How Does a Self Cancelling Installment Note Work?

A self-canceling installment note (SCIN) is a financial instrument used to sell an asset, often within a family, through a series of payments. The defining feature of a SCIN is a provision that automatically cancels the buyer’s remaining payment obligations if the seller passes away before the note is fully paid. This arrangement is primarily used as an estate planning strategy to transfer significant assets, like a family business or real estate, while potentially minimizing taxes. If the seller outlives the note’s term, they receive the full value; if not, the unpaid balance is extinguished.

Core Components of a Self-Cancelling Installment Note

The principal amount is the sale price of the asset being transferred. This price must be based on the asset’s fair market value at the time of the transaction to be viewed as a legitimate sale rather than a partial gift.

The note must also carry a commercially reasonable interest rate. The Internal Revenue Service provides minimum interest rates known as the Applicable Federal Rates (AFRs), which are published monthly. A SCIN’s interest rate must be at least the appropriate AFR, which varies based on the note’s repayment term: short-term, mid-term, or long-term.

The note term is the maximum period for payments. The term cannot be longer than the seller’s life expectancy as determined by actuarial tables when the note is created. If the term exceeds this life expectancy, the transaction risks being reclassified as a private annuity.

To compensate the seller for the risk of dying before receiving full payment, the SCIN must include a cancellation premium. This premium can be structured by either increasing the principal amount above the asset’s fair market value or by charging a higher interest rate than the AFR requires. The choice between a principal or interest premium depends on the tax situations of the buyer and seller.

Establishing a Valid SCIN Transaction

For the IRS to recognize a SCIN, the transaction must be a legitimate sale, not a disguised gift. The buyer must have a real and enforceable obligation to make payments, and there must be a genuine intent to collect on the debt. The terms of the sale should be comparable to what unrelated parties would agree to in a similar transaction.

The seller’s health at the time of the sale is a factor. The IRS will likely disregard the self-canceling feature if the seller is considered terminally ill, defined as having at least a 50 percent probability of dying within one year. However, if the seller survives for at least 18 months after the sale, they are presumed not to have been terminally ill.

The entire agreement must be a legally binding written document. This promissory note must detail all terms, including the purchase price, interest rate, payment schedule, and the self-canceling provision. The cancellation clause must be part of the bargained-for consideration, not a separate agreement or a provision in the seller’s will.

Tax Implications for the Seller

When a seller receives payments under a SCIN, the tax treatment follows the installment sale rules of Internal Revenue Code Section 453. Each payment is divided into three parts: a non-taxable return of the seller’s basis in the asset, a capital gain from the sale, and interest income taxed at ordinary rates.

The primary estate planning advantage occurs if the seller dies before the note is fully paid. In this event, the self-canceling provision is triggered, and the remaining unpaid balance of the note is not included in the seller’s gross estate for federal estate tax purposes.

Upon the seller’s death, any unrecognized gain from the original sale is accelerated and must be recognized. This gain is reported by the seller’s estate on its fiduciary income tax return. The estate becomes liable for the income tax on the remaining deferred gain, even though it will not receive further cash payments.

Tax Implications for the Buyer

For the buyer, tax implications center on the acquired asset’s tax basis. The buyer’s initial basis in the property is its full purchase price as stated in the note. This includes the risk premium if it was structured as an increase to the principal, which can be advantageous for a depreciable property.

The treatment of the buyer’s basis if the seller dies and the note is canceled is an area of unsettled law. One view is that the buyer’s basis remains the full purchase price stated in the note, regardless of the cancellation. An alternative view holds that the buyer’s basis must be reduced to the amount of principal actually paid, which would result in a larger capital gain if the buyer later sells the asset.

The deductibility of the interest paid by the buyer depends on the asset’s use. If the property is used for business or investment purposes, the interest payments are deductible. If the asset is for personal use, such as a primary residence, the interest is not deductible.