Estate Plan Concerns
Susan age 76 and in declining health, owns an asset worth $1,000,000. This asset is expected to generate high levels of income and appreciation for the foreseeable future, resulting in a total after-tax annual return of 14%.
► Asset Generates Income; Would Use Entire Gift Exemption
Understanding that the value of this asset will be includible in her taxable estate for estate tax purposes if she owns it at the time of her death, Susan really likes the idea of gifting the asset, now, to her son, Mark. However, she hesitates to do this because she isn’t comfortable giving up all the income from the asset. Moreover, she has been informed that the gift would constitute a $1,000,000 taxable gift for gift tax purposes, requiring her to use her entire gift tax exemption to shelter the gift from federal gift tax.
► Desire to Reduce Gift Tax and Retain Income
Susan wonders whether there might be a way to move the asset out of her taxable estate at a low gift tax value, while she continues to enjoy an annual income.
Estate Plan Solution
After consulting with her advisor, Susan decides to use an estate planning technique known as a “Sale for a Self-Cancelling Installment Note,” or “SCIN.” Using this technique, Susan will sell the asset to her son, Mark, in return for an interest bearing installment note, which will automatically be cancelled at her death if she dies prior to the end of the term of the note.
Sale for Self-Cancelling Installment Note Process
- Susan and her son, Mark, enter into an agreement in which Susan will sell the asset to Mark in return for an interest bearing, self-cancelling installment note. Interest is payable annually for a period of 10 years, at the end of which time the entire principal balance of the note will become due and payable. If Susan dies before the end of the period, the principal balance will be automatically cancelled, and Mark will owe nothing further. Because of the special cancellation feature, an adjustment (increase) is required to be made either to the principal balance of the note or to the stated interest rate (the interest rate is adjusted from 4.16% to 11.608% in this scenario). Because the transfer is a sale, it is not treated as a gift for federal gift tax purposes.
- Susan receives interest payments from Mark, which is treated for federal income tax purposes as ordinary income. The principal payment at the end of the term will be treated partly as tax free return of her tax basis in the asset and partly as taxable capital gain (eligible for preferential capital gains tax if asset was held for more than a year).
- If Susan dies prior to the end of the term the balance of the note and the value of the asset sold are both removed from Susan’s taxable estate, thereby eliminating estate tax on the note and the asset sold.
- No Gift and Estate Tax: Asset can be transferred to succeeding generations free of gift and estate tax.
- Fixed Income Continues: Donor receives continuing income from payment on the installment note.
- Possible Income Tax Elimination: Income tax consequences of sale may be eliminated with use of a trust that qualifies as a “defective” grantor income trust for federal income tax purposes.
- Integrates with Other Formulas: This technique can be used with other estate planning techniques to enhance overall wealth transfer benefits.
A Sale to a Self-Canceling Installment Note is an estate planning technique that allows an individual to transfer wealth gift tax and estate tax free to his or her family. Typically, it is used in situations where the individual is in declining health and is not likely to survive to his or her life expectancy.
► No Adverse Gift Tax or Estate Tax Consequences
Generally, the desired tax benefits are accomplished by the sale of a selected asset at an arm’s length price to another person (e.g., the seller’s child) in return for an interest bearing installment note, payable over a stated term of years. Included in the note is a “self-cancelling” feature in which the remaining balance on the note will be automatically cancelled at the seller’s death, if death occurs prior to the end of the term of the note. An actuarial adjustment to reflect the value of the cancellation feature is required to be added to the note, which is reflected in either an increased principal amount or an increased interest rate. The asset can be pledged by the buyer to the seller as collateral to secure the payment of the note. If the sale is properly structured as an arm’s length transaction, there will be no adverse gift tax or estate tax consequences.
► Seller’s Estate Does Not Include Asset or Appreciation
At the seller’s death, the asset (including all capital appreciation) that was transferred to the buyer escapes inclusion in the seller’s gross estate for federal estate tax purposes. If death occurs prior to the end of the note term, the value of the installment note also escapes inclusion in the gross estate due to its automatic cancellation at death.
► Capital Gains Tax Limited
For income tax purposes, the seller does not recognize taxable gain at the time of the sale. Instead, any gain from the sale of the asset will be recognized as installment payments of principal on the note are received. Generally, payments of principal are treated partly as tax free return of the seller’s tax basis and partly as taxable capital gain (eligible for preferential capital gains tax if the seller had held the asset for more than a year). Interest payments are taxable as ordinary income. The interest payable by the buyer may be income tax deductible, depending on the type of asset involved and the buyer’s tax situation.
► Irrevocable Trust Can Neutralized Income Tax Liability
It is possible to neutralize the income tax consequences of the transaction
through use of an irrevocable trust that qualifies as a so-called “defective”
grantor income trust for federal income tax purposes. Generally, this technique
would involve the sale of the asset to the trust (created for the benefit of the
seller’s child), instead of to the child. This strategy can eliminate income tax
on payments of principal and interest, but would require the seller to pay
income tax on all taxable income of the trust (which can be a beneficial wealth
► Calculations Will Vary According to Current Market
Unless otherwise stated, actuarial calculations are based on the assumptions that the client is 65 years old and the Section 7520 Rate is 5.00%.
Tax Reduction Formulas To Protect Your Future
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The following notice is required by the IRS: Any U.S. Federal tax advice contained in this communication is not intended to be written or used, and cannot be used or relied upon, to avoid tax-related penalties under the Internal Revenue Code, or to promote, market or recommend to another any tax-related matter addressed herein.