The Internal Revenue Code assesses a tax (gift or estate) on the transfer of money or property from one person to another during life or at death, with some exceptions. If you own accounts or property that are worth a lot of money and you expect them to continue to increase in value, you may want to transfer them out of your estate so you will no longer own them and they will not be subject to estate tax at your death. If you believe this type of planning may benefit you, then you need more than just a simple estate plan. Do not worry, though—there are strategies and tools that we can use to fulfill your goal of getting rid of an account or property while minimizing the tax consequences of this transaction.
Self-Canceling Installment Notes
A self-canceling installment note (SCIN) is a promissory note that can be used to transfer valuable accounts and property from one person to another with minimal gift and estate tax consequences due to a clause in the promissory note that states the buyer’s obligation to repay the loan ends upon the death of the seller.
How SCINs Work
A seller sells an asset (an account or piece of property) to a buyer (often a family member) in exchange for a promissory note, which includes a self-cancellation clause. The self-cancellation clause states that, should the seller die before the balance of the note is paid, the note terminates and the outstanding balance of the note is canceled. If the seller survives the term of the note, the seller will receive the total value of the note in exchange for the asset that was sold. If the seller does not survive the note term, the asset remains with the buyer, and the asset's value is removed from the seller’s estate (with estate being defined as everything the seller owns at the time of death). Further, the note is canceled, and the remaining balance due is not included in the seller’s estate. Overall, because the asset and the unpaid portion of the SCIN are not part of the seller’s estate, it is not subject to estate tax and is not considered a gift that would be subject to the gift tax.
The Term of the SCIN
To be effective for estate planning purposes, the note's term should not exceed the seller’s life expectancy. Determining the seller’s life expectancy and the term used for the SCIN should involve consulting with an experienced professional, as many variables must be considered.
Selecting the Right Interest Rate for the SCIN
Every promissory note needs an interest rate; a SCIN is no exception. Although the transaction may occur between family members, the correct rate must be used. Generally, the interest rate for the SCIN must be equal to or greater than the applicable federal rate (AFR) with semiannual compounding. The specific AFR that should be applied will be determined by the repayment term of the SCIN (short-term rate for repayment term of up to three years, mid-term rate for repayment term between three and nine years, and long-term rate for repayment term greater than nine years).
Your SCIN Must Account for the Risk
Because the seller may die before the note is paid in full, and the seller’s death will cause the note to terminate and cancel the outstanding balance, a premium must be included in the transaction to address this possibility. There are two ways that the risk premium can be addressed within the promissory note: an increase in the sales price to above fair market value or an increase in the interest rate above the standard AFR. Deciding on how to include the risk premium depends on the buyer and seller and their tax circumstances. A professional can help craft terms that will consider the specifics of your proposed transaction.
When Might You Use a SCIN
Although a SCIN is not for everyone, there are some circumstances in which it can be a valuable tool. For instance, if you own assets that are likely to have a large amount of future appreciation (meaning they are likely to become more valuable in the future), and you want to make sure that this future appreciation is not included in your estate for estate tax purposes at your death, you may be looking for ways to give the assets to someone else, such as a child, grandchild, or other family member. If you die before the note's term expires, the remaining balance owed is canceled, and the asset and the unpaid balance will not be included in your estate for estate or gift tax purposes. It is important to note that the ideal time for transactions like this is when we are in a low-interest rate environment.
Additional Considerations
Many different factors go into developing the right estate plan. While taxes may be at the forefront of your mind, we must also ensure that your plan adequately addresses your other areas of concern. If you want to learn more about SCINs and their use in your estate plan, call us. We are also available to assist you in creating or updating your existing estate plan.