Steve Oshins on ILM 201330033: Ruling on Gift and Estate Tax Consequences of Self-Cancelling Installment Notes
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“In this case, the value of the notes was based upon the §7520 tables. The decedent accounted for the self-cancellation mechanism by adjusting the principal to be repaid or the interest rate that applied to the principal. However, the IRS did not believe that the §7520 tables apply to value the notes in this situation.
By its terms, §7520 applies only to value an annuity, any interest for life or term of years, or any remainder. In the case at hand, the items that must be valued are the notes that decedent received in exchange for the stock that he sold to the grantor trusts. These notes should be valued based on a method that takes into account the willing-buyer willing-seller standard in Treasury Regulation §25.2512-8. In this regard, the decedent’s life expectancy, taking into consideration decedent’s medical history on the date of the gift, should be taken into account. I.R.S. Gen. Couns. Mem. 39503 (May 7, 1986).
Because of the decedent’s health, it was unlikely that the full amount of the SCINs would ever be paid. Thus, the SCINs were worth significantly less than their stated amounts, and the difference between the notes’ fair market value and its stated amount constitutes a taxable gift.”
We close the week with Steve Oshins’ update on ILM 201330033 (“the Ruling”), released on 7/26/2013, dealing with Self-Cancelling Installment Notes (“SCINs”) in the context of a decedent whose health was failing at the time of the SCIN transactions.
Steven J. Oshins, Esq., AEP (Distinguished) is an attorney at the Law Offices of Oshins & Associates, LLC in Las Vegas, Nevada. Steve is a nationally known attorney who is listed in The Best Lawyers in America® and has been named one of the Top 100 Attorneys in Worth magazine. He was inducted into the NAEPC Estate Planning Hall of Fame® in 2011. He has written some of Nevada’s most important estate planning and creditor protection laws, including the law making the charging order the exclusive remedy of a judgment creditor of a Nevada LLC and LP (in 2001, 2003 and 2011), the law changing the Nevada rule against perpetuities to 365 years (in 2005) and the law making Nevada the first and only state to allow a Restricted LLC and a Restricted LP, creating larger valuation discounts than any other state allows (in 2009). He is also the author of the Annual Domestic Asset Protection Trust State Rankings Chart and the Annual Dynasty Trust State Rankings Chart. Steve can be reached at 702-341-6000, x2 or at email@example.com. His law firm’s web site is http://www.oshins.com.
In the year prior to the decedent’s death, he revised his estate plan using gifts and sales to multiple grantor trusts established for various family members. The asset used for the transactions was stock in the decedent’s corporation, and all references herein to transfers of stock refer to stock in that corporation. This Ruling illustrates what happens when a person who is in bad health sets up SCIN transactions and dies shortly thereafter.
The Decedent’s Health
Very shortly after the fourth and fifth sets of transactions described below, the decedent was diagnosed with a health issue. After the diagnosis, he survived for less than six months.
The Five Sets of Transactions
The transactions were as follows:
First set of transactions – Stock swaps and then gifts to grantor trusts
The decedent funded newly created grantor trusts with common voting and preferred non-voting stock. On the same date, just prior to making the transfers, the decedent substituted common and preferred shares for preferred shares held by existing grantor trusts that the decedent had previously established. The decedent hired appraisers to value the stock for purposes of the substitutions and the transfers to the newly-created grantor trusts.
Second set of transactions – Stock swaps and then gifts to GRATs
On a later date, the decedent substituted preferred and common shares for other shares held in the previously-established grantor trusts for the benefit of various family members. On the same date, after the substitutions were complete, the decedent made a gift of shares to a grantor-retained annuity trust (“GRAT”). The term of years of the GRAT wasn’t disclosed in the Ruling. Because the decedent died before the end of the GRAT’s term, the value of the assets was included in his gross estate, and under his estate plan, the assets passed to charity.
Observation: Was this GRAT established with the intent to try to convince the IRS that the decedent was healthy as of the date the GRAT was established since one does not typically establish a GRAT when in bad health? Or was it the case that the advisors and the decedent selected a short term and believed the decedent may be able to survive the term? Or did they truly have no idea that the decedent was in extremely bad health at that time given that the actual diagnosis was made at a later date (soon after the fourth and fifth transactions described below)?
