ELITE ADVISOR BEST PRACTICES
Winning the Game
By the SCIN of your client’s teeth
By Alexander Bove
- The Self-Cancelling Installment Note (SCIN) is one of the most overlooked but effective tax planning loopholes.
- The SCIN can provide a step-up in basis to the buyer at no cost.
- A SCIN is a promissory note whose term is considered satisfied if the holder dies before it is in fact paid in full—even if no principal payments are made.
- Although SCINs are often used for intra-family sales of income-producing (debt-free) real estate, they can also be used to acquire shares of a family business under the right circumstances.
The name of the game in good estate planning is to get family assets from A to B at the least possible tax cost with the least possible pain (pain being defined here as a loss of benefits to A). Efforts to develop estate planning tools that in one way or another satisfy this objective have given us such tools and techniques as the Qualified Personal Residence Trust (QPRT), sales to an Intentionally Defective Grantor Trust (IDGT), the Grantor Retained Annuity Trust (GRAT), the Private Annuity (PAN), and the Self-Cancelling Installment Note (SCIN), among others. And a clever estate planner will often combine more than one technique to get from A to B.
The last two of the foregoing five schemes, however, can offer a benefit unmatched by any of the others. That is to say, the PAN and the SCIN can actually cause assets to “disappear” from the estate at a substantially reduced cost. This discussion will review the pros and cons of the SCIN, and our next discussion will address the PAN.
The definition of a SCIN could not be simpler. It is a promissory note that by its terms is considered paid in full if the holder dies before it is in fact paid in full, even if no principal payments are made. That may be where the simplicity stops, however. For example, say that Mom sells her income-producing apartment building to her son for its fair value of $2 million in return for a $2 million SCIN due in 10 years. Mom dies a year later. If the SCIN is properly structured, the entire value of the property would be excluded from Mom’s estate. But if the son made no payments, will he have a $2 million gain? Will there be a deductible loss to Mom’s estate? What if Mom were terminally ill when the note was given?
Requirements for a healthy SCIN
In order to work, the SCIN must meet certain requirements. First, the term of the SCIN should not be longer than the seller’s life expectancy according to applicable IRS tables. For example, if the tables say the seller has a six-year life expectancy, the term of the SCIN should not exceed six years. As a practical matter, advisors often make the term at least six months less than the seller’s life expectancy. If the term of the note exceeds the seller’s life expectancy, the arrangement would be considered a private annuity instead of a SCIN—with substantial tax differences—as will be seen in an upcoming issue of Elite Advisor Report. Next, the fair market value of the SCIN must reflect the fair market value of the asset sold. If it is less, then the seller would be considered to be making a gift of the difference. Note that the price can be more, however, because the seller runs the risk of never being paid the full amount of the sale price, and the note must contain some compensation for that risk, which is referred to as a “premium.” The premium may be in the form of an increase over the normal interest rate called for by the tax code for the loan in question or an increase in the principal of the note or both. So if the called-for interest rate under the applicable IRS table is 2.4 percent, then the note might carry a rate of 7 or 8 percent. (NOTE: This is not a recommendation, as there is no specific formula or rule.) Similarly, the buyer may offer a 20 percent premium on the principal to compensate for the risk. And while a SCIN may offer the best result when the seller has less than a normal life expectancy, it may not be recognized by the IRS if the seller, despite the tables, is likely to live less than a year after the transaction, based on a physician’s prognosis. If the seller lives for 18 months after the sale, there is a presumption that the sale was not made in anticipation of his or her death.
As with any installment sale, the seller’s tax on the gain may be deferred until payments are received. Similarly, interest on the note is taxed when received, but it may not be the subject of the cancellation feature. That is, interest may be paid periodically or deferred, but it must be accounted for in any event. The buyer, on the other hand, will get the benefit of the SCIN “loophole.” Whether or not the seller ever pays the principal on the note, he or she acquires a basis in the property equal to the sales price. This is a huge loophole in the tax law, since this would be the amount that establishes the buyer’s basis for depreciation and later gain, even though he or she may have made no payments other than interest. Note that because this is an intra-family sale (as most SCINS are), the installment sale treatment (deferral of gain) won’t apply if the property is sold within two years of the transaction, and publicly traded securities may never be the subject of an installment sale, intra-family or not.
Further on the seller’s side of the tax coin and the other side of the loophole, although there is no gain to the buyer on the seller’s premature death, the seller’s estate must recognize the full gain on the sale even though full payment may not have been made. This is the tax reconciliation of the buyer’s increased basis.
Although SCINs are often used for intra-family sales of income-producing (debt-free) real estate, they are also attractive for the acquisition of shares of a family business under the right circumstances, removing the value of the transferred shares from the owner’s estate. For example, say that Dad is the sole owner of Dad Inc. He sells 30 percent of the outstanding shares to each of his two children in return for a SCIN, with the sale price based on an independent appraisal but subject to a discount for the minority interests. The interest payments on the SCINs will help fund Dad’s retirement. If the SCINs are properly structured and carried out and if Dad passes before the due date of the notes, then 60 percent of the company will be excluded from Dad’s estate and there will be a discount in the value of the remaining shares in his estate.
In planning with a SCIN in such a case, however, advisors should compare the projected estate tax savings with the capital gains tax to be paid on the death of the seller. Generally, the SCIN works better in larger estates that will be subject to a higher rate of estate tax.
Of course, the morbid aspect of the SCIN is the presumption that the seller will in fact die before the due date of the note; thus it is not a suggested technique for a seller who is the picture of health, regardless of age. If the seller does outlive the terms of the note, what do you do? One option is to make a principal payment (say 3 to 5 percent) of the balance due on the note (to show that there is an intention to pay the note) and renegotiate the term (e.g., extend it) before the due date but certainly not beyond the seller’s new life expectancy (measured at the end of the term). Further, the IRS and the tax regulations put limits on such a “modification” of the note, suggesting that the extension should not be more than the lesser of five years or 50 percent of the original term of the note, again, provided that it does not extend beyond the seller’s life expectancy.
Thus, as with all tax planning ideas, with the SCIN there are opportunities and there are pitfalls. As Woody Allen has said, “The trick is to seize the opportunities, avoid the pitfalls and be home by 5 o’clock.”