Category: Sales & Exchanges; Estate &
Subject: Installment Sales
Title: Self-Cancelling Installment Notes
IRC Sections: 102, 453B, 61(a)(12)
Date Produced: 09/94
Copyright 1998, The Tax Resource Group. All rights reserved.
Telephone 800-578-3498. Internet: www.taxresourcegroup.com
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
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.