Estate planners and valuation analysts were eagerly awaiting a Tax Court decision in Estate of Davidson v. Commissioner for guidance with respect to valuing self-canceling installment notes (SCINs) in this well publicized case. Instead, a stipulated decision was entered in Tax Court indicating the taxpayer and the IRS had reached a settlement agreement providing for a total deficiency in estate, gift, and generation-skipping taxes of approximately $388 million. The IRS originally asserted a deficiency of approximately $2.8 billion. Unfortunately, we are not able to determine how the valuation issues were resolved.

William Davidson died on March 13, 2009, at age 86, owning 78% of the common stock of Guardian Industries Corp., a global manufacturer of glass, automotive, and building products. He also owned the Detroit Pistons, the WNBA Detroit Shock, and the NHL’s Tampa Bay Lightning. In December 2008 and January 2009, Mr. Davidson entered transactions including gifts, substitutions, a five year grantor retained annuity trust (GRAT), and sales utilizing SCINs.

Mr. Davidson’s SCINs were based on his life expectancy as determined by the published mortality tables and interest rates in the regulations under Section 7520. The notes required that only annual interest payments be made with principal paid in a balloon payment at maturity. In one set of transactions, the face value of the SCINs were almost double the value of the appraised value of the stock transferred, which purportedly compensated the seller for the risk he would die before the end of the note term. In another set of SCIN transactions, the interest rate that applied to the principal seller was adjusted to account for the self-cancelling mechanism. Because Mr. Davidson died less than six months after the transfer, no payments of principal or interest were received. Further, given the canceling feature of the notes upon Mr. Davidson’s death, the Estate tax return did not ascribe any value to the SCINs.

To compensate the seller for this risk of cancellation of a SCIN, the terms of the note must reflect a “risk premium,” either in the form of an increased purchase price and the corresponding principal on the note, or by using an increased interest rate on the note. In 2013, the IRS released Chief Counsel Advice 201330033 (the CCA), which rejected the practice of using the Section 7520 mortality tables to value a SCIN where the note holder had a greater than 50% probability of surviving longer than one year. The CCA maintained that the risk premium associated with SCINs must be based on a willing buyer/seller test that accounts for the medical history and health of the seller/creditor as of the date of the sale rather than simply relying on the IRS published mortality tables and rates.

The CCA concluded the arrangement in this case was nothing more than a device to transfer the stock to other family members at a substantially lower value than the fair market value of the stock. The IRS also commented that the notes were not bona fide debt because there must be a reasonable expectation that the debt will be repaid. Further, the CCA indicated that the Section 7520 tables do not apply to value the notes in this situation. By its terms, Section 7520 applies only to value an annuity, any interest for life or term of years, or any remainder. Because of the decedent’s health, the IRS maintained it was unlikely that the full amount of the note would ever be repaid. Thus, the note was worth significantly less than its stated amount, and the difference between the note’s fair market value and its stated amount constitutes a taxable gift.

While this case apparently settled in favor of the taxpayer, planners should be cognizant of the IRS position stated in the CCA and consider documenting the health and probability of survival of the note holder and obtaining an appraisal of the SCIN at inception to shift the burden of proof to the IRS.