use of the property by the buyer, including any restrictions on subsequent sales. (In general, a subsequent sale of the property by the buyer within 2 years of the original sale will trigger recognition of any remaining deferred gain by the original seller, even if the note has not been fully repaid.) Furthermore, it is advisable to avoid using the property sold as collateral for the note so the seller has no right to reacquire the property sold under any circumstances.
What Interest Rate or Discount Rate Should be Used in a SCIN?
Selecting the appropriate market rate of interest is perhaps the most difficult step in the process of designing and implementing a SCIN.
For income tax purposes, self-canceling installment notes are subject to the installment sale rules. Although these rules are complex, the general rule is that the interest rate on an installment sale note must at least equal the appropriate applicable federal rate (AFR) with semiannual compounding. Failure to follow these rules may result in reapportionment of interest and principal of scheduled payments and imputation of interest income to the seller, even in periods in which he or she may not have received payments.
The choice of whether to reflect the risk premium as an increase in the sales price (principal risk premium) or as an increase in the interest rate (interest rate risk premium), depends on the relative tax situations of the buyer and seller. If the risk premium is reflected in the sales price (principal risk premium), the seller will report more of each payment as capital gain and less as interest income. The buyer will pay less interest (which is deductible if the interest is investment or trade or business interest and not personal interest), but his or her basis will be higher. If the property is depreciable and the buyer and seller are in similar tax brackets, the principal risk premium may be preferred to give the buyer a larger depreciable base.
However, if the property is not depreciable, the buyer may prefer the interest rate premium where the basis is lower but deductible interest payments are higher.
Theoretically, some appropriately weighted combination of principal risk premium and interest risk premium would be acceptable. A weighted combination risk premium may be determined using the program in a two-step fashion.
- Compute the principal risk premium and interest rate risk premium using the appropriate market rate of interest.
- Choose an interest rate risk somewhere between the market rate and the risk-premium-adjusted interest rate computed in the first pass and enter it as the market rate of interest in the data input section (leave the §7520 as it is). The resulting principal risk premium will be lower than that computed originally using the market rate of interest. The summary statement and repayment schedule for the installment note with principal risk premium will now reflect the combined risk premiums. The interest rate premium is equal to the difference between the market rate and the second (higher) rate entered. The revised and lower principal risk premium is reflected on the summary statement. The repayment schedule will show the effects of each risk premium the allocation of interest, gains and basis recovery.
What Is the Maximum Allowable Term of a Self-Canceling Installment Note?
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 re-characterize the note as a private annuity for income tax purposes. In this event, the income portion of the payments is nondeductible as interest, which is likely to have adverse tax consequences to the buyer in cases where investment or trade or business property is involved.
Although the internal revenue code, regulations and case law have set no clear guidelines, if the seller is in normal health for his or her age, the expected return multiples for a single life as presented in Table V of IRC Reg. §1.72-9 have been an acceptable measure of life expectancy.
In the past, standard mortality factors and life expectancies could be used unless death was imminent, which had been interpreted to mean death was expected to occur within one year. In recently released proposed regulations, the IRS has amended and expanded this "mortality test." Under the proposed rules, if the individual who is the measuring life of the interest being transferred is known to be terminally ill, special actuarial factors, rather than the standard factors, must be used in valuing the interest.
Terminal illness is defined as an "incurable illness or other deteriorating physical condition that would substantially reduce a person's life expectancy to the extent that there is at least a 50 percent probability that the individual will not survive for more than one year from the valuation date." The proposed regulations would be effective for valuation dates occurring after the date the regulations are published as final regulations.
It is unclear at this time how it is to be determined whether a person has at least a 50 percent probability of dying within a year. However, quite a number of serious diseases and conditions, such as heart disease, diabetes, many cancers, Alzheimer's disease, etc., do not reduce life expectancy to a 50 percent probability of death within one year until they are in quite advanced stages. It would appear, therefore, that under the new proposed "mortality test" many people with serious diseases or deteriorating physical conditions may use standard mortality factors and life expectancies when designing installment sales with a self-cancellation feature.