Third set of transactions – Regular note and SCIN (with principal premium) sales
On the same date as the date of the second set of transactions, the decedent transferred stock to the grantor trusts. In exchange for the stock, the decedent received promissory notes. The term of years of the notes wasn’t disclosed in the Ruling. The Ruling noted that the term was based on the decedent’s life expectancy as determined in the tables in the regulations under §7520. However, technically, the term must have been “within” said life expectancy.
Regular Notes: Some of the promissory notes had face amounts equal to the appraised value of the stock that was transferred to the grantor trusts. The notes required that the trust make only annual interest payments during the term of the note and further required that the principal be paid on the final date of the term.
SCINs: Like the notes discussed above, the remaining notes required only payments of interest during the note term and the payment of principal to the note holder on the last day of the term. These notes, however, differed in one significant way. Each of the notes contained a self-cancelling feature, which effectively relieves the issuer, the grantor trust in this case, of the obligation to make any further payments on the note if the seller, the decedent in this case, dies before all of the payments under the note have come due. The total face value of the self-cancelling notes was almost double the value of the stock. The higher value of the notes was implemented to compensate the decedent for the risk that he might die before the end of the note term in which case neither the principal nor a significant amount, if not all, of the interest would be paid. This is commonly referred to as a principal premium. In fact, the decedent died less than six months after the transfer and, therefore, received neither the interest payments nor the principal due on the notes.
Observation: A SCIN is a promissory note that makes payments until the first to occur of the seller’s death or a term of years. Thus, it is considered a bet-to-die technique given that it has a better economic result for the family for estate tax purposes if the seller dies sooner rather than later.
Fourth set of transactions – SCIN ( with interest rate premium) sales
On a later date, the decedent transferred stock to the previously established grantor trusts. In exchange for the stock, the decedent received additional notes with a face value equal to the appraised value of the stock. These notes had the same term of years as the previous notes, required only interest payments during the term, and contained a self-cancelling feature just like the previous notes. However, to account for the possibility that the self-cancelling feature would take effect, these notes contained a higher interest rate rather than a principal premium. This is commonly referred to as an interest rate premium. Just like the other SCINs, the decedent died less than six months after the transfers, and therefore he received neither the interest payments nor the principal due on the notes.
Observation: Unlike Private Annuities, SCINs do not have definitive mortality rules with respect to when the regular mortality table can be used. For Private Annuities, which are generally payments that occur until death (but there are other variations), the rules are that you can use the regular mortality tables if there is at least a fifty percent probability of living for 12 months, and the presumption is that the person isn’t terminal and can use the regular mortality tables as long as he lives for 18 months unless the contrary is established by clear and convincing evidence. Therefore, when the client is in very bad shape, the advisor should ask the client and client’s family for an estimate of the client’s life expectancy in order to determine whether to use a SCIN versus a Private Annuity. If it is likely that the client will survive 18 months, but not too much longer, the Private Annuity seems safer. Like a SCIN, a Private Annuity is a bet-to-die technique (when designed to make payments stop at the person’s death).
Fifth set of transactions
On the same date as the date of the fourth set of transactions, the decedent created another GRAT. The decedent funded this GRAT with shares of stock plus notes that he received from sales described above.
Gift and Estate Tax Returns – The SCIN Transactions
The decedent’s estate disclosed the SCIN transactions on a Form 709 Gift Tax Return and assigned no gift tax value to those transactions. This was clearly done in order to disclose the material items in order to start the gift tax statute of limitations.
The decedent’s estate filed a Form 706 Estate Tax Return. On Schedule G of the Estate Tax Return, the non-self-cancelling promissory notes from the third set of transactions were included at their face values plus accrued interest. Schedule G of the Estate Tax Return also included the value of the GRATs created in the second and fifth set of transactions. The Estate Tax Return did not, however, include any portion of the self-cancelling notes executed in the third and fourth set of transactions.
There were three primary issues in the Ruling:
- Does all or any portion of the transfers of stock from the decedent to the grantor trusts in exchange for the notes with the self-cancelling feature constitute a gift?
- How should the fair market value of the notes with the self-cancelling feature be determined?
- If the transfers in exchange for the notes with the self-cancelling feature do not constitute a gift, what are the estate tax consequences of the cancellation of the notes with the self-cancelling feature upon the decedent’s death?
