IRS Chief Counsel Advises Sale of Stock in Exchange for Self-Cancelling Note Treated as a Taxable Gift

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By David I. Kempler, Esq., Elizabeth Carrott
Minnigh, Esq. and Christine Bowers, Esq.
 

Buchanan Ingersoll & Rooney PC, Washington, DC

In CCA 201330033, the Chief Counsel's Office advised that (1)
transfers of stock from Taxpayer to grantor trusts in exchange for
a self-cancelling installment note (SCIN) constituted a deemed gift
to the extent that the fair market value of the notes was less than
the fair market value of the property transferred to the grantor
trusts; (2) the notes should be valued based on a method that takes
into account the willing-buyer, willing-seller standard of Regs.
§25.2512-8 and should also account for Taxpayer's medical history
on the date of the gift rather than relying on the mortality
tables; and (3) there was no estate tax consequence associated with
the cancellation of the notes with the self-cancelling feature upon
Taxpayer's death where the transfers constituted a gift. By stating
that value of the SCIN is not determined by applying the mortality
tables, the IRS appears to upend the accepted practice for
calculating the risk premium on SCINs.

A SCIN is an estate planning technique used to transfer value
out of the estate of an individual without incurring gift tax. The
transaction works by having a client sell an asset to a family
member or trust, often an intentionally defective grantor trust, in
exchange for a promissory note that includes a self-cancellation
feature, whereby the note terminates and the outstanding balance is
cancelled if the client dies during the term of the note. In
addition to interest on the promissory note, a SCIN includes a
so-called risk premium for the self-cancellation provision. If the
client survives, then the client is wholly repaid on the note,
including the risk premium.  However, if the client does not
survive, the asset and the remaining note balance are removed from
the client's estate, and value has been shifted transfer-tax free
to the buyer without any additional obligation on the note.

Taxpayer owned a number of assets of substantial value,
including stock in a certain corporation (the "Stock").  In
the year before he died, Taxpayer established separate grantor
trusts for the benefit of his family members and funded certain of
the newly created grantor trusts with the Stock. Taxpayer
subsequently transferred additional Stock to the grantor trusts in
exchange for promissory notes with a certain term of years based on
the Taxpayer's life expectancy as determined in the tables in the
regulations under §7520 of the Internal Revenue Code of 1986, as
amended (the "Code").  The promissory notes contained a
self-cancelling feature that effectively relieved the issuer, the
grantor trust in this case, of the obligation to make any further
payments on the note if the Taxpayer died before all of the
payments under the notes had come due. The SCINs required only
payments of interest during the note term and the payment of
principal to Taxpayer on the last day of the term. The total face
value of the SCINs was almost double the value of the Stock. This
higher face value of the SCINs was a premium designed to compensate
Taxpayer for the risk that he would die before the end of the note
term and therefore neither the principal nor a significant amount,
if not all, of the interest would be paid. Taxpayer died less than
six months after the transfers, and therefore, no interest or
principal payments were made on the notes. Taxpayer's estate filed
a federal gift tax return for the year in which the transfers were
made on which it disclosed the transactions but did not report any
taxable gift as a result of those transactions. Taxpayer's federal
estate tax return did not include any portion of the
self-cancelling notes.

In general, §2501 imposes a tax on the transfer of property by
gift. Section 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
exceeds the value of the consideration is deemed a gift that is
included in computing the amount of gifts made during the calendar
year. Regs. §25.2512-4 provides that the fair market value of the
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. In addition, §2033 of the Code
generally provides that the value of the gross estate shall include
the value of all property to the extent that the decedent had an
interest in such property at the time of his death including,
pursuant to §2038, the value of any interest in property which the
decedent has at any time made a transfer that, in general terms,
was subject to change at the date of his or her death through the
exercise of certain powers by the decedent (except in the case of a
bona fide sale for an adequate and full consideration in money or
money's worth).

The Chief Counsel's Office began its analysis by reviewing the
principles applicable to the self-cancelling feature of the notes,
stating that (1) 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, (2) the face value and length of payments of
the notes must be reasonable in light of the circumstances, (3) to
determine whether the gift tax applies, the IRS must determine the
value of the Stock that Taxpayer transferred to the grantor trusts
shortly before his death and the value of the notes taking into
consideration the notes' self-cancelling feature, and (4) 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 §2512(b) and Regs. §25.2512-8.

