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The Tax Resource Group: Professional Tax Research Material, Resources, and Consulting

Category: Sales & Exchanges; Estate & Gift
Subject: Installment Sales
Title: Self-Cancelling Installment Notes
IRC Sections: 102, 453B, 61(a)(12)
Filename: 1341.html
Date Produced: 09/94

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Individual taxpayer, TP, owns 100% of the stock of an S corporation (S). TP wishes to retire from the business. TP plans to gift 50% of his S stock to his spouse. Thereafter, TP and spouse plan to sell all their S stock to their son and son-in-law on an installment sale basis. The wills of TP and spouse will provide that the installment note held by the first spouse to die will pass to the survivor, and all installment notes will be cancelled on the death of whichever spouse dies last.

It has been suggested that absent a specific bequest pursuant to a will, a so-called self-cancelling installment note (SCIN) will give rise to cancellation of debt (COD) income to the debtor when the note is cancelled. The project is to find the controlling precedent (if it exists) and determine how COD income can be avoided in this case. In addition, confirmation is needed that the deferred installment gain will not be triggered as a result of the note passing on the death of the first spouse to die.

The author of BNA Portfolio 805-1, Private Annuities, comments that it is unclear whether the buyer in an (SCIN) situation must recognize (COD) income. General Counsel Memorandum 39503 which deals with the income tax aspects of SCIN's is silent on this issue, and the author feels that the COD aspect of SCIN's is subject to attack by the IRS.

I cannot locate anything that directly indicates that it is necessary for the taxpayer to provide for cancellation of the installment note in his will in order to avoid COD treatment to the buyer; however, it is now clear to me why the commentator you read suggested this result, and I agree.

§102 provides that gross income does not include amounts received from gifts or in the nature of inheritances. If donative intent were present in all SCIN situations, it would seem that §102 should always control and there would be no COD issue to consider. The key to understanding the proposition that an SCIN should be explicitly handled through the seller's will is the realization that an SCIN is not necessarily associated with family tax planning: donative intent on the part of the seller cannot be assumed by the mere existence of an SCIN. While it is true that many, if not most, SCIN arrangements are between family members, it is not a requirement nor is an SCIN necessarily a vehicle for passing wealth on to future generations even where family members are involved. There are perfectly legitimate, non-donative reasons for entering into an SCIN either with family members or outsiders. Accordingly, donative intent cannot be assumed merely by the existence of an SCIN.

Without a clear indication of donative intent, cancellation of the SCIN on the death of the seller could subject the buyer to the existing uncertainty as to whether COD income should result from the cancellation. Explicitly handling the SCIN in the seller's will puts to rest any doubt regarding donative intent thus allowing §102 to control the buyer's tax consequences at the time of cancellation.

With respect to your question as to whether deferred installment gain is triggered on the death of the first spouse to die, it is clear that no gain is triggered at that time. See §453B(c). The remaining unreported gain is income in respect of a decedent (IRD) under §691(a) and is taxed only as payments are received either by the estate or the beneficiary.

An important collateral issue is of course the income tax treatment to the seller when the last spouse dies. It is clear that any remaining installment gain must be recognized by the seller or the seller's estate when the SCIN is ultimately cancelled. The IRS' position is the gain is IRD and is thus taxable on the estate return. That position, while disadvantageous for the taxpayer, was upheld by the Eight Circuit Court of Appeals in the case of Frane Estate v. Commissioner, 98 TC 341 (1992), aff'd in part and rev'd in part, CA-8, 93-2 USTC ¶50,386.

Incidentally, I found BNA Portfolio 805-1, Private Annuities, to be extremely helpful in solving this tax question. This volume seems to contain a wealth of information both on the subject of private annuities and SCIN's as well. Since you are deeply involved in planning a transaction in which these issues are relevant, you might find it extremely helpful to have this volume yourself. As I understand it, BNA will sell individual volumes for a very nominal amount (about $25, I think). If you are interested, you can contact BNA directly at 800-372-1033.