How Is the Risk Premium Determined?
If the buyer and seller are not close family members and the transaction is at arm's length by an informed seller and informed buyer, neither of whom is under any obligation to sell or buy, the negotiated sales price and note terms can generally be presumed to reflect an adequate premium for the cancellation feature. However, the tax laws essentially presume transactions between close family members are not at arm's length. Therefore, it is critical to establish the adequacy of the risk premium for the cancellation feature. Since a risk premium can only be measured relative to fair market value or the market rate of interest, it is equally critical to properly substantiate the fair market value of the property being sold and the appropriate market rate of interest.
In the case of property such as listed stocks and bonds where there is an established, well-functioning market, fair market value is simply the price at which it could be sold outright based on market prices when the installment sale commences. (Although installment sales of listed stocks are not generally recommended because of the requirement to recognize all gain in the year of sale.) For other types of property, such as closely held stock, artwork, or certain real estate, a professional appraisal may be required to establish fair market value.
The mortality factors used for computing the risk premium for the cancellation feature typically are the same as those used for valuing annuities, life estates, and remainders for gift and estate tax purposes as provided in Table 2000CM, Table 90CM, or Table 80CNSMT.
These mortality factors are not the same as the mortality factors used to compute the life expectancies of Table V of IRC Reg. §1.72-9. However, in contrast with valuations of private annuities and various interests in trust for gift and estate tax purposes, IRS pronouncements indicate that there is some leeway with SCINs to establish that the terms are reasonable. The seller's actual health status and life expectancy rather than his or her actuarial life expectancy may be considered in designing the terms and the risk premium of the SCIN. This means that higher (but probably not lower) mortality factors than those for the seller's attained age from Table 2000CM, Table 90CM, or Table 80CNSMT may be used to determine the risk premium for the cancellation feature if the seller's health is below average. Whether such adjustment is required is uncertain. However, many authorities feel that normal mortality factors based on the seller's attained age may be used even if the seller is in poor health, unless there is at least a 50-percent probability of death within one year.
The risk premium may take one or a combination of two forms. First, the sales price of the property may be increased above the fair market value that would be paid in an outright sale or in an installment sale without the cancellation feature. In this case, the standard AFR would be used to apportion the interest and principal components of the payments. Alternatively, the property may be sold for its fair market value, but an interest rate greater than the standard AFR may be used to apportion interest and principal.
How the principal and interest rate risk premiums are determined is perhaps best explained by example. Suppose your client, aged 60, wishes to sell property with a fair market value of $125,000 to her son in an installment sale. The son will pay $25,000 on the date of the sale and pay off the balance of the note in three equal annual installments. Assuming the applicable federal short-term rate is 6.4 percent, three annual payments of $37,688.17 would be required to pay off the $100,000 balance on a regular non-cancelable installment sale note for 3 years.
This payment is determined by solving the following equation:
Rearranging terms, the equation can be expressed as follows:
Now, assume your client wants to include a cancellation provision in the installment sale and note providing that the sale will be complete and the note will be considered satisfied in full by all payments up to the date of her death in the event she dies before the end of the 3-year term. Assuming she is in normal heath for a 60-year-old person, the note will qualify as a self-canceling installment note, rather than a private annuity, since the Table V life expectancy for a 60-year-old person, 24.2 years, is greater than the 3-year term of the note.
