Succession Planning with Self-Canceling Installment Notes or “Beating the IRS at the SCINS Game”
As a business owner nears retirement, planning for the transfer of the business to the next generation of owners becomes critical, both for the business as well as for the withdrawing business owner. For many business owners, their interest in the business may be the largest single asset in their estate, and the cash flow they anticipate from the sale of the business is a major component of their retirement income. When the transferee of the business is a member of the business owner’s own family, such as a child, the business owner may wish to consider accepting a self-canceling installment note (or “SCIN”) from the purchaser of the business.
A typical SCIN involves the sale of property to a buyer, with the seller taking back an installment note that, by its terms, will automatically expire upon the happening of a certain event, which is typically the death of the seller. A SCIN offers several advantages to both the buyer and seller, such as potential tax savings, deferral of capital gains, and the assurance of a stream of income to the seller (in the form of periodic note payments). In addition, if the seller dies before the SCIN has been paid off, there may be significant estate tax savings to the seller’s estate.
As an example:
Mr. Jones, age 70, sells his business to his son for $1,000,000, taking back a SCIN payable in installments over 12 years. The note requires the son to pay $31,609 per quarter over the 12 year term, which includes interest at 7.397% per year. If Mr. Jones dies 5 years later, the note balance of $686,000 is forgiven, and Mr. Jones has removed $1,000,000 worth of property from his estate, together with five years worth of appreciation, and replaced it with $314,000 in principal payments on the note.
For tax purposes, the seller is entitled to treat the sale of his or her business interest as an installment sale for capital gains purposes, meaning that the seller recognizes capital gains only as principal payments are received. There is a split of authority concerning the buyer’s basis in the purchased property: while an IRS regulation takes the position that a buyer acquires basis only as contingent payments are due, an IRS Revenue Ruling concludes that the buyer’s basis equals the full maximum sale price stated in the SCIN itself.
The major drawback in using a SCIN in a business succession plan is the impact of Internal Revenue Code §453 (B)(f) at the death of the seller. This Code Section provides that, if any installment obligation is canceled, it is treated as if it were disposed of in a transaction other than a sale or exchange. If the seller and the purchaser are related persons, as described in Section 453(f)(1), the fair market value of the obligation disposed of is equal to its face amount. According to the IRS, the deferral gain must be recognized by the seller’s estate at death, and the amount of the gain constitutes income in respect of a decedent, recognized by the estate on the estate’s own income tax return, and there is no estate tax deduction for any of the resulting income tax liability.
In summary, using a SCIN as part of a comprehensive succession play may have significant tax advantages in certain circumstances, especially since payments can be tailor-made to the seller’s needs. If the seller has need for significant cash flow, the term of the note can be shortened; if the seller wishes to defer capital gains as long as possible, the term of the SCIN can be stated to be as long as one month less than the seller’s life expectancy.