Preface: Estate planning is complex. An awareness of options can sometime be helpful when making decisions on transfers of assets. One feature is the self-canceling installment note (SCIN). If you think a SCIN would be applicable to your asset transfer, talk with an estate/tax expert.
Self-Canceling Installment Notes – How They Work
A self-canceling installment note (SCIN) is an estate planning and tax strategy involving installment notes applicable to the transfer of business assets with payment to the seller over time. Installment payments in a SCIN contain both interest and principal, governed by Internal Revenue Code provisions. A SCIN is applicable to say the sale of a business interest between family members. As long as the sales price and stated interest rate are reasonable, no taxable gift occurs on the planned sale.
A SCIN’s self-canceling feature states that if the seller passes during the installment notes term, the buyer is relieved of any future payment requirements – the term cannot exceed actuarial life expectancy at the time of the transaction. So the SCIN offers a variety of valuable tax benefits: i) if the seller passes before the note matures, the outstanding principal is not added to the sellers estate, increasing the amount of tax-free transfers that can be achieved with an estate. ii) the seller can defer the capital gain on the sale with amortization of the gain over the timeframe of the SCIN. iii) the purchaser can deduct the interest paid on the installment note. Often when a SCIN is applied to estate planning, the selling price is higher than fair market value.
So why would anyone choose a SCIN when selling assets in an estate planning? One reason is the option to freeze the value of assets for estate purposes. Say your business value is increasing at 7% per year, the SCIN permits that increase in value to freeze at the point of the memorialization of the note, and future appreciation of the business will not be subject to transfer tax or capital gain. A SCIN is a sale of assets and not a gift, and the cancellation of remaining indebtedness is therefore not a gift to the purchaser. Secondly, when a SCIN is applied to transfers of wealth, the gain is deferred, or amortized along with payments, reducing the applicable amount of capital gain from at one time assessment to increments each year on the appreciated assets.
One risk with a SCIN is that the seller must have the real expectation of receiving all note payments, and enforcing collection of installments, and note merely attempting a disguised gift. This is obtained with timely payments and appropriate documentation of the note. Another risk in a SCIN is the valuation of the sale must be appropriate or fair. The IRS may challenge the SCIN structure, and therefore the valuation if improperly discounted could result in a gift assessment leading to a reduction of the estate exclusion for the seller.
Summary: A SCIN is applicable to business transitions and succession planning with a tax optimization feature. The advantage of a SCIN is the benefit to the seller of collection payments during their lifespan, and transferring wealth, tax free to the purchaser. However, if the seller passes before all payments are received on the note, the remaining capital gain can be charged to the estate. This estate planning and tax optimization option should only be implemented with the assistance of say an experienced estate attorney, to protect the SCIN participants.