To compute the required payments on the note, the payments must be adjusted for the probability that she is alive to receive the payments when scheduled. Let 60Pk represent the probability that a person age 60 will still be alive k years later. Based on Table 80CNSMT factors, the probabilities for the 3-year term of the note are, respectively,
60P1 = 0.98776
60P2 = 0.97464
60P3 = 0.96063
In addition, assuming your client does not reside in the Seventh Circuit Court's region, the interest-rate factor should be the §7520 rate rather than the short-term AFR. Assume the §7520 rate is 7.6 percent. The required annual payment may be computed using a formula that is analogous to that presented above for the non-cancelable installment note. Specifically,
The above calculations assume that payments are received if and only if the client survives to the end of the year, and that assumption is known as a "curtate annuity," which the program can calculate by changing "Annuity Valuation" to "Curtate." However, the IRS usually values annuities using a different assumption, known as the "complete annuity," which is the assumption that is recommended (and is the program default.)
Or, in the rearranged form:
The principal risk premium can now be determined by calculating what the face amount would be for a non-cancelable installment note with three annual payments of $39,511.64 using the short-term AFR of 6.4 percent. That is, the $4,838.30 difference between the $104,838.30 is computed and the $100,000 fair market value is the principal risk premium.
If an interest rate risk premium is preferred to the principal risk premium, the interest rate risk premium may be computed by solving for the interest rate that would equate the discounted value of the 3 annual payments of $39,511.64 with the fair market value of $100,000. That is, solve for the interest rate, I that satisfies the following equation:
In this case, I is equal to 10.5970 percent. Therefore, the interest rate risk premium is equal to 4.1970 percent (10.5970 percent minus the 6.4 percent short-term AFR).
Which Risk Is Preferable?
The choice of whether to reflect the risk premium as an increase in the sales price (principal risk premium) or as an increase in the interest rate (interest rate risk premium), depends on the relative tax situations of the buyer and seller. If the risk premium is reflected in the sales price (principal risk premium), the seller will report more of each payment as capital gain and less as interest income. The buyer will pay less interest (which is deductible if the interest is investment or trade or business interest and not personal interest), but his or her basis will be higher. If the property is depreciable and the buyer and seller are in similar tax brackets, the principal risk premium may be preferred to give the buyer a larger depreciable base. However, if the property is not depreciable, the buyer may prefer the interest rate premium where the basis is lower but deductible interest payments are higher.
Is It Possible to Split the Risk Premium between Principal and Interest?
Theoretically, some appropriately weighted combination of principal risk premium and interest risk premium would be acceptable. A weighted-combination risk premium may be determined using the template in a two-step fashion. First, compute the principal risk premium and interest rate risk premium using the appropriate market rate of interest. Second, choose an interest rate somewhere between the market rate and the risk-premium-adjusted interest rate computed in the first pass and enter it as the market rate of interest in the data input section (leave the §7520 rate as it is). The resulting principal risk premium will be lower than that computed originally using the market rate of interest. The summary statement and repayment schedule for the installment note with principal risk premium will now reflect the combined risk premiums. The interest rate premium is equal to the difference between the market rate and the second (higher) rate entered. The revised and lower principal risk premium is reflected on the summary statement. The repayment schedule will show the effects of each risk premium in the allocation of interest, gains, and basis recovery.
How Can the Analyses Be Adjusted to Reflect Greater-Than-Average Mortality Risk?
One simple method to adjust for a shorter-than-average actual life expectancy, if desirable, is to use mortality factors for an age that is older than the seller's actual age. For example, assume the actual life expectancy of a 60-year-old seller is only about 5 years, due to some health problem such as an advanced heart condition. An inspection of Table V shows that a normal 90-year-old person has a life expectancy of 5 years. The mortality factors for a 90-year-old person could be used to determine the risk premium by simply entering age 90, rather than age 60, as the age of the seller.
Can the Life of Someone Other Than the Seller Be Used to Trigger the Cancellation Feature?
Although there is little case law or precedent on SCINs to draw upon, if the precedents set for private annuities apply as well to SCINs, it would appear the measuring life for a SCIN may be someone other than the seller. For instance, in special circumstances it might be desirable to use the buyer, the first of either the buyer or seller to die, or another third person as the measuring life or lives for the cancellation feature. It would appear that if the term of the note does not exceed the life expectancy of the reference life, whomever that may be, and the risk premium is computed based on that life, the SCIN should pass muster with the IRS.
