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Self-canceling installment debt and private annuities: effective intrafamily stock transfer planning tools.

Many business owners are faced with the question of how to effectively pass stock in a closely held business to the next generation. Unfortunately, a formal succession plan for the transfer of stock is rarely developed; nor is a formal succession plan developed for the transfer of company leadership in many cases. The stock merely passes to the heirs under the terms of a will and the estate is saddled with estate taxes as high as 55%, (1) absent a significant marital or charitable deduction. An election under Sec. 6166 can defer the payment of estate taxes associated with the value of certain closely held businesses over a 15-year period; however, this election creates no reduction in the ultimate estate tax liability. Thus, a liquidation of the stock outside the family may become the only feasible option to pay the estate taxes.

Development of a Viable

Stock Succession Plan

In developing a viable stock succession plan, the tax professional must take into consideration the income, estate, gift and nontax effects of the transfer. Typically, a stock succession plan attempts to achieve the following goals.

* Provide an income stream to the transfer for a substantial duration of time while not burdening the successor with an unreasonable payment schedule.

* Significantly reduce,if not eliminate, the estate and gift tax consequences associated with the lifetime transfer of stock.

* Minimize and defer the income tax consequences of the stock transfer.

* Provide the transferor with sufficient collateral.

The plan should also address the tax and nontax effects of whether the successor acquires the stock interest via stock redemption or a direct purchase.

This article will analyze the goals of a viable stock succession plan in relation to two techniques that have been made more attractive by the retroactive repeal of Sec. 2036(c): (2) the use of a private annnuity and self-canceling installment debt. When Congress opened the door to these techniques with the repeal of Sec. 2036(c), it appears that there was no intent to close it by the enactment of Chapter 14 (Secs. 2701-2704). (3) These new Code sections attack estate valuation freeze attempts at the time of the initial transfer through strict gift tax valuation requirements. Use of private annuities and self-canceling installment debt in stock succession planning do not provide for retained right features (Sec. 2701), are not transfers of interest in trust (Sec. 2702), do not involve an option or buy-sell agreement (Sec. 2703) and do not contain a lapsing right or restriction used to reduce the value of transferred property (Sec. 2704).

Annuity vs. Installment Sale

The Treasure Department describes the key differences between an installment note and an annuity in GCM 39503. (4)

...where the conveyor of property receives a right to periodic payments for the remainder of his life, with no monetary limit ...the payments represent an annuity....

...When the terms of property transaction are structured so that there is a stated maximum payout that will be achieved in a period less than the life expectancy of the transferor (as determined at the time od the transaction in accordance with Table I, [Regs. Sec.] 1.72-9), then the transaction will be characterized as an installment sale with a contingent sale price....

Thus, for purposes of this article, a private annuity stock succession (PASS) is an arrangement under which an individual transfers stock to a successor in exchange for the successor's agreement to make periodic payments in fixed amounts to the transferor for the remainder of the transferor's life. A self-canceling installment debt stock succession (SCIDSS) is a debt obligation created on the transfer of stock from the transferor-creditor to a successor-debtor. The debt instrument has a fixed term less than the life expectancy of the transferor and contains a provision that automatically voids all future payment obligations on his death.

Estate Tax Ramifications

Freezing the value of the older generation's stock, in order to prevent its future appreciation from being subject to estate taxes, is a goal in most stock succession plans. An outright sale or normal installment sale accomplishes that goal and the cash or note (albeit frozen or slowly melting) is considered part of the transferor's gross estate. (5) The primary advantage of a properly structured PASS or SCIDSS is that the annuity or note's value to the transferor at the date of death is zero. Accordingly, there are no estate tax ramifications to holding a PASS or an SCIDS at death. (6)

For a stock succession to qualify as a PASS and not be deemed a gift with a retained life estate includible in the transferor's gross estate under Sec. 2036(a), the following IRS and case law guidelines must be followed.

* The transferor must not retain control over the stock or its future disposition. (7)

* The annuity payments must not be substantially the same as, or limited to, the income generated by the stock. (8) The definition of income generated by stock should be limited to dividends. As most closely held C corporations pay minimal (if any) dividends it is unlikely that dividend distributions would even be sufficient to cover the required annuity payments. However, partial use of S corporation dividends may fund the obligation.

* The successor must be personally liable for the annuity payments regardless of the income generated by the stock and must have the wherewithal to make these payments. (9)

For a stock succession to qualify as an SCIDSS and not be includible in the transferor's gross estate under Sec. 2033 or 2036(a), the following structure is imperative.

* The successor must pay the transferor a risk premium for the right to obtain the stock at a reduced price if the seller dies during the note's term. (10) This premium distinguishes the transaction as a bona fide extinguishment of a legal obligation as compared to a testamentary disposition of stock.

