SCINs Are Still Useful Tools
Despite Recent Decision

In Frane, the Eighth Circuit ruled that an estate recognized income upon the cancellation, at death, of a self-canceling installment note. This article examines SCINs and compares them to similar estate planning devices.

By: Howard M. Esterces hesterces@mlg.com

Frane, recently decided by the Eighth Circuit, has focused attention on self-canceling installment notes or "SCINs." Two issues considered in Frane were whether previously unrecognized incoem from a SCIN must be recognized when a seller dies, and by whom. The Eighth Circuit held that it is the estate that must recognize income on the seller's death.

SCIN's can still be a useful estate planning tool despite Frane, but cannot be evaluated ina vacuum. Other techniques – such as private annuities, regular installment sales, GRATs, and GRUTs – can achieve similar aims, sometimes with superior results.

A SCIN typically arises through the sale of shares of stock or an interest in real estate to a family member in exchange for an installment note. Unlike a note used in a normal installment sale, a SCIN includes provisions for cancellation of the unpaid balance on the seller's death. The desired result is to exclude the unpaid balance of the note from the seller's estate and to avoid any gift tax. The Franes had also hoped to avoid income tax on the remaining gain, but that was not possible.

The Frane case

Robert Frane, age 53, sold all his shares in a closely held corporation to his four children. Each child signed a note for the appraised value of the stock he or she purchased, payable in annual installments over 20 years. This was less than Frane's actuarial life expectancy. As required by the stock purchase agreements, the notes provided:

"...that in the event of [Frane's] death prior to the final payment of principal and interest under said note, the unpaid principal and interest of such note shall be deemed cancelled and extinguished as though paid upon the death of [Frane]."

Frane lived o receive two of the installments, recognizing income on each installment under the installment sales method of Section 453. None of the remaining gain, however, was recognized when Frane died, either on his final individual income tax return or on his estate's fiduciary return.

The Frane's position was that no cancellation occurred within the meaning of either Section 453B of Section691(a)(5), since the notes were extinguished in accordance with their terms rather than by some subsequent, independent act. Both the Tax Court and the Eighth Circuit rejected this argument and concluded that neither Code section required such a limited definition of the term "cancellation." The Tax Court found that income was to be recognized on the decedent's final income tax return under Section 453B. If income must be recognized, it is generally preferable for it to be recognized on a decedent's final return because the additional income taxes may then be claimed as a deduction under Section 2053 for estate tax purposes. The Eighth Circuit reversed to the extent of requiring the estate to recognize gain under Section 691(a)(5).

Section 453B applied, according to the Tax Court, because Section 453(a)(2) requires recognition of gain when an installment obligation is distributed, transmitted, or disposed of otherwise than by sale of exchange. Section 453(B)(f)(1) treats cancellation of an installment obligation as a disposition in a transaction other than a sale of exchange. The exemption for transmission at death in Section 453B(c) did not apply, stated the Tax Court, because one of the other alternate events specified had already occurred, namely a "disposition."

The Eighth Circuit disagreed with this reasoning in light of the plain language of Section 691(a)(5)(A)(iii), which provides that "any cancellation of [an installment obligation] occurring at the death of the decedent shall be treated as a transfer by the death of the decedent shall be treated as a transfer by the estate of the decedent...," thereby causing recognition of the remaining gain under Section 691(a)(2). Section 691(a)(5)(B) further provides that fair market value is not to be less than the face amount of a note when a decedent and obligor are related persons. The appeals court found no unfairness in this result, since the purchaser's basis is correspondingly increased at the time of sale to the face amount of the note, in accordance with GCM 39503.

The dissent by five of the 19 judges in the Tax Court evidences the difficulty of the issue presented. The dissent found the notes similar to a private annuity where no income is recognized at death, and suggested that the true nature of the transaction could have readily been expressed as follows, in which case gain clearly would not have been recognize:

"THE PARTIES INTEND THIS TO BE A CONTINGENT PAYMENT SALE. The purchase price of the stock is variable, and will be somewhere between $0 and $141,050, depending on how long seller lives. A condition precedent to each contingent payment is that seller be alive on the scheduled potential payment date. Consequently, if seller dies before any scheduled potential payment, the obligation to make such payment does not come into existence."