What Kind of Repayment Schedules Are Used in SCINs?
Installment notes may be designed with virtually any schedule of payments, but they most frequently conform to one of two basic payment schedules. Level-principal notes schedule equal periodic payments of principal on the note together with accrued interest. For example, if the principal value of the note is $1,000 and it is to be paid off over 5 years, the debtor would pay $200 of principal each year together with the accrued interest. If the interest rate were 10 percent, for instance, the first payment would be $300, $200 of principal and $100 of interest. The second payment would be only $280, $200 of principal and $80 of interest on the remaining principal balance. Although the principal amount is fixed or level each year, the total payment declines each year because of the decreasing interest component of the payment.
Level payment self-amortizing notes are the second and most frequently used type of installment note. This type of note is similar to the standard home mortgage 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 with each payment 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.
For example, assume the client discussed above wants the term of the note to remain at 3 years, but wants the payment schedule to be based on a 5-year amortization period. In this case, the first two payments would be less than the $39,634 determined above, but the final payment would be higher. Specifically, the first two annual payments would be equal to $25,498 and the third-year payment would be equal to $71,985.
Deferring a larger portion of the repayment on the note to the later years increases the risk premium. In this case, the principal risk premium is $6,248, or $1,085 more than the $5,163 risk premium associated with three equal annual payments of $39,634. Similarly, the interest rate risk premium also increases. In this case, it is 2.8065 percent as compared with the 2.7826 percent associated with the three equal annual payments.
An installment note is a promissory note (evidence of debt) usually issued in conjunction with the sale of property where at least one payment is to be received by the seller after the close of the taxable year in which the sale occurs. A self-canceling installment note is an installment note which contains a provision under which the buyer's obligation to pay automatically ceases in the event a specified person, called the measuring or reference life (usually the seller), dies before the end of the term of the note.
Click any of the following links to learn more about a self-canceling installment note.
- Transfer Date: Enter the month and year for the installment sale.
Note: For May or June of 2009, you have the choice of using mortality Table 90CM or 2000CM (see https://www.irs.gov/irb/2009-20_IRB). After June 2009, the program will automatically use Table 2000CM. For dates before May 2009 and after June 1999, the program will use Table 90CM. For May or June of 1999, you have the choice of using Table 80CNSMT or Table 90CM. For dates before May 1999 and after April 1989, the program will automatically use Table 80CNSMT. For dates before May 1989, the program uses Table LN from Treas. Reg. section 20.2031-7A(d)(6).
- Discount Rate: Enter the IRC §7520 discount rate (which is 120% of the applicable federal midterm rate, rounded to the nearest 2/10ths of 1 percent) for the month in which the transaction is completed. The default for this entry is the current month's Section 7520 rate from the AFR table stored in the program.
- FMV of Property: Enter the fair market value of the property being sold.
- Cost Basis: Enter the cost basis in the property being sold.
- Recapture (Sec. 1245 or 1250): Enter the IRC §1245 (personal property) or §1250 (real estate) depreciation recapture, if any.
- Initial Down Payment: Enter the down payment or other property (boot) paid to seller in year of sale.
- Age(s): Enter the age (to the nearest birthday) of the seller(s) (or measuring life, if different). Enter "0" if there is no second measuring life.
- Term of Note: Enter the term of the installment note (which must be less than the remaining life expectancy of the seller (or measuring life, if different).
- Type of Note: Select Self-Amortizing, Level Principal, or Interest-Only. Self-amortizing means that the combined principal and interest payments are constant over the term of the note (so the interest component of each payment will decline over the term of the note, while the principal component increases). Level Principal means that the principal of the note is paid in equal annual installments, with annual interest payments based on the principal then outstanding (so the interest payments will decline over the term of the note). Interest Only means that only interest is paid over the term of the note, with a balloon payment of principal at the end of the note.
