Understanding the Pros and Cons of a SCIN

Many estate planning techniques minimize or even eliminate gift and estate taxes when transferring assets to family members. Sometimes, the most powerful techniques will also have a significant drawback: mortality risk. A person must outlive the trust’s term to realize the benefits. Thus, a self-canceling installment note (SCIN) may be appropriate for anyone in poor health who isn’t expecting to reach his or her actuarial life expectancy.

How a SCIN works

To use a SCIN in estate planning, you sell your business or other assets to your children or other family members (or to a trust for their benefit) in exchange for an interest-bearing installment note. As long as the purchase price and interest rate are reasonable, there’s no taxable gift involved. So you can take advantage of a SCIN without having to use up any of your annual gift tax exclusions or lifetime gift tax exemption.

Generally, you can avoid gift taxes on an installment sale by pricing the assets at fair market value and charging interest at the applicable federal rate. As discussed below, however, a SCIN must include a premium.

The “self-canceling” feature means that if you die during the note’s term — which must be no longer than your actuarial life expectancy at the time of the transaction — the buyer (that is, your children or other family members) is relieved of any future payment obligations.

A SCIN offers a variety of valuable tax benefits. For example, if you die before the note matures, the outstanding principal is excluded from your estate. This allows you to transfer a significant amount of wealth to your children or other family members tax-free. And any appreciation in the assets’ value after the sale is also excluded from your estate.

You also can defer capital gains on the sale by spreading the gain over the note term. If you die before the note matures, however, the remaining capital gain will be taxed to your estate even though no more payments will be received. Finally, your children or other family members can also benefit because they may be able to deduct the interest they pay on the note.

Beware of the “premium”                           

Like most things in life, you can’t get something for nothing. To compensate you for the risk that the note will be canceled and the full purchase price won’t be paid, the buyers must pay a premium — in the form of either a higher purchase price or a higher interest rate. There’s no magic number for this premium; the appropriate premium is a function of the age of the payee and the stated duration of the note. If the premium is too low, the IRS may treat the transaction as a partial gift and assess gift taxes.

Both types of premiums can work, but they may involve different tax considerations. If you add a premium to the purchase price, for example, a greater portion of each installment will be taxed to you at the more favorable capital gains rate, and the buyers’ basis will be larger. On the other hand, an interest-rate premium can increase the buyers’ income tax deductions.

But the premium also comes with some risk. In fact, SCINs present the opposite of mortality risk: The tax benefits are lost if you live longer than expected. If you survive the note’s term, the buyers will have paid a premium for the assets, and your estate may end up larger rather than smaller than before.

Understand what you’re getting into

Keep in mind that, by using a SCIN, you’re taking a risk that you won’t survive the installment note’s term. Moreover, you can’t take advantage of this strategy if you’re terminally ill. Why? Because the IRS will likely view the transaction as a sham. But if your health is poor or your family has a history of shorter-than-average life expectancies, a SCIN may be a bet worth taking.

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