Heart disease runs in William’s family — all his male relatives have died before the age of 65. Although now, at age 50, William is in fairly good shape, he thinks his chances of living to a “ripe old age” aren’t good. William is therefore considering putting some of his wealth into a self-canceling installment note (SCIN) as an estate planning strategy.
People who use a SCIN as an estate planning tool take an informed risk that they won’t reach their actuarial life expectancy. Financial planners call this mortality risk.
SCINs and estate planning
One way to use a SCIN in estate planning is to sell your business or other assets to your children or other family members (or to a trust for their benefit) in exchange for an interest-bearing installment note. As long as the purchase price and interest rate are reasonable, there’s no taxable gift involved. So you can take advantage of a SCIN without having to use up any of your annual gift tax exclusions or lifetime gift tax exemption.
Generally, you can avoid gift taxes on an installment sale by pricing the assets at fair market value and charging interest at the applicable federal rate. As discussed below, however, a SCIN must include a premium.
The “self-canceling” feature means that if you die during the note’s term — which must be no longer than your actuarial life expectancy at the time of the transaction — the buyer (that is, your children or other family members) is relieved of any future payment obligations.
A SCIN offers a variety of valuable tax benefits. For example, if you die before the note matures, the outstanding principal is excluded from your estate. This allows you to transfer a significant amount of wealth to your children or other family members tax-free. And any appreciation in the assets’ value after the sale is excluded from your estate.
You also can defer capital gains on the sale by spreading the gain over the note term. But, if you die before the note matures, the remaining capital gain will be taxed to your estate even though no more payments will be received. Finally, your children or other family members can benefit because they may be able to deduct the interest they pay on the note.
Keep in mind that you can’t take advantage of a SCIN strategy if you’re terminally ill. Why? Because the IRS will likely view the transaction as a sham.
Factoring in a premium
Like most things in life, you can’t get something for nothing. To compensate you for the risk that the note will be canceled and the full purchase price won’t be paid, the buyers must pay a premium — in the form of either a higher purchase price or a higher interest rate.
There’s no magic number for the premium; the appropriate amount is a function of the payee’s age and the note’s stated duration. If the premium is too low, the IRS may treat the transaction as a partial gift, which may lead to gift tax consequences.
Both types of premiums mentioned above can work, but they may involve different tax considerations. If you add a premium to the purchase price, for example, a greater portion of each installment will be taxed to you at the more favorable capital gains rate, and the buyers’ basis will be larger. On the other hand, an interest-rate premium can increase the buyers’ income tax deductions.
There is a negative: The premium comes with some risk. In fact, SCINs present the opposite of mortality risk: The tax benefits are lost if you live longer than expected. If you survive the note’s term, the buyers will have paid a premium for the assets, and your estate may end up larger than before, rather than smaller.
A good fit?
Your estate plan should be developed with your individual situation and goals in mind. Give us a call if you think a SCIN it might be a good fit for your future financial plans.