Selecting the appropriate market rate of interest is perhaps the most difficult step in the process of designing and implementing a SCIN. This is because of conflicting requirements under the imputed interest or OID rules and the gift tax discounting rules of IRC §7520.
For income tax purposes, self-canceling installment notes are subject to the installment sale rules of IRC §453 and, in most cases, the imputed interest or original issue discount (OID) rules of IRC §483, §1274, or §1274A. 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.
Interest Rate Requirements for Installment Sale Notes
If the Term of the Note Is:
- Not Over 3 Years then the Applicable Federal Rate Is Federal Short Term Rate.
- Over 3 Years Up to 9 Years then the Applicable Federal Rate Is Federal Midterm Rate.
- Over 9 Years then the Applicable Federal Rate Is Federal Long Term Rate.
When a note is an installment note, providing for payments of principal during the term of the note (i.e., the note is not interest-only), the "term" of the note for purposes of determining whether to apply the short-term, mid-term, or long-term rates is the "weighted average maturity" of the note as defined by Treas. Reg. Sec. 1.1273-1(e)(3).
The applicable federal rates change monthly, are published each month by the IRS, and appear in many financial publications such as The Wall Street Journal (see Federal Interest Rates in the Money & Investing section, generally between the 18th and 23rd of the preceding month).
In general, the applicable federal rate that must be used depends on the term of the note. The rate that is used must equal or exceed the lowest of the appropriate-term rates for the month in which the transaction takes place or the prior two months. For example, assume the transaction takes place in June and the term of the note is 6 years. The interest rate should be selected from the lowest federal midterm rate for April, May, or June. If the federal midterm rates for April, May, and June are 6.78, 6.44, and 7.02 percent, respectively, the appropriate (minimum allowable) interest rate is 6.44 percent.
There are several important exceptions to the general rule for selecting the required interest rate for income-tax purposes. First, if the transaction involves a sale-leaseback, the required interest rate is the 110-percent applicable federal rate for the appropriate term. Second, if the stated principal amount (essentially the total sales price of the property) is less than $2,800,000 (as indexed for inflation since 1990), a cap of 9 percent compounded semiannually applies. That is, if the appropriate AFR exceeds 9 percent, 9 percent may be used; if not, the appropriate AFR is the minimum allowable rate. Third, installment sales involving certain transfers of land between family members may use a 6 percent interest rate compounded semiannually, but only in cases where the sales price of the land does not exceed $500,000.
To complicate matters, valuations of remainder interests for gift tax purposes are governed by the rules of §7520, which use the 120-percent applicable federal midterm rate to determine what is called the §7520 rate. In the absence of an adequate price or interest rate premium, a SCIN contains a potential gift tax element equal to the actuarial value of the canceled portion of the note in the event of the seller's premature death. Therefore, it appears that two different interest rate factors must be used when structuring a SCIN:
- The applicable federal rate (AFR) for the purpose of allocating interest income and principal on payments on the note and,
- the §7520 rate for determining the principal or interest rate risk premium.
Although §483 explicitly states that the imputed interest rules (which apply to most installment sale notes for less than $2.8 million) are applicable for both income tax and gift tax valuation purposes, the case law has been inconsistent. The U.S. Court of Appeals for the Seventh Circuit has upheld the interpretation that §483 applies for both income and gift tax purposes. However, the Tax Court has refused to follow this precedent in other circuits. The Tax Court has held in other circuits that §483 only applies for income tax purposes, not gift tax valuation purposes. If the Seventh Circuit Court's position is ultimately sustained in the other circuit courts, then one interest rate, the applicable federal rate (AFR) under the imputed interest rules, will serve for both income tax and gift tax valuation purposes in most self-canceling installment sale notes. Otherwise, in all circuits but the seventh it may be necessary to use the §7520 rate for purposes of determining the risk premium in SCINs and the AFR under the imputed interest rules to allocate interest and principal on payments on the note. (More on the risk premium later.)
However, the imputed interest rules essentially set a minimum interest rate on installment sale notes for income tax purposes. Consequently, §7520 rate is typically higher than the AFR under the imputed interest rules, the §7520 rate is probably a safe-harbor rate that can be used for both income tax and gift tax purposes.
For a given face amount and term of a note, a higher interest rate assumption means greater payments on the note. If the objective is to minimize the cost to the buyer, as is often the case in the typical intra-family transfer, required payments on the note will be minimized if the (usually) lower AFR, rather than the (usually) higher §7520 rate, is used for determining the required payments and for apportioning interest and principal.