The conclusions reached by the IRS in response to each of the primary issues were as follows:
- If the fair market value of the notes is less than the fair market value of the property transferred to the grantor trusts, the difference in value is a deemed gift.
- The notes should be valued based on a method that takes into account the willing-buyer willing seller standard of Treasury Regulation §25.2512-8 and should also account for the decedent’s medical history on the date of the gift.
- In this case, the IRS believes there is no estate tax consequence associated with the cancellation of the notes with the self-cancelling feature upon the decedent’s death.
Law and Analysis – Issues 1 and 2
IRC§2512(b) provides that where property is transferred for less than an adequate and full consideration in money or money’s worth, then the amount by which the value of the property exceeded the value of the consideration is deemed a gift that is included in computing the amount of gifts made during the calendar year.
Treasury Regulations §25.2512-4 provides that the fair market value of notes, secured or unsecured, is presumed to be the amount of unpaid principal, plus accrued interest to the date of the gift, unless the donor establishes a lower value. Unless returned at face value, plus accrued interest, it must be shown by satisfactory evidence that the note is worth less than the unpaid amount (because of the interest rate, or date of maturity, or other cause), or that the note is uncollectible in part (by reason of the insolvency of the party or parties liable, or for other cause), and that the property, if any, pledged or mortgaged as security is insufficient to satisfy it.
Treasury Regulations §25.2512-8 provides, in part, that a sale, exchange, or other transfer of property made in the ordinary course of business (a transaction that is bona fide, at arm’s length, and free from any donative intent), will be considered as made for an adequate and full consideration in money or money’s worth.
In general, a transaction where property is exchanged for promissory notes will not be treated as a gift if the value of the property transferred is substantially equal to the value of the notes. The face value and length of payments of the notes must be reasonable in light of the circumstances. To determine whether the gift tax applies, the Internal Revenue Service must determine the value of the stock that the decedent transferred to the grantor trusts shortly before his death and the value of the notes taking into consideration the notes’ self-cancelling feature. If the fair market value of the notes is less than the fair market value of the property transferred to the grantor trusts, the difference in value is deemed a gift under IRC§2512(b) and Treasury Regulations §25.2512-8.
The Ruling described and distinguished the facts of Estate of Costanza v. Comm’r, 320 F.3d 595 (6th Cir. 2003), rev’g T.C. Memo 2001-128, where the decedent sold real property to his son, in exchange for a note with a self-cancelling feature that was fully secured by a mortgage on the property. The note provided for monthly installments over a period of 11 years and for the payment of interest at a rate that increased every 24 months. The initial interest rate was 6.25 percent, and the rate increased by one half percent at each 24-month interval, until reaching a final rate for the last 12 months of 8.75 percent. The decedent died unexpectedly five months after the issuance of the note. The court concluded that the decedent was not willing to gift the business properties to his son because he required a steady stream of income in order to retire. In addition, the taxpayer could show that, at the time of the transaction, a real expectation of repayment existed and decedent intended to enforce the collection of the indebtedness. Therefore, there was a bona fide transaction.
The Ruling distinguished Estate of Costanza by noting that Costanza required the payments for retirement income and, thus, had a good reason, other than estate tax savings, to enter into the transaction. In contrast, the decedent in this Ruling structured the note such that the payments during the term consisted of only interest with a large payment on the last day of the term of the note (balloon payment). Thus, a steady stream of income was not contemplated. Moreover, the decedent had substantial assets and did not require the income from the notes to cover his daily living expenses. The arrangement in this Ruling was nothing more than a device to transfer the stock to other family members at a substantially lower value than the fair market value of the stock.
In addition to the foregoing, in this Ruling the IRS believed that the notes lack the indicia of genuine debt because there must be a reasonable expectation that the debt will be repaid. They further noted that the estate must demonstrate that the trust that issued the note has the ability to repay the amount of the note. In the third set of transactions, the trust received stock valued at a substantially smaller value than the face value of the SCIN given the principal premium applied to the note. The decedent did fund the grantor trusts with gifts during the first set of transactions although it is unclear how much of this amount was allocated to the various trusts. Thus, one might argue that there was sufficient seed money that can be applied to reduce the debt and avoid any argument that the notes are not bona fide (i.e., the trust has sufficient assets such that it can repay the loan).
