Category: Sales & Exchanges; Deductions & Credits; Estates & Trusts
Subject: Installment Sales
Title: Self-Canceling Installment Notes (SCIN's)
IRC Sections: 691(a)(2), 691(a)(5), 453B(f)
Filename: 1156.html
Date Produced: 6/96

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Background
At the time of his death, the taxpayer held a self-canceling installment note. By its terms, no further interest or principal payments were due in the event the taxpayer died before the note was paid off. The taxpayer died prior to full repayment of the note. At the time of his death, both principal and accrued interest remained unpaid.

Issue
The issue is the treatment of the unpaid interest on the installment note. The disposition of the principal portion is controlled by the Frane interpretation of the IRD rules. Is the taxpayer's estate required to recognize the canceled interest? If so, does the estate get a distribution deduction? Does the beneficiary (the obligor) get an interest deduction?

Answer
Although the matter is not 100% free from doubt, it appears there is a very strong case for excluding the interest income entirely. Having so concluded, the other issues are moot.

Discussion
If a taxpayer is entitled to income and dies before having recognized that income, the person who actually collects the income is taxed on it under the principles set forth in Section 691. Such an item of income is referred to as income in respect of a decedent, or IRD, and the right to receive such income is referred to as an IRD receivable.

If an IRD receivable is sold or transferred, the IRD is triggered and the transferor must recognize the income. This is the general rule regarding transfers of IRD receivable and is found at IRC 691(a)(2).

The second sentence of Section 691(a)(2) provides an exception to the general rule. If the transmission of an IRD receivable is to a person pursuant to that person's right to receive it by reason of a decedent's death or by bequest from the decedent, the transmission does not trigger recognition of the IRD.

691(a)(2) INCOME IN CASE OF SALE, ETC.--If a right, described in paragraph (1), to receive an amount is transferred by the estate of the decedent or a person who received such right by reason of the death of the decedent or by bequest, devise, or inheritance from the decedent, there shall be included in the gross income of the estate or such person, as the case may be, for the taxable period in which the transfer occurs, the fair market value of such right at the time of such transfer plus the amount by which any consideration for the transfer exceeds such fair market value. For purposes of this paragraph, the term "transfer" includes sale, exchange, or other disposition, or the satisfaction of an installment obligation at other than face value, but does not include transmission at death to the estate of the decedent or a transfer to a person pursuant to the right of such person to receive such amount by reason of the death of the decedent or by bequest, devise, or inheritance from the decedent. [Emphasis supplied.]

In other words, if a person inherits the right to receive IRD, the transfer of the IRD right to that person by reason of inheritance does not trigger the IRD. For example, suppose the taxpayer was due to receive a bonus from his employer, and the taxpayer died prior to receiving the bonus. Suppose further that the decedent's estate distributed the right to receive the bonus to the taxpayer's widow who under the decedent's will inherited the whole estate. The estate's transfer of the right to receive the bonus to the widow does not trigger the IRD. The widow will then recognize the IRD income when she actually collects the bonus from the taxpayer's employer.

Installment obligations represent a special case. The exception to the general rule of Section 691(a)(2) set forth in the second sentence thereof does not apply in the case of installment obligations canceled or transmitted to the obligor. This is an exception to the exception to the general rule of Section 691(a)(2). In essence, the general rule (which says that a transfer triggers recognition of IRD) applies if the property transferred is an installment obligation transferred to the obligor. Special rules are provided at Section 691(a)(5)(A) which explicitly remove installment obligations that are canceled or transferred to the obligor from the exception general rule of Section 691(a)(2).

In essence, if an installment obligation is canceled or transferred to the obligor by reason of death, the transfer triggers IRD in the amount of the fair market value of the installment obligation at the time of transfer reduced by the decedent's basis in the obligation.

Section 691(a)(5)(iii) goes on to provide that a cancellation of the obligation occurring at death of the decedent shall be considered a transfer by the estate. This final provision, Section 691(a)(5)(iii) squarely hits the principal portion of self-canceling installment notes (SCIN's). At one time there was some doubt about all this, although I fail to see why. In any event, any doubt that Section 691(a)(5)(iii) applies directly to SCIN's was erased by Estate of Frane, 998 F2d 567, 93-2 USTC ¶50,386 (CA-8, 1993).

