Historically, the gift and estate tax laws have limited the ability of wealthy individuals to transfer their interests in family businesses to their children without suffering potentially severe tax consequences.  However,  many wealthy taxpayers are interested in shifting the appreciation in their business out of their estate and into the hands of their children.

Transfers by Gift

Usually, a gift of property to a family member will remove the property, and any subsequent appreciation in its value, from the donor’s estate.  If the taxpayer does not transfer the property during his life, the full value of that property as of his date of death is included in his estate and is subject to transfer tax.  In general, a gift transfer occurs if the consideration received by the donor is less than the value of the property transferred. In that case, the amount of the gift is equal to the excess of the value of the property transferred over the amount of the consideration received.

To the extent that adequate consideration has been received, the transferor has made a sale that is subject to the income tax.

For some, though, an outright gift may not be the most attractive option because the business represents their main source of revenue. Such a taxpayer may want to consider a form of transfer which provides a stream of payments in exchange for the interest.  (It should be noted that, by their nature, interests in closely-held entities are difficult to value. Even if the taxpayer relies upon a well-reasoned appraisal, the IRS will often challenge the reported value. )

Transfers by Sale

 One way to transfer property to beneficiaries, while receiving a stream of income therefrom, is through a sale of the property, often to an irrevocable, grantor trust (funded with a not insignificant “seed gift”), in exchange for a trust-buyer’s installment note.  The sale to the trust is not subject to income tax (because the taxpayer is dealing with himself), and the issuance of the note prevents any gift tax (because there is adequate consideration). The value of the business interest sold is frozen in the seller’s hands at the amount of the note. The future appreciation of, and the cash-flow from, the interest should cover the loan service.

In order to avoid gift characterization for the sale-transfer, the taxpayer must establish:

  1. the value of the property sold, and
  2. the value of the note received in exchange.

The installment note must bear a minimum rate of interest. The installment obligation should be memorialized in writing and, preferably, it should be secured. The term of the note should not exceed the seller’s life expectancy, and payments should be made as required by the terms of the sale and note agreements.

If the taxpayer-seller should die before the note is satisfied, the value of the note (presumably the outstanding principal amount as of the date of death) will be included in the seller’s estate for estate tax purposes.

SCINs to the Rescue!

The inclusion of the note in the seller’s estate in the event of his premature death presents an issue which taxpayers have sought to address through a sale of the property to a trust in exchange for a self-cancelling installment note (“SCIN”). Under the terms of a SCIN, if the taxpayer-seller dies before the end of the note term, the remaining principal on the note is cancelled.  This, of course, benefits the buyer, and it also avoids inclusion of the note in the seller’s estate.  In general, this technique works best where the seller is not expected to survive his actuarial life expectancy, but is not terminally ill.

In order to avoid a bargain sale and gift when using a SCIN, the seller must be compensated for the self-cancellation feature, either through an interest rate premium or through a purchase price premium. In general, during the term of the note, both principal and interest should be payable currently.

An Example

While the forgoing may sound fairly straightforward, a recent advisory issued by the Office of the Chief Counsel of the IRS illustrates how things can go wrong in structuring a SCIN transaction. The taxpayer in IRS CCA 201330033 participated in two transactions involving SCINs.

In both transactions, the taxpayer transferred shares of to a grantor trust of which he was the deemed owner. In exchange, the trusts issued promissory notes with a term based upon his actuarial life expectancy as derived from IRS tables used in the valuation of annuities, term and remainder interests. The notes bore interest that was payable annually. No principal was payable until the end of the note’s stated term. The notes included a self-cancellation feature.

The shares were appraised at $X. In the case of the first trust, the face amount of the notes was almost double the appraised value, supposedly to compensate the taxpayer for the cancelation feature. As to the second trust, the interest rate was above-market in order to account for the cancelation feature. The ruling makes no mention of the taxpayer’s health as of the time of the transactions. In a typical SCIN transaction, the taxpayer will have contemporaneously obtained a relatively clean bill of health from a physician.

The taxpayer died less than six months later. The taxpayer received neither any interest payments nor the principal due on the notes. The SCINs were not included on the decedent’s estate tax return, nor were they reported as gifts on his gift tax return.

The advisory indicated that a transaction where property is exchanged for promissory notes will generally not be treated as a gift if the value of the property transferred is substantially equal to the value of the notes. The face value and term of the notes must be reasonable in light of the circumstances.

The IRS noted that a SCIN transaction between family members is presumed to be a gift, and not a bona fide transaction, though the presumption may be rebutted by an affirmative showing that there existed at the time of the transaction a real expectation of repayment and an intent to enforce the collection of the indebtedness; for example, if the taxpayer was not willing to gift the stock to his family because he required a steady stream of income, he would transfer the stock in exchange for a note that provided for both installment payments of principal plus interest which, had he lived, he would have throughout the term of the note.  In other words, there must be a real expectation of repayment, and the intention to enforce the collection of indebtedness.

In contrast, the IRS pointed out, the decedent in the advisory structured the notes such that the payments during the term consisted of interest only, with a balloon payment at the end of the note’s term. A steady stream of income was not contemplated. Moreover, the decedent had substantial other assets and did not require the income from the notes to cover his living expenses. Thus, the arrangement in this case was nothing more than a device to transfer the stock to family members at a lower value than the fair market value of the stock.

In addition, the IRS stated that the notes lacked the indicia of genuine debt because there was no reasonable expectation that the debt would be repaid. The estate must demonstrate that the trusts that issued the notes had the ability to repay the amount of the note. According to the IRS, it failed to do so.

Finally, the IRS stated that it was inappropriate to value the notes using the actuarial tables described above. Rather, the notes should have been valued based on a method that takes into account the so-called “willing-buyer willing-seller” standard. In this regard, the decedent’s life expectancy, taking into consideration the decedent’s medical history on the date of the gift, should have been taken into account. (The IRS made the same argument in its recently filed answer to the taxpayer’s petition in Est. of Davidson v. Commissioner, T.C., No. 013748-13, where the decedent died shortly after the SCIN transaction.)

The IRS concluded that, because of the decedent’s health, it was unlikely that the full amount of the note would ever be paid. Thus, the notes were worth significantly less than their stated amounts, and the difference between the fair market value of the notes and the value of the shares sold to the trusts (as reflected in the notes’ stated amounts) constituted a taxable gift at the time of the transfer to the trusts.

Conclusion

The foregoing highlights some of the issues and pitfalls that need to be considered before embarking on a sale of an interest in a closely-held business in exchange for a SCIN. While a sale to a trust in exchange for a SCIN can be a useful estate planning tool, it is not appropriate in all circumstances. As with all estate planning in the context of a closely-held business, the taxpayer has to consider a number of consequences that may arise out of any  transfer decision.