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April 1993

The problem of SCIN. (self-canceling installment notes) (Federal Taxation)

by Taylor, Ronald L.

    Abstract- The 'Estate of Robert E. Frane' case has cast a considerable shadow of doubt on the value of self-cancelling installment notes (SCINs) as an instrument for estate planning. The Tax Court decided, based on IRC Section 453(B)(f), that the installment obligations of the four children of Frane, who sold them common stocks at fair market value and died before two of the four could complete their payment, are nullified. Thus, the fair-market rate of the notes must not be lower than their face value, and deferred profit on the sale of the installment must be reflected on the final tax return of the decedent. Taxpayers are advised to tag a risk premium in the sale price, given the uncertainty involved in the collection of the full payment.

The Estate of Robert E. Frane has a chilling effect on this planning device by holding that the installment obligations were canceled within the meaning of IRC Sec. 453(B)(f). As a result, the fair-market value of the notes cannot be less than their face value, and deferred profit on the installment sale must be recognized on the decedent's final tax return.

Cancellation and Taxable Disposition

Robert Frane formed a corporation (Sherwood) by transferring cash and stock to it in exchange for stock in the newly formed corporation. Later that year, he sold to his four children equal amounts of common stock in Sherwood. The purchase agreement stated that the purchase price was equal to the fair market value of the stock, as determined by appraisal. It also provided for 20 annual installments with interest at the rate of 12% on the unpaid principal. Each promissory note contained a provision that unless sooner paid, the obligations would be "canceled and extinguished as though paid" upon the death of Robert Frane.

Robert Frane's life expectancy exceeded the 20-year term of the promissory notes at the time of sale, but he died after two years. He reported capital gain with respect to the two payments received, but no gain attributable to the canceled notes was reported on his final tax return, and the value of the notes was reported as zero on his Federal estate tax return. Two of his children reported a loss on the disposal of the Sherwood stock by using a basis equal to the principal amounts paid. The other two children did not report either a gain or loss.

The IRS claimed that because of the cancellation provisions contained in each of the promissory notes, the estate should recognize gain under IRC Sec. 691. Alternatively, the IRS claimed that IRC Sec. 453(B)(f) causes the cancellation of the notes to be a taxable disposition, with the gain on the unpaid installments to be due and payable on the decedent's final income tax return.

The petitioners countered that the unpaid installment notes were not disposed of in a taxable disposition under either IRC Sec. 691 or 453(B)(f). Instead, the notes were extinguished by the decedent's death, and no obligation survived his death to be canceled or otherwise become taxable under the above code sections.

Analysis of the Tax Court's Decision

The Tax Court clearly rejected the initial argument by the IRS that the installment notes were taxable in the estate of the decedent under IRC Sec. 691. However, they were just as forceful in their argument that the notes were subject to the provisions of IRC Sec. 453(B)(f) which states- -

...if any installment obligation is canceled or otherwise becomes unenforceable--1) the obligation shall be treated as if it were disposed of in a transaction other than a sale exchange, and 2) if the obligor and obligee are related persons (within the meaning of IRC Sec. 453(f)(1)), the fair-market value of the obligation shall be treated as not less than its face amount.

An installment obligation which is disposed of in a transaction other than a sale or exchange is subject to tax to the extent the obligation's fair market value at the time of the transaction exceeds basis |IRC Sec. 453(B)(a)(2). As a result, the remaining deferred gain should be recognized on decedent's final tax return.

The majority opinion of the Tax Court placed great weight on the ill- fated wording found in the promissory note stating that Frane's death would cause the notes to be canceled and extinguished as though paid. In the view of the majority opinion, such cancellation is explicitly within the scope of IRC Sec. 453(B)(f).

They also quoted an example from the Senate Finance Committee report accompanying IRC Sec. 453(B)(f) indicating that Congress was specifically attempting to make it clear that the installment disposition rules could not be circumvented by canceling the disposition.

However, the example given in the Senate Finance Committee Report specifically refers to the situation where a living taxpayer forgives a portion of the notes as they become due. Frane is clearly a different situation, where an event outside the control of the taxpayer causes all the notes to have a value of zero.

Judge Halpern, in his excellent dissenting opinion distinguishes clearly between an obligation that exists and is later canceled, and an obligation that is subject to a contingency. When an obligation is subject to a contingency, and the contingency is not met, the obligation does not exist. This is different from canceling an existing obligation.

Unfortunately, to apply this to Frane, it is necessary to acknowledge that this is probably what the writers of Frane's installment notes intended, but not necessarily what they said. They said "canceled." Judge Halpern is willing to allow what they meant, and not hold them to what they said. Quoting from the 9th Circuit Court of Appeals decision in Pacific Rock & Gravel v. U.S., he said, "One should not be garroted by the tax collector for calling one's agreement by the wrong name."

Unfortunately, form-over-substance arguments work against the taxpayer more often than they work for him. As a result, we are left in the uncertain position of wondering if another taxpayer with the correct form will prevail against the IRS, or if SCINs are now limited for all taxpayers.

Unanswered Questions

Aggressive taxpayers can certainly use language in their SCIN that does not state that the note will be canceled. Judge Halpern uses the following as an example in his argument:

THE PARTIES INTEND THIS TO BE A CONTINGENT PAYMENT SALE. The purchase price of the stock is variable, and will be somewhere between $0 and $141,050 depending on how long the seller lives. A condition precedent to each contingent payment is that the seller be alive on the scheduled potential payment date. Consequently, if seller dies before any scheduled potential payment, the obligation to make such payment does not come into existence.

In this example, the obligation clearly does not exist unless the seller is alive at the time the installment payment is due. Therefore, there is no cancellation. As obvious as the analysis appears to be, there is no guarantee that the courts will accept it. It is always possible for the courts to reclassify the transaction as a cancellation of debt under the substance versus form argument. Alternatively, they may disregard the entire transaction as being too contingent to be treated as a sale. This alternative would result in the de facto overturning of Estate of Moss, and therefore less likely to occur.

Another unanswered question involves the sale price. In Frane, the IRS did not challenge the adequacy of the consideration. Therefore the Court did not discuss this issue. Future taxpayers may not be as lucky.

Given the uncertainty of collecting all the payments, taxpayer should build a risk premium in the sale price. In other words, the total of all payments, assuming that the vendor does not die, should be equal to the value of the property at the time of transfer plus a premium for the risk of not collecting the entire sum. There is minimal guidance on setting the amount of risk premium. Given the fact that the vendor's life expectancy should exceed the payment period, the premium should not be excessively large. However, in cases in which the vendor's actual life expectancy is shorter than the life from a standard mortality due to illness or other known reasons, the risk premium would be increased accordingly. Failure to do so will result in an IRS attack on the grounds of a disguised gift.

A final unanswered question is the basis of property in the hands of the purchaser. In Frane, the children used actual cost. However, they assumed that income would not accrue at the death of their father. Given the Tax Court's decision, can the children increase their basis? The question was not before the Court, and therefore was not addressed.

An argument can be made for increasing the purchaser's basis. The Committee report which the Tax Court cited as support for its conclusion states that under prior law taxpayers were using cost basis for the assets without the seller reporting gain. IRC Sec. 453(B)(f) was enacted to prevent the omission of income. Given the fact that the Court concluded that income should be recognized, it is logical for the children to use cost as the basis for the assets. Alternatively, it could be argued the children's basis is equal to the amount they paid plus the gain recognized by their father. This would equate the tax position of the seller and purchaser.

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