How is a Self-Cancelling Promissory Note Treated in Estate Death Tax Administration

Understanding What a Self-Cancelling Note Means

Self Canceling NoteUnder federal law “[t]he value of a gross estate shall include the value of all property to the extent of the interest therein of the decedent at the time of his death.”  I.R.C. § 2033.  In the context of the estate tax, when properly written, a self-cancelling installment note (“SCIN”) functions to remove from the estate the property that is the subject of the installment note leaving no taxable asset in its place.

An installment note reflects an agreement related to an installment sale.  As defined by the code, “‘installment sale’ means a disposition of property where at least 1 payment is to be received after the close of the taxable year in which the disposition occurs.”   I.R.C. § 453 (b)(1).  A self-cancelling installment note represents “[a] debt obligation that is automatically extinguished at the creditor’s death.  Any remaining balance on the note becomes uncollectible.  Self-cancelling notes are typically used in estate planning.

To be recognized a SCIN, the transaction must be bona fide, for full and adequate consideration, the seller must not retain control over the property, the cancellation provision must be bargained-for consideration, and the terms of the alleged note must not exceed the seller’s life expectancy.  In addition, the seller must receive a risk premium as consideration for the cancellation clause since it may prevent seller from receipt of the full purchase price.  The risk premium is generally reflected as an increased purchase price or interest rate.  (“To obtain benefit [of a SCIN, a] premium is required to be paid…  A premium must be paid by the buyer to ensure that no gift arises from the cancellation provision.”)

“[A] SCIN signed by family members is presumed to be a gift and not a bona fide transaction.”  One who shows a real expectation of repayment and intent to enforce the collection of indebtedness may rebut the presumption.  As an intra-family transaction, the estate has the burden to prove that “there existed at the time of the transaction a real expectation of repayment and intent to enforce the collection of indebtedness.”  Where the evidence is clear there was no obligation that borrowers repay the loan, the SCIN will be rejected.

The decedent offered to sell 231 shares of corporate stock and real property to his -corporation in exchange for promissory notes.  The sale was considered to be a “bona fide sale for adequate and full consideration.”  The promissory notes “provided for 4 percent interest and equal monthly payments” over the course of nine years and seven months.  At 72 years of age, decedent was in average health.  The court found “[t]here was nothing to indicate that his life expectancy would be shorter than the approximate 10 years of life expectancy which was indicated by generally accepted mortality tables.  Nearly ten months later, the decedent was diagnosed with terminal cancer for which he underwent treatment.  The installment note by which the decedent sold the stock and property to the corporation contained a cancellation clause:  “unless sooner paid, all sums, whether principal or interest shall be deemed cancelled and extinguished as though paid upon death…”  The decedent received timely payments under the notes until the date of his death.  According to the executor, the unpaid balances of the notes had no value at decedent’s death.  The estate argued the loan obligation is a self-cancelling installment note (“SCIN”) extinguished at decedent’s death pursuant to the agreement between borrowers and decedent.  In accepting the Federal Form 706 as filed, the estate contended that the IRS improperly included the loan principal and taxation erred by including the loan proceeds in the gross estate.  In support of the assessment, New Jersey argued the loan constituted a gift of money conferred on the borrowers at decedent’s date of death, the equivalent of a testamentary disposition.  The state further contended the court should look to standards established by the New Jersey inheritance tax statute and the interpretive case law, and extend that law to this case.  Specifically, the state argued that a SCIN constitutes a gift in contemplation of death subject to inheritance tax when made within three years of decedent’s death.  It contended the SCIN represents evidence of a debt extinguished at decedent’s death.  Fortunately, the NJ Tax Court rejected the state’s reliance on principles of the New Jersey inheritance tax.  The court found no basis to extend that law to an SCIN.  Moreover, the state’s position disregards federal precedent that recognizes a SCIN as a valid device for the avoidance of federal estate tax.  The NJ tax court is guided by federal precedent where the issue before the court is governed by federal law.

To discuss your NJ estate administration matter, please contact Fredrick P. Niemann, Esq. toll-free at (855) 376-5291 or email him at fniemann@hnlawfirm.com.  Please ask us about our video conferencing consultations if you are unable to come to our office.

By Fredrick P. Niemann, Esq., a Freehold Township, Monmouth County NJ Probate and Estate Administration Attorney

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