In addressing the issue of the extent to which transfers of the
Stock from Taxpayer to the grantor trusts in exchange for the
self-cancelling notes constituted a deemed gift, the Chief
Counsel's Office distinguished the present case from the facts of
Estate of Costanza v. Commissioner.1 In
Costanza, the appellate court stated that a
self-cancelling note signed by family members will be presumed to
be a gift and not a bona fide transaction but that the presumption
may be rebutted by an affirmative showing that there existed at the
time of the transaction a real expectation of repayment and an
intent to enforce the collection of the indebtedness.  The
court concluded in Costanza that the presumption had
been rebutted because the father could not gift the business
properties at issue to his son being that he required a steady
stream of income in order to retire and there existed a real
expectation of repayment at the time of the transaction. The Chief
Counsel's Office explained that in Costanza, the decedent
required the payments for retirement income and, thus, had a good
reason, other than estate tax savings, to enter into the
transaction but that in contrast, Taxpayer in this case had
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. The Chief Counsel's Office concluded that the
arrangement in the present case 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 on the basis that a
steady stream of income was not contemplated and that Taxpayer had
substantial assets and did not require the income from the notes to
cover his daily living expenses.

The Chief Counsel's Office concluded, further, that the §7520
tables did not apply to value the self-cancelling notes in this
situation, reasoning that §7520, by its terms, applied only to
value an annuity, any interest for life or term of years, or any
remainder and did not apply to notes decedent received in exchange
for the Stock that he sold to the grantor trusts. In addition, the
Chief Counsel's Office stated that the self-cancelling notes should
be valued based on a method that takes into account the
willing-buyer, willing-seller standard in Regs. §25.2512-8, as well
as Taxpayer's life expectancy, taking into consideration decedent's
medical history on the date of the gift.

In addressing the issue of whether there were any estate tax
consequences associated with the cancellation of the notes with the
self-cancelling feature upon Taxpayer's death, the Chief Counsel's
Office discussed two other cases involving self-cancelling notes.
In Estate of Moss v. Commissioner,2 the Tax Court
held that the self-cancelling notes were not included in the
decedent's estate where, at the time of sale, there was nothing to
indicate that his life expectancy would be shorter than the
approximate ten years of life expectancy that was indicated by
generally accepted mortality tables but the decedent discovered
that he had cancer and died shortly after the sale. In Estate
of Musgrove v. United States
,3 the Court of
Federal Claims held that a transfer by the decedent to his son,
less than one month before the decedent's death, in exchange for an
unsecured, interest-free demand note with a cancellation on death
provision was not bona fide where the decedent 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, the decedent offered to loan the funds to his son
in exchange for a demand note with a cancellation upon death
provision, the decedent indicated that he did not believe he would
ever need to make a demand for repayment, and the son indicated
that he did not know if or when he could ever repay the debt.

The Chief Counsel's Office found that there were similarities
between Taxpayer in the present case and the decedent in
Musgrove, because 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 and there was a
legitimate question as to whether the note would be repaid in each
case. The Chief Counsel's Office noted that because of Taxpayer's
health in the present case, it was unlikely that the full amount of
the note would ever be paid. Thus, the Chief Counsel's Office
concluded that the note was worth significantly less than its face
value, the difference between the note's fair market value and its
face value constituted a taxable gift, and that there was no estate
tax consequences associated with the cancellation of the notes upon
Taxpayer's death.

By stating that the transferor's life expectancy had to be
considered in light of his particular medical history as of the
date of the gift to determine the value of the SCIN rather than
applying the mortality tables, the IRS appears to upend the
accepted practice for calculating the risk premium on SCINs. The
standard applied by the IRS creates uncertainty regarding how to
calculate the risk premium in future transactions and may also
invite IRS challenging to prior SCIN transactions in which the
§7520 mortality tables were used, even if no medical condition was
known at the time of the transfer.

This commentary also appears in the October 2013 issue of
the
 Real Estate Journal. For more information in the
Tax Management Portfolios, see Wojnaroski, 805 T.M.
, Private
Annuities and Self-Canceling Installment Notes, and in Tax
Practice Series, see ¶6350, Estate Planning.


 


 

  1 320 F. 3d 595 (6th Cir. 2003),
rev'g T.C. Memo 2001-128.

  2 74 T.C. 1239 (1980), acq. in result,
1981-2 C.B. 1.

  3 33 Fed. Cl. 657 (1995).