* The risk premium should consider the age and health of the transferor at the time of the sale, the sufficiency of any collateral, the size of the transaction, the down payment received and the duration of the installment payment period.

* The risk premium may be reflected in either an above market interest rate or increased sales price. The choice of which premium form to use will normally depend on the respective tax positions of the parties involved. Interest deductibility versus increased bases will be the consideration of the successor. Ordinary income versus capital gain will be the consideration of the transferor.

* The risk premium must be bargained for between parties who are in equal positions. (11) Because an SCIDS will normally be between related parties, the bargained-for element night be more evident if both sides of th transaction retain separate legal counsel

* Both the stock transfer agreement and the installment note should contain the self-canceling wording to ensure that the intent of both parties is documented at the time of transfer. (12)

* The transferor must not retain control over the possession, use or enjoyment of the transferred stock. (13) Thus, the transferor can in no way restrict the future transfer of the stock or maintain any of the benefits associated with the holding of the transferred stock in the corporation.

Gift Tax Ramifications

Avoiding gift characterization by the IRS in a stock succession plan sale is essential. Both the PASS nd the SCIDSS have pitfalls to avoid and guidelines to follow.

With a PASS, the transferor will be deemed to have made a taxable gift when the fair market value (FMV) of the stock transferred exceeds the present value of the annuity received. (14) The annuity calculation requires the use of the actuarial tables in Sec. 7520 and an interest rate of 120% of the mid-term applicable federal rate (AFR). Because the annuity payments will typically be determined based on the FMV of the stock, the possibility of a taxable gift is remote if the correct annuity table and interest rate are used. However, any increase in the value of the stock as a result of a posttransfer revaluation by the IRS could result in the assessment of gift taxes. Therefore, it is recommended that a professional, independent appraisal of the stock value occur before entering into the annuity arrangement.

Under an SCIDSS, a taxable gift is unlikely if the sales price (not adjusted for the risk premium) is based on the FMV of the stock, the risk premium is reasonably based on the facts and circumstances and minimum statutory interest rate is charged. (15) However, a taxable gift may result if an insufficient or excessive interest rate is used. (16) Because the SCIDSS must contain a risk premium and does not require reliance on the actuarial tables, the assessment of gift taxes is much more subjective. However, this subjectivity does not extend to the value of the stock and, therefore, a professional, independent appraisal of the stock value is recommended.

Income Tax Considerations

Determining annuity payments under a PASS is a function of the FMV of the stock to be transferred, the age of the annuitant and the mid-term AFR in the month of transfer. Using the tables prescribed by Sec. 7520, the formula for determining the annual PASS payment is as follows.

Value of stock / Present worth of annuity factor = Annual PASS payment

Once the annual PASS payment is determined, the transferor's income taxation of the payment is divided into three components: capital gain, non-taxable recovery of stock basis and ordinary annuity income. (17) The capital gain and recovery of stock basis will be spread ratably by the transferor over his life expectancy as determined under Regs. Sec. 1.72-9. The ordinary annuity income component of the payment will be the total PASS payment less the capital gain and recovery of basis components. See Example 1 on page 303.

The annual income taxation of an SCIDSS to the transferor is determined under Sec. 453 and is similar to that of a PASS in that the transferor is receiving ordinary income (interest), capital gain and a return of capital. However, the tax effects are not pro rata. A gross profit ratio is established (capital gain/sales price) and this ration is applied to all principal payments made under the contract to determine the annual capital gain. Interest income is determined by the normal amortization of the debt. See Example 2 on page 304.

The SCIDSS also may be stated in the form of principal plus interest, which modifies the cash flow requirement of the SCIDSS, the annual interest and the annual capital gain. Ultimately, the determination of what will be the optimum terms of the SCIDSS obligation is dependent on the bargaining of the two parties and their respective tax positions.

Apart from the timing and character of income disparities resulting from the computational differences between a PASS and an SCIDSS, there are two true differences between the two techniques. First, all payments made by the successor under a PASS represent basis. (18) Therefore, no interest deduction is allowed for any portion of these payments. In contrast, the interest component of payments made under an SCIDSS are fully deductible by the successor. Second, use of a PASS would not require income recognition by the transferor or the transferor's estate on the unreported stock capital gain in the year of the transferor's death. In contrast, the transferor's death triggers recognition of the deferred stock gain under an SCIDSS. (19) These two dichotomies must be considered and empirically analyzed when choosing between a PASS and an SCIDSS.

