TrustLawyer

Tax-Efficient Installment Sales

“Self Canceling” Installment Notes and Private Annuities

Selling on the installment plan

“Livin’ on Love – Buyin’ on Time.” Nice song. But what does it have to do with estate tax? Only this. People sell businesses and other assets “on the installment plan.” It’s often a win-win. The seller has a source of income and defers capital gain tax. The buyer need not come up with a large amount of cash.

Here are some of the pitfalls and opportunities in installment sales.

Straight installment sale

This is a “plain vanilla” installment sale. Joe sells an asset to Moe for a sum payable over a fixed period at a stated interest rate.

CAVEAT intra-family sale

An installment sale to a family member will be carefully scrutinized by the IRS. They may try to re-characterize it as a gift. The formalities of a transaction may have been observed and the “debt” adequately secured. Additionally, if there is no real intention of making repayment or enforcing the obligation, these facts are of little significance. The IRS has prevailed in several cases, including one in Connecticut, when the parties didn’t treat the deal as a normal business transaction. In one case, the donor structured the payments to equal the annual gift tax exclusion and then forgave each payment as it came due.

Self Canceling Installment Note (SCIN)

What is it?

  • A sale for a promissory note for a term of years.
  • If the seller dies prior to end of term, the buyer has no further obligation.
  • Because, when the debt is “cancelled”, the seller’s estate is not entitled to any payments, any “balance” should escape estate taxation. WATCH OUT Read further to find out why you should not use the word, “cancel.”
  • The note must reflect a “premium” because the seller’s estate may not collect the full amount. It must take into account the age and, possibly, the state of health, of the seller and the financial stability of the buyer. The premium can be an increase in the sale price or in the interest rate.

When a SCIN makes sense. If the seller is “sicker than his age” but not expected to die in the near future, a SCIN or a private annuity, discussed immediately below, can be an excellent way to pass an asset to the next generation.

No Retained Interests. A business owner should make a complete break with the business. The seller should not retain any economic benefits from the business which a “stranger” in a similar situation would not have. The more that he “keeps his hand in,” the more it looks less like a sale and more like a transfer with retained interest, which could trigger an estate tax.

Don’t “cancel” it -- pay it off. It may sound like a distinction without a difference, but it is important not to have the note be “cancelled” when the seller dies. Instead, the note should provide that, at the seller’s death, the obligation is paid in full. “Cancellation of indebtedness” will trigger income tax. Payment of a debt will not.

For a detailed discussion of some of the court decisions, as well as suggested language for SCINS, please click here.

Private Annuity.

What is it?

  • Sale for a series of unsecured annuity payments over the seller’s, or the seller’s and another’s presumed life expectancy. The payments do not stop if the seller beats the actuarial odds.
  • Income for Ma and Pa. It can provide a stream of income for the seller and his or her spouse.
  • Estate Tax Exclusion. Like a SCIN, generally no portion of the asset is included in the seller’s gross estate because the annuity obligation terminates at his or her death. If the asset is incorrectly valued, a portion of the purchase price can be considered a “transfer with retained interest” and included in the seller’s taxable estate. See: “Necessity for Proper Valuation”, below.
  • No Security. Unlike a SCIN, the annuitant (seller) may not retain a security interest in the asset. Retention of a security interest could cause all of the gain to be recognized within one year.
  • Do Not Key Annuity to Income. The annuity payments should not “track” the income from the asset. A “bootstrap acquisition” may be re-characterized as a “transfer with retained life interest” and included in the seller’s taxable estate. The annuity should be structured so that, using the appropriate rate of interest under the IRS rules, the value of the asset will be totally exhausted by the annuity payments up the date of the seller’s presumed “actuarial death.” This is probably the largest difference between a properly structured private annuity and an installment sale or SCIN.

Risks.

  • Buyer may have insufficient resources to pay the annuity. He could become insolvent or acquire creditors.
  • Seller could “live too long.” If the seller keeps ticking, the buyer could take a licking.
  • Is the Seller’s Health a Factor? In a sense, the worse the seller’s health, the better it is to do a SCIN or private annuity transaction. Suppose the seller has an “actuarial” life expectancy of 15 years, but is quite sick and is expected to only live for 2 of 3? If he dies before receiving the full value of the transferred asset, only a portion of that value has come back into his estate via the note or annuity payments. The balance may be subject to capital gain tax or income tax (with a private annuity, but possibly not with a SCIN). However, the net savings could be substantial because estate tax rates are substantially higher than income tax rates. NOTE: The Treasury Regulations provide that if, at the time of sale, the seller was known to have had a disease and dies within a fairly short time, this deal may not work. This presumption can be overcome, however. We settled an estate where the annuitant-seller died about 9 months from the date of sale. We proved that, on the sale date, neither he nor his doctor realized that he had the condition from which he died.

Important Issues and SCINS and Private Annuities.

Necessity for Proper Valuation. Both a SCIN and a private annuity require that the asset be properly valued. To the extent that there is a “bargain sale,” the transaction may be re-characterized as a gift with retained life interest.

No Forgiveness. The need to structure the transaction in a commercially reasonable manner cannot be overemphasized. Just as in a straight installment sale, the deal could be re-structured unless all of the formalities are observed.
       

Some Comparison of SCINS and Private Annuities

  SCIN PRIVATE ANNUITIES
Income for Seller More geared to “bargain to buyer” than to income stream to seller. Can provide ongoing source of income for the seller and his spouse.
Security Seller can retain mortgage or other security. No security interests allowed.
Estate Freezing Yes Yes
Basis Value of obligation at inception Generally fair market value, but may be reduced if annuitant dies early or increased if he lives beyond his life expectancy
Interest Deduction Interest deductible by buyer Not deductible by buyer
More expensive for buyer than SCIN
Actuarial Risk No real actuarial risk. Impetus for SCIN may be more "donative" than economic. Risk to buyer that seller will live too long.
Taxation of Gain Gain taxed over term of note. Gain taxed over life expectancy.

Conclusion

Self canceling installment notes and private annuities are one of the most written about estate planning techniques. They are also one of the least utilized. The reason is not that they don’t work. They do. It’s also not that they are complex. Moar sophisticated estate planning techniques are complex.

The reason that there are not more SCINs and private annuities is that they are, in a sense, specialized tools. They are useful for clients who have somewhat less than average life expectancy.

They also make sense in a situation where a parent is leaving a business to his or her child. Rather than have the child pay estate tax on his or her inheritance, he or she could buy the business, provide his or her parent with an ongoing income, and eliminate the estate tax.

If you think that a SCIN or private annuity would make sense for you, please let us know.