Got Premium? Costanza v. Commissioner and the Tax Treatment of Scins Cancelled by Death

• Citation: Vol. 15 No. 3
• Publication year: 2009

GOT PREMIUM? COSTANZA V. COMMISSIONER AND THE TAX TREATMENT OF SCINS CANCELLED BY DEATH

By Gadi Zohar^*

I. INTRODUCTION

This article hopes to accomplish one goal for the practitioner who is essentially unfamiliar with self canceling installment notes and another for the seasoned practitioner who is more versed in their use. In the first instance, the article seeks to introduce a practitioner to the basics of the self canceling installment note (SCIN) along with some general considerations regarding their use in practice. A SCIN, usually executed between family members, is different from other notes in that a person's death (usually the note's holder) immediately terminates any future obligations to pay on the note. The primary purpose of a SCIN is to get property (typically a closely held business) out of the donor's estate without incurring transfer taxes.

A basic illustration follows. Mother, seventy-five years old and in average health, owns an auto dealership with a fair market value of $5,000,000. She sells the dealership to Daughter in exchange for a SCIN. The $5,000,000 note matures in eight years, is payable quarterly and accrues interest at a rate of AFR + 5%. Keep in mind that at this point, Mother could live for three years, in which case the note, if respected by the IRS, avoids transfer tax consequences (income tax consequences are discussed below). If Mother lives long enough for the note to mature, she has essentially imposed de facto transfer tax consequences to daughter who paid full price plus a high interest rate for the dealership while Mother paid income taxes on the payments. Moreover, whatever is left of the payments in Mother's estate is subject to estate taxes. Thus, one can take from this example that a SCIN is only advantageous if the holder dies before maturity.

The SCIN must be an objectively bona fide transaction. Because two unrelated business people would not likely consider such a deal, the "objectivity" of the SCIN exists within the world of SCINs entirely. A simple way to conceive of the objectively bona fide transaction is by asking what the reasonable parent actually selling (as opposed to a sham sale) the business to her child would do. Also, a SCIN must be a subjectively bona fide transaction in which the parties manifest a subjective intention of creating a debtor-creditor relationship. Also, the SCIN must be exchanged for full and adequate consideration in order to be effective.

Whether analyzing for a bona fide transaction or for full and adequate consideration, the author argues that the crux of the SCIN is the risk premium: an enhancement in either interest rate or principal balance accounting for the fact that a person's death may cancel the obligation to pay on the note before its maturity date. After all, if one exchanges a straight installment note, the note holder gets guaranteed payments, but if one exchanges a SCIN, the holder knows that payments stop at the holder's death. It follows that full and adequate consideration, therefore, would have to include a premium for the potential death cancellation of what otherwise would be a simple term installment note. The author argues, moreover, that the same premium is the strongest evidence of an objectively bona fide transaction as well as a subjectively bona fide transaction. A variation of the car dealership example appears in Section II, infra, to illustrate the point.

For the seasoned practitioner, this article cautions against the lure of reliance upon a pro-taxpayer case, Costanza v. Commissioner of Internal Revenue,¹ as a guide to one's execution of SCINs. The trickery of the SCIN is that there are no hard and fast rules to what is considered bona fide, or full and adquate consideration. For example, there is no life expectancy table the IRS expressly recognizes as a guide for SCINs. The practitioner may use the Ordinary Life Annuities Table of Treas. Reg. § 1.72-5, and the IRS is free to reject the use of that table. With such a treacherous roadmap for a tool that by design is a suspect transaction, practitioners need to exercise care in creating SCINs that will muster IRS scrutiny, and reliance on Costanza, as will be argued below, is not the care a prudent practitioner should exercise if that practitioner wants to avoid costly Tax and Appeals Court trials with unpredictable outcomes. There are other aspects of estate planning and administration, such as valuation of non-cash property in determining its fair market value, for which there are no hard and fast rules. This is to say, the fact that SCINs lack a clear regulatory roadmap is not in and of itself problematic. Rather, like the issue of valuing non-cash property for transfer tax purposes, practitioners should exercise appropriate prudence in navigating with such a treacherous roadmap.