* Basis considerations

It is also important to evaluate the income tax impact of an eventual sale by the successor because the successor's stock basis is different for the two methods. Under an SCIDSS, the basis is the bargaining for purchase price. The computation of the successor's stock basis under a PASS is much more complicated and depends on whether the annuity contract has expired due to the death of the transferor. If the annuity contract has expired, the successor's stock basis is determined by the amount actually paid under the PASS. (20) However, if the transferor is living, the basis is dependent on whether there is a gain or loss. There rules are summarized as follows.

* When there is a gain on a subsequent sale or exchange, the successor's basis is equal to the sum of the payments made through the date of the sale plus the actuarial value of the remaining annuity payments. Additionally, gain or loss must be recognized in later years if actual future payments do not equal the actuarial value determined at the time of sale by the successor.

* When there is a loss, the successor's basis includes only the sum of the actual payments made under the PASS before the sale.

* If the sales price of the stock sale is less than the gain basis and more than the loss basis, neither gain nor loss is recognized at the time of the successor's sale of the stock. The ultimate gain or loss must be recognized at a later date. Gain would be recognized at the time of the transferor's death if the sales price exceeded total payments actually made. If, on the other hand, the total payments ultimately made exceed the sales price, the excess would be deductible. (21)


Adequacy of collateral is one of the primary considerations in any debt financed transaction. Although the security may be less important in a stock succession plan due to its related party nature, it should be given consideration. One of the disadvantages of a PASS is that it must be unsecured in order for the stock gain not to be immediately taxable to the transferor. (22) An SCIDSS may be collateralized. Although it has been held that the stock itself may be the collateral for an SCIDSS, (23) it may be prudent that other assets be identified as the collateral in order to ensure that the retained-rights conditions of Sec. 2036 do not pull the stock back into the estate of the transferor.

Redemption or Direct Purchase?

The decision of whether to us a PASS or an SCIDSS cannot take place in the vacuum of the Code sections, regulations, rulings and court decisions relating specifically to those topics. The stock purchaser also plays an important role in the decision. The transferor may consummate the succession by redeeming his stock in the corporation using a PASS or an SCIDSS. The successor, in the capacity or a minority stockholder, then becomes the sole owner of the stock. (24) Alternatively, the successor may purchase the transferor's stock directly, using a PASS or an SCIDSS.

* Stock redemption

In order for a typical intrafamily stock succession with a corporate purchaser to be treated as a sale or exchange and not a dividend, the transaction must normally be in complete termination of a shareholder's interest. (25) One of the requirements of a complete termination is that immediately after the transfer of stock the transferor retain no interest in the corporation (including an interest as an officer, director or employee), other than an interest as a creditor. (26) Careful study of the proposed duration of a PASS or an SCIDSS is warranted in order to determine if the duration creates a continued equity interest in the corporation as opposed to an interest as a creditor. The longest installment obligation litigated by the Tax Court permitted "sale treatment" under a complete termination stock redemption when the payout period on the installment obligation was 20 years. (27) However, the IRS has formally announced that it will not ordinarily issue advance rulings or determination letters on Sec. 302 redemptions of stock for notes when payments on the notes are to be made over a period in excess of 15 years. (28) To receive a favorable letter ruling, the IRS required two taxpayers to stipulate that PASS payments would not exceed 15 years. (29) Whether justified or not, if the 15-year threshold is to be observed the following corollaries result.

* If the life expectancy of the transferor is greater than 15 years at the time of the PASS a 15-year warranty would recharacterize the PASS as an SCIDSS. However, there is a serious potential pitfall: because the premium for the self-canceling provision was never separately bargained for, the whole transaction could be reacharacterized as a regular installment sale.

* If the life expectancy of the transferor is less than 15 years at the time of the PASS, the value of the PASS is less than if it did not contain such a restriction. Therefore, this valuation reduction should be considered in the computation of the PASS payments in order to avoid potential gift taxes. One taxpayer, however, successfully negotiated this problem by entering into a PASS and requiring a lump-sum payment in year 15 equal to the present value of the remaining annuity. (30)

If an SCIDSS is used in a stock redemption, the "risk premium" should be reflected in an increased interest rate. The interest expense is deductible by the corporation, while a "risk premium" reflected in an increased purchase price would result in no tax benefit to the corporation. From the transferor's perspective the character of the income, capital versus ordinary, would change. However, because the current capital gain rate differential is only 3%, the benefit of an interest deduction at the corporate level (as compared to a nondeductible payment for stock) will generally exceed the additional tax owed at the individual level.

* Direct purchase

A direct purchase of stock by the successor using a PASS or an SCIDSS provides the following benefits compared to a redemption.