Observation: This means that SCINs with high principal rate premiums (i.e., especially older clients since the premium is much higher) where there isn’t sufficient equity in the trust to make the large payment of principal are more likely to be attacked than using the interest rate premium option. The estate planner should be aware of this in determining which type of SCIN premium to utilize in a transaction.
In this case, the value of the notes was based upon the §7520 tables. The decedent accounted for the self-cancellation mechanism by adjusting the principal to be repaid or the interest rate that applied to the principal. However, the IRS did not believe that the §7520 tables apply to value the notes in this situation. By its terms, §7520 applies only to value an annuity, any interest for life or term of years, or any remainder. In the case at hand, the items that must be valued are the notes that decedent received in exchange for the stock that he sold to the grantor trusts. These notes should be valued based on a method that takes into account the willing-buyer willing-seller standard in Treasury Regulation §25.2512-8. In this regard, the decedent’s life expectancy, taking into consideration decedent’s medical history on the date of the gift, should be taken into account. I.R.S. Gen. Couns. Mem. 39503 (May 7, 1986).
Because of the decedent’s health, it was unlikely that the full amount of the SCINs would ever be paid. Thus, the SCINs were worth significantly less than their stated amounts, and the difference between the notes’ fair market value and its stated amount constitutes a taxable gift.
Observation: It is not clear from the Ruling that the decedent had any adverse medical history as of the date of the transactions, or some of the transactions. The facts only indicate that the decedent was diagnosed with the health issue soon after the fourth and fifth transactions. Most likely, the health issue didn’t suddenly appear, but it’s interesting that there was no analysis of the snapshot of his health as of the actual dates of the transactions and was merely a reliance on a later, albeit not much later, diagnosis.
Law and Analysis – Issue 3
IRC §2033 provides that the value of the gross estate shall include the value of all property to the extent of the interest therein of the decedent at the time of his death.
IRC §2038 provides that the value of the gross estate includes the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer (except in the case of a bona fide sale for an adequate and full consideration in money or money’s worth), by trust or otherwise, where the enjoyment thereof was subject at the date of his death to any change through the exercise of a power (in whatever capacity exercisable) by the decedent alone or by the decedent in conjunction with any other person (without regard to when or from what source the decedent acquired such power), to alter, amend, revoke, or terminate, or where any such power is relinquished during the 3-year period ending on the date of the decedent’s death.
The IRS compared the case at hand to the facts of Estate of Musgrove v. United States, 33 Fed. Cl. 657 (1995). In Estate of Musgrove, the United States Court of Federal Claims addressed the issue of whether a transfer by the decedent to his son, less than one month before the decedent’s death, in exchange for an interest free demand note with a cancellation on death provision was bona fide. The decedent in Estate of Musgrove was an 84-year-old man suffering from angina, arteriosclerosis and hypertension. The decedent’s son needed to borrow money to satisfy a debt of his sister’s estate, and decedent offered to loan the funds to his son in exchange for a demand note with a cancellation upon death provision. When consummating the transaction, the decedent indicated that he did not believe he would ever need to make a demand for repayment. The son indicated that he did not know if or when he could ever repay the debt. The trial court held that the transaction was not bona fide, since the note was unsecured, the parties failed to schedule regular payments, and the note provided for no interest. The court indicated that the decedent retained an interest in the amount transferred because he maintained possession of the note until his death and had not made a demand for payment on the note. Furthermore, son could not use the money for any purpose other than to pay the debt on his sister’s estate, and therefore, decedent had maintained control over the money. The court held that the amount should be included in the decedent’s estate under IRC§§2033, 2035, and 2038.
The IRS noted in ILM 201330033 that there are similarities between the decedent in the subject case and the decedent in Estate of Musgrove. In each case, the decedent who received a promissory note with a self-cancelling feature was in very poor health and died shortly after the note was issued. In addition, there is a legitimate question as to whether the note would be repaid in each case.
CITE AS: LISI Estate Planning Newsletter #2131 (August 15, 2013) at http://www.leimbergservices.com Copyright 2013 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Permission.
CITES: ILM 201330033 (July 26, 2013); Estate of Costanza v. Comm’r, 320 F.3d 595 (6th Cir. 2003), rev’g T.C. Memo 2001-128; Estate of Musgrove v. United States, 33 Fed. Cl. 657 (1995)
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