This article may be bifurcated into 1) a primer on self canceling installment notes, and 2) a comment on a case that the author feels is bad law despite the allure of its taxpayer-friendly holding. Section II, below, starts with a primer on SCINs. In addition to introducing a practitioner to when SCINs may or may not be appropriate, the section addresses the negative consequences of a failed SCIN. Section III briefly summarizes the Costanza case and asserts why the author thinks it was poorly decided on appeal. Section IV discusses the risk premium. The author weaves in the Costanza facts along with some analogous facts from other cases in his attempt to demonstrate the central role of the risk premium to SCINs. Section V uses Costanza as a vehicle for discussing the possibility that even where a SCIN is deemed a bona fide transaction, the practitioner risks gift tax treatment where the Tax Court finds less than full and adequate consideration. Section VI, again using Costanza as a jumping off point, discusses the income tax treatment of SCINs cancelled before maturity. Finally, Section VII concludes with a synopsis of this work.

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II. INTRAFAMILY SCINs: A PRIMER

A SCIN is a hybrid of an installment sale and a private annuity.² Typically, SCINs are used to transfer a family business or other valuable assets to lower generations without incurring gift or estate tax liability. Often, a parent sells assets to a child in exchange for a note entitling her to regular payments (at least annual) of a certain sum over a fixed number of years. The "self-canceling" part of the transaction comes from a note provision which cancels the obligation of the child to continue making payments on the note upon the death of the parent. The SCIN has no value at death and, thus, neither the property nor the note is included in the gross estate.³ SCINs have a ghoulish taint: the SCIN is financially advantageous only if the parent dies prior to the expiration of the note's term. If the parent outlives the SCIN's term, she pays income taxes on the installments and estate taxes on the accumulated SCIN payments remaining in her estate at death.⁴

SCINs are usually intrafamily transactions. As such, they must be objectively bona fide transactions due to their potential as a tool for evading estate or gift taxes. The following example is a twist on the example given in the introduction of the auto dealership. Imagine Father selling his auto dealership to Son for $5,000,000 (current fair market value) in exchange for a SCIN with a twenty-year term at four percent interest, payable in equal yearly installments. Now imagine that the Applicable Federal Rate for long-term loans at the time of the transaction is eight percent, that Father is eighty-five years old and that he suffers from advanced terminal cancer. If effective, such terms would constitute an end-run around the gift and estate taxes - allowing the parent to reduce his taxable estate by disguising a sizeable gift under the cloak of the SCIN.⁵

A SCIN may escape transfer tax inclusion if the transaction is deemed to be bona fide and for adequate and full consideration.⁶ One of the most important factors in assessing whether the SCIN represents a bona fide transaction is determining whether the value assigned to the note reflects an appropriate premium for such factors as the time value of the money (the longer the note, the higher the premium should be) and the age and health of the person whose death cancels the note.⁷ The premium charged (often referred to as a "risk premium") on the note can come in the form of an above-market interest rate, or an increase in the principal.⁸ As mentioned in the introduction, there are no hard and fast rules as to what an appropriate risk premium would be. It is the author's opinion that courts should give much weight to the risk premium in determining whether an intrafamily SCIN was a bona fide exchange, because appropriate pricing is the crux of a bona fide business transaction.

A. When Is an Intrafamily SCIN Appropriate?

Even if the sale for a SCIN can be arranged to satisfy the bona fide transaction requirement, an intrafamily SCIN does not always make estate planning sense. After all, the holder of the SCIN must pay income taxes on the payments received over the term of the note. Moreover, as discussed in section VI, below, the decedent's estate realizes any deferred gain upon the cancellation of the SCIN. Thus, one must ask if the income tax liability attached to the note is worth the estate and gift tax savings offered by the note.

We are already approaching a point where potential tax benefits may not obviate a SCIN, again, depending on the potential taxpayer's specific situation. In 2009 the highest marginal personal federal income tax rate was thirty-five percent⁹ and the estate and gift tax rate was forty-five percent.¹⁰ President Obama has proposed to restore the highest marginal income tax rate to 39.6%,¹¹ exceeding the current (temporary?) gift tax rate of thirty-five percent and approaching his proposed estate and gift tax rate of forty-five percent.¹² Given record-breaking projected federal...