* The strict redemption rules of Sec. 302 are not applicable. Therefore, the duration of the PASS or the SCIDSS is not potentially limited as in the case of the redemption. Furthermore, the transferor may continue working for the corporation if desired.

* The transaction does not appear onthe corporate income tax return and no elections need to be filed with the IRS.

* The debt obligation of a PASS or an SCIDSS is not reflected in the corporation's financial statements.

* As an individual, the successor obtains basis in the stock purchased. The basis associated with the direct purchase will serve to reduce the income tax impact to him as he attempts to pass his stock to a successor.

A caveat should be addressed with respect to the interest deductibility under an SCIDSS. Under Sec. 163(d), interest paid to purchase stock in a C corporation constitutes "investment interest expense" and is deductible only to the extent that investment income is generated by the successor. The disallowed investment interest carries forward indefinitely and can be deducted in later years when investment income is generated by the successor. The character of interest expense paid to purchase the stock of an S corporation is determined by the nature of the activity engaged in by the S corporation and the relationship of the successor to the S corporation.


Both the private annuity stock succession and the self-canceling installment debt stock succession should be carefully considered when determining alternative methods of passing ownership of a company to the next generation. By carefully evaluating the estate, gift and income tax implications of a PASS versus an SCIDSS and coordinating these with the choice of buyers--corporation versus the successor shareholder--it is possible not only to freeze the transferor's estate value, but also to shelter the note or annuity from a potentially formidable estate tax.

(1) Sec. 2001(c), 50% for decedents dying after 1992.

(2) Revenue Reconciliation Act of 1990 (RRA) Section 11601(a), retroactive to Dec. 17, 1987.

(3) RRA Section 11602(a), generally effective for transfers after Oct. 8, 1990.

(4) GCM 39503 (6/28/85) (date document numbered, 5/17/86) was issued by the Office of Associate Chief Counsel (Technical). Under Sec. 6110(j), a GCM cannot be relied on as precedent, however, a GCM does indicate how the IRS may interpret a transaction.

(5) Sec. 2033.

(6) For private annuities, see Est. of Hedwig Zietz, 34 TC351 (1960); Est. of Mary Clare Milner, 6 Tc 874 (1946); Rev. Rul. 55-438, 1955-2 CB 601. For self-canceling installment debt, see Est. of John A. Moss, 74 TC 1239 [1980], acq. in result, 1981-1 CB 2, Ruby Louise Cain (transferee, Est. of Martha King Disborough), 37 TC 185 (1961), acq.

(7) Est. of Pamelia D. Holland, 47 BTA 807 (1942).

(8) Rev. Rul. 79-94, 1979-1 CB296.

(9) See Rev. Rul. 68-183, 1968-1 CB 308.

(10) Moss, note 6, Cain, note 6.

(11) Id

(12) Est. of Abraham L. Buckwalter, 46 TC 805 (1966).

(13) Moss, note 6; Cain, note 6; Sec. 2036(a).

(14) Rev. Ruls. 69-74, 1969-1 CB 43, 55-119, 1955-1 CB 352. If death a clearly imminent at the time of transfer, the annuity is not valued in accordance with the actuarial tables. Rev. Rul. 80-80, 1980-1 CB 194.

(15) See Secs. 1274 and 1274A.

(16) Est. of Buckwalter, note 12.

(17) Rev. Rul. 69-74, note 14.

(18) Rebecca Bell, 76 TC 232 (1981), aff'd per curiam, 668 F2d 448 (8th Cir.l 1982)(49 AFTR2d 82-538,82-1 USTC [paragraph] 9148); Rev. Rul. 55-119, note 14.

(19) Rev. Rul 86-72, 1986-1 CB 253, and GCM 39503, note 4, hold that the deferred installment sale gain at death is recognized on the decedent's estate income tax return under Sec. 691(a)(2) and (5).

(20) Rev. Rul. 55-119, note 14.

(21) Id.

(22) 212 Corp., 70 TC 788 (1978), Est, of Lloyd G. Bell, 60 TC 469 (1973).

(23) Moss note 6.

(24) The successor may have attained the status of a minority stockholder through prior acquisitions of stock. This status could occur as a result of an issuance of stock from the corporation, direct purchase, gift or bequest.

(25) Sec. 302(b)(3).

(26) Sec. 302(c)(2).

(27) Claude J. Lisle, TC Memo 1976-140.

(28) Rev. Proc. 89-3, 1989-1 CB 761, at 764.

(29) IRS Letter Rulings 8313073 (12/28/82) and 8503058 (10/24/84).

(30) IRS Letter Ruling 8701030 (10/7/86).
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Author:Launceford, John T.
Publication:The Tax Adviser
Date:May 1, 1992
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