- Annuity Valuation: Select the Complete Method or the Curtate Method. These are the two possible methods for valuing periodic payments. The IRS consistently values annuities and other periodic payments using the "complete annuity" assumption, which is that, if the recipient dies during the year, the recipient receives a pro-rata payment for the year, regardless of whether or not the recipient is entitled to any payment under the governing document. The other method is known as a "curtate annuity", and it assumes that the recipient receives nothing if the recipient dies before the end of the year.
- No-Risk-Premium Market Interest Rate: Enter a market rate of interest for the note, which should not be less than the applicable federal rate for the month in which the sale occurs. The applicable federal rate for a note of not more than three years will be the federal short-term rate, the applicable federal rate for a note of more than three years but not more than nine years will be the federal mid-term rate, and the applicable federal rate for a note of more than nine years will be the federal long-term rate.
- Payment Period: Select the number of payments that will be made each year to the beneficiary (Annual, Semiannual, Quarterly, Monthly, Quarterly, and Weekly).
- Amortization or Principal-Recovery Period of Note: Enter the amortization or principal-recovery period of the note (which must be equal to or greater than the term of the installment note).
- Balloon Payment: Select the check box to use an amortization or principal-recovery period that is greater than the term of the note, so that there will be a balloon payment of unpaid principal at the end of the note.
- View Repayments: Click the button and the repayment schedules will show the amount of principal and interest paid each year, the amount of capital gain and return of basis attributable to each payment of principal, and the principal balance remaining at the end of the year.
This calculation determines both the principal risk premium and the interest rate risk premium for the self-cancellation feature of the selected type of installment note. It does this in a manner which is consistent both with the installment sale and imputed interest rules of IRC §453, 483, 1274, and 1274A and the gift tax valuation rules for remainders using the discount rate of IRC §7520 and the mortality factors of Table 80CNSMT, Table 90CM, or Table 2000CM.
The calculation also presents summary statements and repayment schedules for the case where the risk premium is included in principal and where it is included in the interest rate. These statements and schedules show the allocation of interest, principal (and its components of gain and basis recovery), and recapture (if any) both in the year of sale and in subsequent years over the selected term of the note.
The Summary Tab will include the following results:
- Mortality Risk Premium (Principal): This is the amount that must be added to the principal of the note in order for the present value of the future payments of interest and principal to equal the unpaid purchase price.
- Total Sale Price: The sum of the fair market value of the property and the principal premium (if any).
- Principal Amount of Note: The total sale price, less the initial down payment.
- Mortality Risk Premium (Interest): This the amount that must be added to the market interest on the note in order for the present value of the future payments of interest and principal to be equal to the unpaid purchase price.
- Total Interest Rate: The sum of the market rate of interest on the note and the interest premium (if any).
- Annual Principal Payments: If the note payments are level principal, the amount of each year's principal installment. (The other types of notes result in varying principal payments.)
- Annual Interest Payments: If the note payments are interest only, the amount of each year's interest payment. (The other types of notes result in varying amounts of annual interest.)
- Total Annual Payments: If the note payments are amortized, the total amount of each year's principal and interest to be paid. (The other types of notes result in varying totals of principal and interest.)
- Total Interest To Be Paid: The total amount of the interest to be paid on the note if payments continue to the end of the term of the note (i.e., the seller does not die before the end of the term of the note).
- Total Capital Gain: The total amount of capital gain to be realized on the sale, both from the original down payment and principal payments under the note.
- Profit Percentage: The amount of capital gain divided by the total sale price (including any principal premium). The amount of gain to be realized each year upon each payment of principal will be the amount of the payment times this percentage.
- Capital Gain Recognized in Year of Sale: The profit percentage, multiplied by the initial down payment.
- Basis Recovery in Year of Sale: The amount of nontaxable basis to be recovered from the initial down payment.