What Is a Self Cancelling Promissory Note?

A self-cancelling installment note, or SCIN, is a financial instrument used to sell an asset, often between family members. It functions as a promissory note where a buyer makes a series of payments to a seller over a predetermined period. The defining characteristic is a provision that automatically cancels any remaining debt if the seller passes away before the note is fully paid. This feature makes it a distinct tool for estate planning, allowing for the transfer of assets like a family business or real estate while managing potential tax consequences.

Core Components of a Self Cancelling Note

The foundation of a SCIN is a sale price based on the asset’s fair market value. This ensures the transaction is viewed as a legitimate sale rather than a disguised gift, which would have different tax implications. An independent appraisal is often necessary to formally document this value at the time of the sale.

The note’s payment period cannot be longer than the seller’s life expectancy, as determined by the actuarial tables published by the Internal Revenue Service (IRS). This requirement links the payment obligation directly to the seller’s lifespan. If the seller outlives the note’s term, they will have received the full value as planned.

Every SCIN must carry an interest rate at least equal to the Applicable Federal Rate (AFR) for the month the sale occurs. The AFR is the minimum interest rate that the IRS allows for private loans and is published monthly. Using the appropriate AFR, which varies based on the loan term, prevents the IRS from imputing interest on the transaction and creating unintended tax liabilities.

A SCIN must also include a cancellation premium to compensate the seller for the risk that they might die before receiving all payments. This premium is what makes the transaction commercially reasonable. It can be structured in one of two ways: either by increasing the total principal amount of the note above the asset’s fair market value or by charging an interest rate higher than the required AFR.

Income Tax Treatment for the Seller

For the seller, payments received from a SCIN are divided into principal and interest. The interest portion of each payment is considered ordinary income and is taxed at the seller’s regular income tax rate. This income is reported annually as it is received over the life of the note.

The principal portion of each payment is generally handled under the installment method of reporting, which allows the seller to defer capital gains over the note’s term. With each principal payment, a portion is treated as a tax-free return of the seller’s original investment, or basis. The remaining part is recognized as a capital gain, typically taxed at lower long-term rates if the asset was held for more than one year.

A significant tax event occurs if the seller dies before the note is fully paid and the debt is cancelled. In this scenario, any capital gain that has been deferred is accelerated and must be recognized. This unrecognized gain is reported on the seller’s final income tax return or, in some cases, on the income tax return for the seller’s estate.

Income Tax Treatment for the Buyer

The income tax treatment for the buyer centers on their basis in the acquired asset and the deductibility of interest payments. If the asset is used for business or investment purposes, the interest paid may be deductible as a business or investment expense, subject to applicable limitations.

The buyer’s cost basis in the asset is determined by the total amount of principal they ultimately pay. This basis is used to calculate depreciation deductions and to determine the gain or loss upon a future sale of the asset. The final basis is not known until the note is either fully paid or cancelled.

If the seller survives the note’s term, the buyer’s basis equals the total principal paid, including any premium structured as an increase in principal. Conversely, if the seller dies and the cancellation provision is triggered, the buyer’s basis is fixed at the total principal payments made up to that date. This lower basis means the buyer would have a larger capital gain if they later sell the asset.

Estate and Gift Tax Considerations

The primary motivation for using a SCIN is often estate and gift tax planning. A properly structured note can remove a significant asset from a seller’s estate, reducing potential estate tax liability. Because the obligation to pay is extinguished upon the seller’s death, the note’s value becomes zero. Consequently, the unpaid balance is not included in the seller’s gross estate for federal estate tax purposes.

This allows for the transfer of wealth to the next generation without the value of future payments being subject to estate tax. This can be particularly advantageous for individuals whose estates are near or above the federal estate tax exemption amount. This high exemption is scheduled to sunset at the end of 2025, reverting to a much lower, inflation-adjusted amount if no new laws are passed.

A carefully constructed SCIN also avoids triggering federal gift tax. For the transaction to be considered a bona fide sale, it must be for “full and adequate consideration.” The SCIN’s structure, which includes a sale at fair market value and a commercially reasonable cancellation premium, is designed to meet this standard. This avoids any assertion that a partial gift was made to the buyer, thereby sidestepping gift tax liability.