From the February 2009 issue of Wealth Manager Web • Subscribe!

A Noteworthy Strategy

Over the past year, the tumultuous economic environment has had wealth managers searching for ways to increase the value they bring to their client relationships. The search has taken them well beyond the ideals and techniques that encompass portfolio management, such as the undervalued asset class or the latest beaten-down stock being touted by analysts. So where do opportunities exist today? I believe there are certain wealth transfer strategies that can be more advantageous now-- while asset values are depressed and interest rates are low.

In addition to the grantor retained annuity trusts and charitable lead annuity trusts that could be effective in today's environment, the self-canceling installment note is another technique which some high-net-worth clients may find effective in helping them transfer wealth to family members at little to no cost.

The self-canceling installment note (SCIN)

The world of wealth transfer consists of numerous techniques and strategies for reducing the size of a taxable estate, while keeping the tax liability for the transfer to a minimum. The $12,000 annual gift tax exclusion ($13,000 in 2009) is a welcome wealth transfer tool--especially when leveraged by gifting discounted assets such as family limited partnership interests--but for the high-net-worth client, this may not be enough. In fact, many high-net-worth clients may have exhausted their applicable lifetime gift exclusion through previously implemented planning strategies. For such clients who continue to have wealth transfer needs, a SCIN may be worth considering.

A SCIN is an estate-freeze technique that combines several of the advantageous features available in private annuities and traditional installment sales. The SCIN is similar to a private annuity in that payments will cease at the death of the seller if it occurs prior to the completion of the SCIN term. Like traditional installment sale payments, SCIN payments are made over a specified term; the payments consist of principal, capital gain and interest, which allow the seller to defer taxation over the term of the SCIN.

As a mechanism for transferring assets to family members, the SCIN essentially locks in the current value of estate assets and removes their subsequent appreciation from the estate, at little to no cost to the client. Upon execution, a SCIN allows a seller to immediately transfer property out of his or her estate for a price that reflects the current fair market value. And, as mentioned above, the seller receives payments for the length of the period agreed upon in the note or until his or her death. (With a traditional installment note, the payments would continue to be made to the seller's estate until the completion of the note's term.)

It's easy to recognize how advantageous a SCIN could be for transferring assets out of an elderly client's estate. So why wouldn't everyone use a SCIN to transfer property to their heirs? "The devil," as they say, "is in the details."

The Details

The cancellation of payments upon the seller's death is certainly an attractive planning feature, but it comes at a cost. Because there is the possibility that the seller may not receive the full value of the note (i.e., if he or she predeceases the term), a risk premium must be built into the transaction. The premium can come in the form of an inflated fair market value for the asset being sold, an increased interest rate above the applicable federal rate (AFR) for the note's term, or a combination of both.

The risk premium is a significant factor to consider in structuring the note. Hindsight being 20/20, a SCIN that reaches full term may not be as effective as a traditional installment sale. The higher payments associated with such a SCIN would result in a higher cost to the buyer (typically, a family member) and a larger amount being returned to the seller's gross estate.

Another factor that is as significant as the premium is the length of the SCIN term. It can be tempting to structure a long-term note based on the expectation that the seller will not live long enough to receive a majority of the payments owed. Such a scenario would result in a significant transfer of assets with very little consideration paid to the seller or the seller's estate. And, as you may have guessed, it is not allowable. To avoid any perceived abuses of the technique, the term of the SCIN must be less than the seller's life expectancy, as determined using IRS actuarial tables.

The Benefits

As with any planning technique, the potential benefits are largely determined by the client's circumstances.

Similar to a traditional installment sale, a SCIN provides a mechanism for pro-rating any gain associated with the sale over the term of the note. The seller only has to pay taxes on the payments he or she receives during the term of the note. The payments are divided proportionately between return of principal, capital gain, and interest. The portion of the payment that represents return of principal is not taxable, while the portions representing capital gain and interest are taxable at capital gain rates and ordinary income rates, respectively.

This pro-ration of gain is particularly advantageous for clients selling appreciated assets with a low basis, as it allows the taxable gain to be deferred over the term of the loan. Clients must keep in mind, however, that the current political environment may bring tax changes which could result in a period of higher rates and payments. Also, the use of a SCIN will negate the step-up in tax basis generally available to capital assets upon the owner's death.

Another caveat: If the transaction takes place between family members, the asset cannot be sold until at least two years after the SCIN is executed, or all gain associated with the subsequent sale will be realized immediately by the original seller, rather than pro-rated and deferred over the SCIN term.

Of course, one of the greatest benefits is the SCIN's ability to freeze the estate value. Once the SCIN is executed, the property being sold is removed from the seller's estate. Its value is then effectively transferred to the value of the SCIN payments, which--should the seller pre-decease the term's end--could potentially cease earlier than the agreed upon term. All the appreciation associated with the asset occurs outside of the seller's gross estate.

Assets expected to appreciate significantly are the preferable assets for a SCIN, because the result could be a sizeable transfer of wealth without gift tax or other transfer costs.

Why consider a SCIN now?

Asset values are significantly depressed from their values just six months ago. Interest rates have fallen to historical lows as well. These factors combined present an opportunity to shift assets to family members at a low cost. Future appreciation can occur in the hands of family members outside of the seller's gross estate, and the taxable components of the SCIN payments will be reduced due to erosion of gain and low interest rates.

While the SCIN can be an effective planning tool, it may not be appropriate for every client. There are additional rules and regulations that may affect SCIN transactions between family members but may not be applicable to unrelated parties. Certain types of property (e.g., business interests) may also provide the buyer with an additional benefit in the form of an income tax deduction. Always work with experienced tax and legal professionals when drafting and implementing a SCIN.

Gavin Morrissey, JD (, is the director of advanced planning at Commonwealth Financial Network(R) in San Diego, Calif.

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