Gift Tax Consequences of Self-Cancelling Installment Notes
In a Chief Counsel Advice Memorandum, CCA 201330033, the IRS reviewed the gift tax consequences involving the transfer of stock to grantor trusts in exchange for self-cancelling installment notes (SCIN). The IRS held that the transfers resulted in taxable gifts because, under the facts, the value of the stock transferred by the decedent exceeded the value of the SCINs he received.
The decedent established several trusts for the benefit of family members. Each of the trusts was a grantor trust for income tax purposes pursuant to Section 671 et seq. The decedent made several transfers of stock and promissory notes to the trusts. Two of the transfers to the trusts consisted of transfers of stock to the trusts in exchange for SCINs. One of the transfers involved SCINs that provided that interest was to be paid annually by the trusts and that the entire principal was to be paid in a balloon payment at the end of the term of the note.
The self-cancelling feature provided that no further payments of interest or principal would be required if the decedent died during the term of the note. In order to compensate the decedent for the risk that he could die before the trust had paid the note off in full, the face amount was almost twice the fair market value of the stock transferred to the note. The other transfer also involved SCINs that provided for the annual payment of interest and for a balloon payment of interest. In order to compensate for the possible death of the decedent before the note was paid in full, these SCINs provided for a higher rate of interest.
The decedent filed a gift tax return disclosing the SCINs but did not report any taxable gift as a result of the transactions. Shortly after the transfers, the decedent was diagnosed with an incurable disease and died six months later. The decedent's estate tax return did not report any portion of the SCINs as being a part of his estate.
The IRS stated that the fair market value of promissory notes is presumed to be the amount of the unpaid principal, plus accrued interest, unless the donor establishes a lower value.1 The IRS stated that a transaction where property is exchanged for promissory notes will not be treated as a gift if the value of the property transferred is substantially equal to the value of the notes. The IRS stated that in order to determine whether the decedent made a taxable gift, the value of the stock that the decedent transferred to the trusts shortly before his death must be ascertained as well as the value of the notes taking into consideration the notes' self-cancelling feature. If the fair market value of the notes is less than the fair market value of the property transferred to the trusts, the difference in value is deemed a gift.2
The IRS cited Estate of Costanza,3 in which a taxpayer sold real property to his son in exchange for a note with a self-cancelling feature. The court stated that a SCIN between family members is presumed to be a gift and not a bona fide transaction but that the presumption may be rebutted by an affirmative showing that there existed a real expectation of repayment and intent to enforce the collection of the debt. The court concluded that, on the facts before it, the presumption had been rebutted since the decedent was not willing to gift the business properties to his son because he required a steady stream of income in order to retire. In addition, the taxpayer could show that, at the time of the transaction, a real expectation of repayment existed and the decedent intended to enforce the collection of the debt. Therefore, the court concluded that the transaction was bona fide.
In the Chief Counsel Advice, the IRS stated that this case is distinguishable from Estate of Costanza. The IRS stated that in Estate of Costanza, had the decedent lived, he would have received monthly payments consisting of income and principal throughout the term of the note. The decedent in Costanza required the payments for retirement income and, thus, had a good reason, other than estate tax savings, to enter into the transaction. In contrast, the IRS stated, the decedent in this case structured the note such that the payments during the term consisted of only interest with a large balloon payment on the last day of the term of the note. Moreover, the IRS noted that the decedent in this case had substantial assets and did not require the income from the notes to cover his daily living expenses.
The IRS stated that the arrangement in this case was nothing more than a device to transfer the stock to other family members at a substantially lower value than the fair market value of the stock. Thus, the IRS concluded that the note was worth significantly less than its stated amount, and the difference between the note's fair market value and its stated amount was a taxable gift.
More than a few practitioners may consider that, in spite of the premium features of the SCINs, the notes were structured in an aggressive manner because of the balloon payment of principal. In addition, although the decedent's health was not discussed in any detail, one is left to wonder whether the IRS's conclusion was based in part on the very short period between the decedent entering into the transactions and his death.
1See Reg. 25.2512-4.
2See Reg. 25.2512-8.
391 AFTR 2d 2003-988 , 320 F3d 595, 2003-1 USTC ¶50268, 2003-1 USTC ¶60458 (CA-6, 2003), rev'g TC Memo 2001-128 , RIA TC Memo ¶2001-128, 81 CCH TCM 1693.
Frank Baldino is an estate planning attorney who co-chairs Lerch, Early & Brewer’s Estate Planning & Probate group in Bethesda, Maryland. His focus is on protecting the assets of high net worth individuals to minimize federal and state tax liability. For more about gift tax consequences, contact Frank at (301) 657-0175 or email@example.com.
This article originally appeared in the December 2013 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.