Planning with self-canceling installment notes.

Intrafamily installment sales of closely held corporate stock may be an effective estate planning tool. Sellers may enjoy the benefits of capital gain treatment while avoiding some of the more onerous aspects of a Sec. 302 redemption. On the seller's death any remaining obligations may be transferred to the buyer or deemed satisfied by bequest.

Through the use of a self-canceling installment note (SCIN) an individual may eliminate the value of intrafamily installment obligations from the gross estate. A contingent payment arrangement that meets the requirements of a contingent payment sale under Temp. Regs. Sec. 15a.453-1(c) terminates the buyer's payment obligation by establishing the seller's death as the contingency event.

An installment sale agreement should clearly state the intentions of the parties as to the contingent payment arrangement in the promissory note and the purchase agreement. Frane, 98 TC No. 26 (1992), illustrates that the form of a transaction can be crucial to the success for failure} of an estate plan.

Facts

Frane sold shares of his wholly owned corporation to his four children at fair market value for each block of shares. The purchase agreement called for Franc and each child to execute a note, payable in 20 annual installments with an interest rate of 12%, for the stock purchase price, and a collateral pledge and security agreement stating the total purchase price. Each note contained a provision which "... canceled and extinguished as though paid ..." all unpaid amounts on the seller's death. Frane's life expectancy at the time of the sale was more than the notes' 20-year terms.

On his death two years later, Franc had already received two years of installment payments that had been reported under the installment method. No gain was reported on his final income tax return from the remaining installment obligations.

The Service asserted tax deficiencies against Frane's estate, or against his final income tax return for the remaining deferred installment gain.

Holding

The Tax Court concurred with the Service's alternative position that the notes were canceled in accordance with Sec. 453B(f} and resuited in a taxable disposition at Frane's death. Because of the relationship of the parties the notes were valued at their face amount (as required by Sec. 453B(f)(2)), resuiting in a gain equal to the excess of face amount over basis at the date of death, to be reported on the final return.

In rejecting the estate's argument that the sales were contingent sales under Temp. Regs. Sec. 15A.453-I(c), the court concluded that{l} the stock's sales price was determinable, not contingent, and (2} the agreement's express terms called/or the cancellation of the debt "as though paid" and could not be construed as a reduction in purchase price.

The court rejected the IRS's primary argument, based on Sec. 691 and Rev. Rul. 86-72, that the cancellation provision caused a deemed transfer of the obligations resulting in taxable gain to be reported by the estate under Sec. 691(a)(21.

Dissent argues substance over form

The dissent contended that the majority ignored the true nature of the obligations between the deceased and his children. In its view, the economic substance of the transaction did not provide for an absolute right to full payment of the maximum stated sales price, since there was no obligation to make further payments after the seller's death. An obligation that was not in existence could therefore not be canceled.

Planning after Frane

The Tax Court's rejection of the Service's position that the SCIN generated income in respect of decedent at the seller's death adds appeal to the use of a contingent sale. Thus, it should be considered for clients with closely held businesses needing succession planning.

When structuring SCIN plans the following elements are essential.

[] Contingent payment plan intent should be stated in the agreement.

[] Negotiations should be at arm's length.

[] Risk premium should be bargained for.

[] The actuarial life expectancy of the seller should exceed the term of the installment note.

[] There should be no retention of rights over the shares sold.

As the minority in Franc suggests, a careful rewording of the sales agreement can make or break a contingent sales agreement. The Tax Court defined a "cancellation" provision in the strictest of terms so future drafters of SCINs should avoid "cancellation"-type language. From Jennifer Bowers, CPA, White, Petrov, McHone, P.C., Houston, Tex.