Several observations about Frane are of interest. First, there was never any challenge to exclusion of the unpaid balance form Frane's estate for estate tax purposes. The appellate decision noted in passing that the notes had an above average interest rate of 12%, which was consideration for the cancellation feature.

Second, it is not clear from the facts why the family's position on appeal was that income should be recognized by the estate rather than on Frane's final individual income tax return, if income would have been available for the additional taxes assessed on the decedent's final return.

Third, the problem of recognition of gain on death in Frane does not occur for a sale at a loss. Losses are not recognized on sales to family members by virtue of Sections 267(a)(1), 267(b)(1), and 267(c)(4). If, however the shares appreciate in value, the original purchaser's gain on a later sale is reduced by the original seller's unrecognized loss, pursuant to Section 267(d). This may be a valuable tax planning device because under Section 1014, no loss will ever be recognized if the shares are held until death.

The decision on appeal is consistent with Rev. Rul. 86-72 and GCM 39503, both of which held that Section 691(a)(5) applies when the payee of a SCIN dies. The dissent in the Tax Court would clearly be incorrect if GCM 39503 applied. Under the GCM, a transaction is taxed as a SCIN if payments end on the seller's death or when a stated amount is reached, if the stated amount is expected to be reached within the seller's lifetime. This was the situation in Frane.

Estate, gift tax consequences of SCINs

Estate of Moss is the seminal case that excludes the unpaid balance of a SCIN from the seller's gross estate. There, the seller sold stock in a funeral corporation, and real estate, to the corporation for notes due within his life expectancy. The seller's physical condition was average. The court observed that the cancellation upon death feature was bargained for and was reflected in the sales price of $800 pe share, compared to a price of $440 per share used in a buy-sell agreement among employee shareholders. The arrangement was found to be comparable to an annuity, and inclusion in the estate under Section 2033 was rejected.

The court in Moss contrasted the arrangement with one involving forgiveness of a note by a will and to Estate of Buckwalter, where a note was included in the estate of a decedent who controlled the note until his death. In Cain, a claim for inclusion in the estate under Section 2036 was denied because payment was not linked or related to income of the shares transferred, and the decedent divested himself of all title to, and control of, the shares.

Under the reasoning of Moss, it is inadvisable to have a SCIN payable on demand or on "120 days after demand," as was the case in Wilson.

Gift Tax. Wilson, where no gift tax was found, points out the desirability of securing a SCIN by pledge. The SCIN there was secured by the property sold to Wilson's children. The face amount of the note was approximately $12 million, while the fair market value of the property sold was stipulated by the parties to be approximately $4 million, far less than the family probably originally contemplated. Although the children did not have sufficient funds of their own to pay the note, the court found genuine intent to resell the property and pay the note. The court rejected the contention that a gift occurred because the fair market value of the note was less than the value of the property. The note was secured by a pledge of the property sold, and the face amount of the note exceeded the value of the property. According to the court, this, in itself, was sufficient to remove any doubt that the seller would receive less than the value of the property at the time of sale.

The self-cancellation feature was not discussed in Wilson, despite the admonition in GCM 39503 that het particular facts and circumstances must be considered in determining whether a gift occurs. The fact that the note was virtually payable on demand (i.e. 120 days after demand) may have had some bearing on the court's decision.

What premium should be added for the cancellation feature? Although no cases or rulings specifically address this issue, adjustment for the probability of death appears appropriate. Table 80 CNSMT in Publication 1457, U.S. Government Printing Office, should be suitable. For example, suppose a seller is age 5 when a SCIN payable in 15 years, at age 70, is issued. A cancellation premium of 22.8% should apply, assuming the seller is of average health, as illustrated below:

As shown in the table, of 88,348 persons alive at age 55, 68,248 are expected to still be alive at age 70. Therefore, the premium would be

It may be possible to use a higher interest rate as consideration for the cancellation feature, but no specific guidance is available. Without a sufficient cancellation premium, there will be a gift tax if the maximum term of the note exceeds the seller's life expectancy because it will be unlikely from the inception of the transaction that a part of the note will be paid.