All this is leading up to a discussion of interest income which was canceled along with the installment note in question in this matter. Neither the applicable IRC Sections, the underlying regulations, nor Frane deal with matter of interest. In Frane, there was clearly some interest canceled by operation of the terms of the note. The note in question was interest bearing. The facts of the case do not explicitly address the issue of unpaid interest; however, the case does set forth the dates on which installment payments were due as well as the date of the taxpayer's death. Having scrutinized those facts, it is quite obvious to me that there was unpaid interest at the time of the taxpayer's death. Yet, interest was not an issue raised in Frane. In addition, prior to Frane, the IRS had taken a position on the IRD aspect of installment obligations. That position, as set forth in GCM 39503 and Revenue Ruling 86-72, 1986-1 C.B. 253, does not address the interest issue.

It is my view that it would be possible to take either of the two following positions.

Position One: General IRD Receivable Rule
The unpaid interest portion of a SCIN is directly addressed by the second sentence of IRC Section 691(a)(2) and unaffected by Section 691(a)(5). It seems to me the unpaid interest is clearly an IRD receivable: it is a right existing at the decedent's death the income from which was not reported as a result of the decedent's method of accounting. (Incidentally, if the interest receivable is not an IRD receivable, there is no taxation of the interest because the IRD rules are the vehicle driving income inclusion in the first instance.)

Recall that the second sentence of Section 691(a)(2) provides that transfer of an IRD receivable to its obligor pursuant to the obligor's right to inherit that item does not trigger the IRD receivable. This relieves the estate from taxation. Since the obligor is clearly not going to pay himself the interest he owed the decedent, there is nothing to trigger subsequent recognition of the IRD once the transfer is made.

Position Two: No IRD
As alluded to above, if the unpaid interest is not an IRD receivable, then there is no inclusion of the interest at all. Section 691 is the mechanism forcing consideration of income inclusion. If the unpaid interest is not IRD, then Section 691 does not apply.

In the lower court decision in Frane, there was a very strong dissent by several judges to the effect that the entire installment note should not represent IRD at all. The dissenters argued that it is impossible to cancel a right that never existed in the first instance. Absent a right, there can be no cancellation of that right. By the terms of the note, the decedent had no right to receive anything under the note because the whole obligation under the note terminated at the decedent's death. If there is no right existing at the time of the decedent's death, there is no IRD.

The majority in Frane ruled that income inclusion is required by virtue of Section 453B(f) with respect to the principal portion of the installment note. This argument was overruled by the appeals court in favor of requiring income inclusion with respect to the principal portion of the note by virtue of the language of Section 691(a)(5)(iii).

The majority reached its conclusion not because they considered and rejected the argument put forth by the dissenters, but rather because they felt that Section 453B(f) controlled. I do not fully buy into the no-IRD argument with respect to the interest; however, several Tax Court judges were sufficiently convinced of its merits that they joined in a very strong dissent to the majority opinion. Perhaps it would work for the taxpayer in this case if the need arose.

Possible IRS Response: The Installment Note Rule Controls All
In my first position, I contend that the unpaid interest is an IRD item controlled by the rule set forth in the second sentence of Section 691(a)(2). I contended that the special rules for installment notes do not apply to the interest portion of those notes.

There is a risk that the IRS could argue that the interest portion of an installment note should not be severed from the principal portion in determining the tax results with respect to IRD. The amount of income inclusion required if Sections 691(a)(2) and (a)(5)(iii) apply is controlled by Section 691(a)(4)(b) which provides that the fair market value of the note less the decedent's basis therein is an item of IRD.

If for this purpose, the installment obligation includes the interest portion as well , then the fair market value the obligation (and hence the amount of income recognized) also must include the unpaid interest portion.

I think this is a ludicrous argument for the following reasons.

1. The phrase "installment obligation" is not defined for purposes of Section 691. In the context of income taxation, the common usage of the phrase excludes interest. In the installment sale provisions (IRC Sections 453, 453A, and 453B) there is no definition of the phrase, but it is clear from context that only the principal portion is included when the phrase is used.

2. The legislative history of Section 691(a)(5) (Senate Report No. 96-1000 and 1980-2 CB 494, 508) makes it clear that the provision was enacted to avoid a situation in which the buyer under a SCIN arrangement could obtained a stepped-up basis without the seller having recognized the full measure of gain. If Section 691(a)(5) is a prophylactic measure designed to prevent the aberration just described, it is fairly clear that any interest associated with the installment note is ignored for this purpose since the interest portion of the installment obligation does not affect the buyer's basis.