SCIN –
Self-Canceling Installment Note
This procedure involves an installment sale of
property. It has the estate freezing
attributes of an installment sale. The
seller acquires a fixed value note in exchange for property which is likely to
realize future appreciation in value.
The note includes a provision which states that the note will be
canceled upon the death of the seller.
Mr. Goldberg owns 350 shares (out of 500 issued shares) of
Max Goldberg Plumbing. An appraisal report indicates that the value of Mr.
Goldberg’s interest in the corporation to be $1,000,000. His income tax basis in the stock is
$50,000. Mr. Goldberg sells the stock to
his son and daughter, Alex and Irma, in exchange for an installment obligation.
Mr. Goldberg expects to acquire J.M. Plumbing, which could
cause the sales and net worth of the corporation to more than double over the
next 10 years. Mr. Goldberg presently
receives a salary of $50,000 from the corporation and a bonus in addition to other benefits equaling $325,000. .
The note is structured for a payout of 20 years. The note includes the following
provision: "For additional
consideration, the payment obligations of this note, both as to principal and
interest, will terminate upon the death of
Mr. Goldberg."
Issues: What
premium must Alex and Irma pay for the cancellation on death provision? What are the income tax consequences to Mr.
Goldberg? Is he entitled to an
installment payout of capital gains?
Must he realize interest income as ordinary income? What are the income tax consequences to his
estate upon his death? What are the tax consequences to Alex and Irma? Can they deduct the investment interest
expense? Would the tax results be
different if the corporation redeemed all of Mr. Goldberg’s stock and if Mr.
Goldberg ceased to be an employee of the company?
Mr. Goldberg dies 10 years thereafter. If the transaction complies with all of the
requirements prescribed by law, neither the stock sold to Alex and Irma, nor
the promissory note will be an asset taxable in Mr. Goldberg's estate.
What is the
precedent for this procedure?
Estate of
Moss, 74 T.C. 1239 (1980), acq. in result only. The Tax Court held that the remaining note
balance due under a self-canceling installment note was not includible in decedent's
gross estate under Section 2033 of the Internal Revenue Code since the
cancellation provision was part of the bargained-for consideration. The Installment Sales Revision Act of 1980
amended Section 453(b) to permit a sale of appreciated property to qualify for
installment reporting even though some or all of the future payments are
contingent in amount. The Internal
Revenue Service ruled in Rev. Rul. 86-72, 1986-1 CB 253 that the decedent's
estate must recognize the deferred installment gain on the estate's initial
income tax return. So, we have
recognition of the self-canceling installment note by the Tax Court and the
Internal Revenue Service. The estate of
a deceased taxpayer contested Rev. Rul. 86-72 in the Frane case. Notably, the
Internal Revenue Service did not contest the validity of the cancellation
provision in the note or the premium paid for the cancellation privilege. Estate
of Robert Frane, 98 T.C. 341 (1992), affd
in part, revd in part, 72 AFTR2d 93-5268, 93-2 USTC ¶50386 (8th Cir. 1993).
The Tax Court also recognized the validity of
the self-canceling installment note in Cain
v. Commissioner, 37 T.C. 185 (1961), acq.
1962-2 C.B. 4. Martha King Disborough
sold, without reservation or contingency, stock in a family-owned corporation
to the corporation for $150,000. The corporation was to pay $6,000 at the time
the stock was transferred and $1,000 per month for 12 years or until decedent's
death, whichever occurred first. When decedent died, the balance remaining due
under the contract was $44,135. The Tax
Court held that no part of the purchase price or the stock should be included
in the decedent's gross estate or be taxed to Ruby Louise Cain as the
transferee of Mrs. Disborough's estate.
In the Frane
case, Mr. Frane issued 20-year installment notes to his four children for the
sale of common stock in a newly organized family corporation. Interest was payable at the rate of 12
percent. Each note provided that
"Unless sooner paid, all sums due hereunder. . . shall be deemed canceled
and extinguished as though paid upon the death of Robert E. Frane." At age 53, Mr. Frane's life expectancy
exceeded the 20-year term of each note.
Mr. Frane died two years after delivery of the notes and after only two
installment payments had been made. The
Tax Court held that the gain from the sale, reported in installments, must be
recognized upon cancellation of the note - on the final joint return of
decedent and his wife. The Eighth
Circuit Court of Appeals reversed, recognizing the validity of Rev. Rul. 86-72.
A minority opinion written in the Frane case leaves the door open to the
use of this technique. That opinion held that in lieu of an installment note,
the sale was a contingent sale (the actual amount that will be paid to Mr.
Goldberg is unknown – not unusual in the sale of a professional practice where
the buyer pays the seller a percent of revenue generated from the seller's former clients for
the next number of years), the capital gains would not be recognized for
income tax purposes.