Interest rate considerations are also important in avoiding gift tax. Section 7872, concerning "below market loans," provides that in a case of a "gift loan," the excess of the amount loaned over the present value of all payments (principal and interest) is considered a gift. Present value is determined under Section 1274(d) using applicable Federal rates (AFRs) announced by the Service at he time of the transaction. These rates are based upon the term of the note as follows:

For example, in September 1993, the applicable Federal Rates using annual compounding were 3.91% for short-term, 5.35% for mid-term, and 6.28% for long-term debt instruments. A gift is avoided if interest payable under the note is at a rate at least equal to the AFR for debt instruments fo the same term. Even if some interest is deferred, there will not be a gift if unpaid interst is compounded at the applicable AFR and is payable when the note matures. In that case, an added premium for possible cancellation should also be included.

SCINs vs. other strategies

GCM 39503 defines a private annuity as "....generally an arrangement whereby an individual transfers property, usually real estate, to a transferee who promises to make periodic payments to the transferor for the remaining life of the transferor. A private annuity may also include a transaction whereby the transferee agrees to make periodic payments until a specific monetary amount is reached or until the transferor's death, which ever occurs first." According to the GCM, if the specific monetary amount will be reached within the transferee's life expectancy (determined under Reg. 1.72-9, Table V), the transaction will be treated not as an annuity, but rather as a SCIN. Basic authority for taxing private annuities can be found in Rev. Rul. 69-74 (pertaining to the transferor of seller) and Rev. Rul. 55-119 (pertaining to the transferee of purchaser). GCM 39503 is also helpful.

If the seller survives his initial life expectancy, or until the specified monetary amount is reached, the income tax results are substantially similar to those of a SCIN with the same sales price. The first step is to determine the present value of the annuity, using 120% of the Federal mid-term rate at the time of sale, as required by section 7520, and Table S of Publication 1457. If the fair market value of the property sold exceeds the present value of the annuity, the excess is a gift. The seller's cost basis is subtracted from the present value of the annuity to determine potential gain on the sale. The gain is then divided by the seller's life expectancy under Reg. 1.72-9, Table V, to compute the amount of gain that must be reported each year.

The portion of each payment deemed a recovery of the seller's cost is determined based on an "exclusion ratio." This is the ratio of the seller's cost to the product of the annual annuity amount multiplied by the seller's life expectancy. As a result, each year's annuity payment is divided in to the following parts:

1. Tax free recovery of basis.
2. Gain (usually capital gain).
3. Ordinary income for the balance.

If the property involved is resold by the purchaser after the seller's death, the basis for calculating gain or loss is the total of annuity payments made until the seller's death. Revenue Ruling 55-119 contains rules for determining basis for gain, loss, and depreciation during the seller's lifetime.

SCINs and private annuities are similar in that the property sold and any remaining payments are excluded from the seller's estate at death. Private annuities have advantages over SCINs in some situations, however. For example, Frane does not apply to a private annuity, and gain will not be recognized because of the seller's death. A higher sales price will also be required for a SCIN to compensate for the cancellation feature. Private annuities, in contrast, can be designed based on the tables, according to Rev. Rul. 80-80, "...unless the individual is known to have been afflicted, at the time of transfer, with an incurable physical condition that is in such an advanced stage that death is clearly imminent. Death is not clearly imminent if there is a reasonable possibility of survival for more than a very brief period." A period longer than one year is defined in the Ruling as being more than brief.

Section 453(e), which ccelerates gain if property is resold by related purchasers within two years, applies to SCINs but not to private annuities.

Private annuities may not be suitable in some cases if security is important to the seller because gain is recognized immediately if a private annuity is secured. Most significantly, SCINs, unlike private annuities, can be structured with flexibility, since SCINs do not require substantially constant annual payments. Principal need not be payable until future dates, and interest may be accrued. Even the Frane issue may not be that important because the purchaser's basis in a SCIN is stepped up at the time of sale to the face amount of the note.

EXHIBIT I
Transferor Survives Life Expectancy
Savings/(Loss) Compared to Retaining Property
$(000 omitted)

SCINs compared to GRATs and GRUTs.

GRATs and GRUTs under Section 2702 both involve the transfer of property to a trust with a retained right to an annuity, payable at least annually. In a GRAT, the annuity amount is fixed. The annuity in a GRUT is a fixe percentage of each year's value of the property. The Trust property passes to a family member at the end of the trust term, which is designed to occur during the grantor's lifetime. Here lies the risk, because the trust property will be included in the grantor's gross estate under Section 2036 if the grantor dies before the trust ends.

