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Notes that cancel at death mean estate owes income tax.

Frane sold stock in his company to each of his four adult children. Each block of stock was worth $140,000. The children signed promissory notes, agreeing to pay the $140,000 principal amount in 20 annual installments at an interest rate of 12%. The notes provided they would be "canceled and extinguished as though paid" on Frane's death.

Although Frane's life expectancy at the time of the sale exceeded 20 years, he died less than 3 years later, after only two payments had been made on the notes.

Frane used the installment method to report gain on the stock sale attributable to the two payments while he was alive. No income from the canceled notes was reported on the decedent's final return or the estate's income tax return.

The IRS claimed the notes' cancellation resulted in the recognition of income that had to be reported either on the estate's income tax return or on the decedent's final return.

IRC section 453B(a) provides: "If an installment obligation is ... distributed, transmitted ... or otherwise disposed of, gain or loss shall result ...... Section 453B(f) treats an installment obligation that is canceled as if it was "disposed of" Section 453B(c) provides that section 453B does not apply to the transmission of installment notes at death, "except as provided in section 691 (relating to ... income in respect of decedents)

IRC section 691(a)(5)(iii) contains rules similar to those of section 453B(f) and governs income in respect of a decedent occurring on cancellation of installment notes.

The Tax Court ruled in the IRS's favor, holding that the income from the notes' cancellation had to be reported on Frane's final return. The case was appealed to the Eighth Circuit Court of Appeals, where the estate's representative argued

* No reportable income resulted from the notes' cancellation because the statute was not intended to cover death-terminating installment notes such as those used in this case.

* If there was income, it was reportable by the estate and not Frane.

Result: For the IRS in part. The facts of the case fall squarely within the language of the statute and the cancellation results in reportable gain. The taxpayer's attempt to exclude death-terminating installment notes from operation of the statute is ineffective. However, the gain from the stock sale must be reported not on the decedent's final return but, rather, by the estate as income in respect of a decedent. (The court cited revenue ruling 86-72 in support of the second half of its decision.)

* Frane Est. (8th Cir., 1993), affirming in part and reversing in part 98 TC no. 26.
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Title Annotation:Estate of Frane
Publication:Journal of Accountancy
Article Type:Brief Article
Date:Sep 1, 1993
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