United States: Self-Canceling Installment Notes: A Useful Tool in Transferring the Family Business to the Next Generation

A Self-Canceling Installment Note (SCIN) is a technique used to sell an asset, usually shares or partnership interests in a closely held family business, in exchange for an interest-bearing promissory note. An appropriately structured SCIN will remove the future appreciation in the family business from the seller’s estate. In addition, if the seller dies prior to the maturity of the promissory note, the then-outstanding principal amount of the note may be excluded from the seller’s gross estate.

A SCIN can also provide income tax benefits in that the recognition of the seller’s gain on the sale of an appreciated family business interest can be deferred over the term of the note until principal payments are received, provided that the seller is eligible for installment sale treatment. If the seller dies prior to the maturity of the note, the seller’s estate must recognize the remaining deferred capital gain on the estate’s initial fiduciary income tax return as income in respect of a decedent. Although no cash payments would be received to pay the tax on the deferred gain, the estate would still be liable for the decedent’s outstanding deferred income tax obligation.

The advantages of a SCIN from a purchaser’s perspective are that the purchaser’s basis in the property is generally stepped up to the asset’s purchase price and the purchaser will generally be entitled to a current interest deduction for the interest portion of the periodic payments on the promissory note.

In order for the IRS to respect the validity of the cancellation provision, the term of the promissory note must not exceed the seller’s life expectancy at the time of sale. If the term exceeds the seller’s life expectancy, the transaction will be treated as a private annuity transaction, which could have adverse income tax consequences for the parties. Such adverse consequences could include the characterization of annuity payments received beyond the seller’s life expectancy as ordinary income and possible limitations on the purchaser’s basis in the acquired asset.

The terms of the promissory note must include either an interest rate premium or a purchase price premium to compensate for the cancellation provision. The after tax consequences for the parties differ depending on which premium alternative is selected. If the principal premium approach is selected, the seller will recognize a larger amount of capital gains, presumably subject to taxation at lower rates, and the purchaser will have a higher basis in the acquired property. On the other hand, if the interest premium approach is selected, the seller will have a greater amount of ordinary income subject to higher income taxation and the purchaser could have a larger current income tax deduction. In most cases, actual after tax cash flow projections are required to evaluate and compare the consequences of the possible alternatives.

The mechanics of a SCIN are illustrated by the following example. Assume the seller is age 65 and desires to sell an interest in a family business with a current fair market value of $1,000,000 and a cost basis of $100,000. The determination of the fair market value should reflect appropriate discounts for a minority interest in the business, if applicable, and for a lack of marketability. The benefit of such discounts would pass to the purchaser-family members. For income tax purposes, absent installment sale treatment discussed below, the seller would have to report currently a capital gain of $900,000. Assuming the interest being sold is stock in a family corporation with a long-term holding period, the gain would be subject to a federal income tax of approximately $135,000, based on the current favorable 15-percent tax rate.

Based on a five-percent annual minimum interest rate, if a 10-year, self-amortizing promissory note, with a $100,000 down payment, is chosen by the parties, one of two annual payment arrangements would have to be selected. If the principal premium alternative is used, the purchase price would have to be increased from $1,000,000 to approximately $1,528,300 to reflect the cancellation feature with annual interest and principal payments of approximately $114,600 per year. If the interest premium alternative is used, the annual interest rate of five percent would have to be increased to at least 12.577 percent with annual interest and principal payments of approximately $124,900 per year.

The consequences of the transaction differ depending on the specific terms selected by the parties. A key component of a SCIN is the term of the promissory note. As indicated above, the term must be less than the seller’s life expectancy to avoid annuity treatment. If the seller outlives his or her projected life expectancy and the promissory note is satisfied in full, however, the purchaser will have paid a premium and the seller’s net worth may have been increased rather than reduced. In such a case, a SCIN would yield an estate tax benefit only if the appreciation of the subject asset is greater than the premium paid by the purchaser. Finally, if the cancellation feature is triggered, the seller’s estate must have sufficient liquidity to pay the income taxes attributable to any deferred gain, which must be recognized upon the seller’s death. In this case, no additional payments will be made by the decedent’s estate.

Other terms, which may be varied by the parties, include the amount of the down payment, the frequency of the periodic payments, the amount of the payments and changes in the interest rate. In determining the amount of interest to be charged, the minimum rates established monthly by the IRS based on the term of the note and the frequency of payment should be used to avoid imputed income tax consequences.

Unlike either a Family Limited Partnership (FLP)¹ or a Grantor Retained Annuity Trust (GRAT),² a SCIN, assuming the interest is appropriately valued, does not require the use of any of the seller’s lifetime gift tax exemption or annual exclusions. On the other hand, also unlike a FLP or a GRAT, a SCIN could result in a substantial out-of-pocket cost for both the seller and purchaser, with a stepped-up basis for the purchaser. A key difference is that the purchaser must have a source of funds to payoff the SCIN promissory note as the purchaser’s payment obligations become due. Presumably, those funds would be used by the seller to satisfy the seller’s income tax obligation on the deferred gain. In the other two estate planning devices, neither seller nor purchaser have similar obligations. Another consideration in the case of a SCIN is that the installment sale proceeds received by the seller prior to the date of death is included in the seller’s gross estate, which is generally not the case for transferred FLP interests or GRAT proceeds received by a trust beneficiary.

As the above discussion illustrates, the use of a SCIN has the potential for a significant estate tax savings in the case of an asset with a strong likelihood of future appreciation, provided there is a bona fide sale for adequate and full consideration. Moreover, the form and substance of the installment sale should be observed to preclude a claim that the SCIN is a sham. The cash costs of a SCIN, however, could be significant and the seller and purchaser must each carefully evaluate the after tax consequences, both from income and estate tax perspectives.

Because of their unique cash flow considerations, the costs and benefits of a SCIN must be carefully evaluated on a case-by-case basis. In appropriate circumstances, SCINs provide family business owners with a valuable estate planning tool to transfer the business to the next generation.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.