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).