The amount of any gift involved with a GRAT of GRUT is determined by subtracting th actuarial value of the retained annuity from the value of the trust property. The value of the retained annuity is based on the grantor's age, the period the annuity is to last, and 120% of the federal mid-term rate at the time of the transfer. Table H of Publication 1457 is used for a GRAT, while Publication 1458 is used for a GRUT.

GRATs and GRUTs are usually grantor trusts under Section 673 (i.e., the trust property reverts to the grantor's estate if death occurs before the end of the trust term, and the reversionary interest initially exceeds 5% of the value of the trust property), or under Section 675 (i.e., typically by the grantor's retaining the right, in a nonfiduciary capacity, to substitute property of equal value in the trust). Grantor trust status results in trust income and gains being taxed to the grantor, as though the trust does not exist.

EXHIBIT II
Transferor Survives Life Expectancy
Savings/(Loss) Compared to Retaining Property
$(000 omitted)

GRATs and GRUTs have a number of similarities to SCINs and private annuities. In each case, the transferor retains the right to payments during a specified period (or for life), with the ail of keeping the transferred property out of the transferor's estate. No Frane problem exists with a GRAT or GRUT. Assuming the GRAT or GRUT is a grantor trust, there is only a single tax on trust income, and no capital gains tax is imposed on annuity payments either during the grantor's lifetime or at death. On the other hand, there is no step-up in basis at death if the original property remains in the trust. Only a GRAT of GRUT, however, affords the grantor an opportunity to regain a step-up in basis by repurchasing the trust property at fair market value before the trust ends. The trust's sale to the grantor does not have any income tax consequences under Rev. Rul. 85-13, which ignores transactions between a grantor and grantor trust. Despite their positive features, GRATs and GRUTs are the riskiest of all the options discussed because the grantor's premature death brings the trust property back into his gross estate and undoes any tax savings.

Illustrations

The two illustrations that appear in Exhibit I and Exhibit II are based on a 78-year-old woman who wishes to transfer a minority interest in real estate to her children. The interest being transferred generates a cash flow of approximately $71,000/year, which the transferor wishes to retain for a period equal to her life expectancy (i.e., 10.6 years under Reg. 1.72-9, Table V). The interest being transferred is worth $1 million (after a 25% minority discount) and is expected to appreciate at approximately 4% per year; 120% of the Federal mid-term rate at the time of transfer is 6.4%, and the transferor is in the 55% estate tax bracket. In each case illustrated, there is a transfer of the same $1 million in exchange for the same $71,000/year, payable over the same period. The only difference is that in one case, the transaction is structured as a private annuity; in another, as a regular installment sale; in another, as a SCIN; and in the last, as a GRAT. Exhibit I assumes that the transferor survives her life expectancy, while Exhibit II assumes the transferor dies in the middle of her life expectancy.

In Exhibit I, estate taxes are saved in each case on minority discount and on appreciation. The results for the private annuity and regular installment sale are identical if the transferor survives her life expectancy. The SCIN does not fare as well because a cancellation premium of approximately 64% must be added in determining the interest purchased. The GRAT has the potential for the greatest savings if the property is repurchased from the trust and held until death, thereby receiving a step-up basis. No adjustment was made for accumulation of annuity or installment payments by the transferor because it is assumed that these would have been received as investment income, even without the transfer.

As Exhibit II illustrates, if the transferor dies midway through her life expectancy, the private annuity produces the best results. No capital gain is recognized at death on the unpaid balance, unlike a SCIN or regular installment sale (where payments continue to the estate). The SCIN suffers from the required cancellation premium. The GRAT is out of the picture as the grantor's premature death brings the property back into her gross estate and erases any savings.

Conclusion

Theoretically, the present value of payments reserved by the transferor (whether in the form of annuity payments or sales price), plus any gift annuity in a transfer, will equal the value fo the transferred property. Viewed from this perspective, removal of appreciation from the estate, and a possible discount for the minority interest, offer the most predictable savings. Premature death will be a boon in the case of a private annuity, a lessor boon for SCIN, no help in a regular installment sale, and a financial disaster for a GRAT or GRUT. There is another key element, though. In most cases, the transferor would have been receiving comparable payments from the transferred property in the form of income, dividends, or salary, even if the transfer had not been made. Through the use of a private annuity, SCIN, installment sale, or GRAT, these same payments are simply recharacterized as annuity or note payments, and a business or real estate interest will be magically removed from a transferor's estate.