From a valuation perspective, there are some very interesting things coming from the well- publicized tax controversy surrounding the Estate of William M. Davidson. The IRS, in asserting additional taxes, penalties and interest of over $2 billion, appears to be advocating a wholesale change in the way self-cancelling installment notes (“SCINs”) are to be valued. Historically, there has been no real need for business appraisers to get involved in the valuation of SCINs.

Depending on the outcome of the trial in the Davidson Estate, taxpayers wishing to avail themselves of this strategy would have to retain an appraiser, an actuary and a physician. As we will discuss, if the IRS were to win the case, there may be little future for SCINs. However, whether or not the IRS prevails in Davidson, it is very likely that existing SCINs may be reviewed by the IRS from the valuation standpoint viewpoint they now espouse. In such case, the taxpayer may need the services of a professional expert in determining the fair market value of notes.

SCINs have long been used in estate planning for individuals in poor health who are not expected to survive as long as the predicted life expectancy found in the IRS tables. Most tax practitioners consider a SCIN to be similar enough in structure to a private annuity that its tax governance would fall under Section 7520.

The ability to use the provisions of Section 7520 are key for four primary reasons. First, the mortality table (2000CM) associated with Section 7520 provides for the normal life expectancy of the overall population. This life expectancy is used to set the amortization of the note. To be valid, a SCIN’s term must not exceed the life expectancy of the seller. Second, the Section 7520 interest rate is ordinarily well below the market rate. Third, and most important, transactions falling under Section 7520 may use the “terminally ill” test. If the seller was deemed to be terminally ill, the note would be declared invalid by the IRS.(1)  However, under Section 7520, if the seller has credible evidence (usually a doctor’s opinion) that he or she had a 50 percent probability of living over one year, then the seller is presumed to be not terminally ill. Finally, the mortality adjustment is determined using the factors found in the 2000CM tables. This payment enhancement was deemed to be an adequate trade-off for the possibility of the note being cancelled early due to the seller’s death.

The IRS strategy in Davidson appears to contradict these commonly-held views on SCINs. The IRS contends the SCINs are notes and not annuities and, therefore, may not rely on Section 7520. Most importantly, this means there is no “terminally ill” safe harbor. Whether or not there is a reasonable expectation of repayment will be a somewhat subjective “facts and circumstances” debate. The interest rate and note terms might wind up being judged on the marketplace-not the statutory Section 7520 or AFR. The mortality adjustment may have to be based on the “actual” life expectancy of the seller much in the way viatical settlements are valued.

According to what the IRS seems to be saying regarding the Estate of Davidson, SCINs should be valued as debt instruments based on a method that determines the market rate of interest by taking into account the willing-buyer/willing-seller standard described in Treasury Regulation §25.2512-8. The market rate will consider many factors including:

1. Term and Duration of the Note
2. Default Risk
3. Security
4. Payment History (if any)
5. Specific Provisions of the Note
6. Marketability

The interest rate determined based upon the above will have to be adjusted to take into account the “mortality premium” required by the termination of the note upon the death of the seller. Since the mortality would be based on a medically-informed actuarial study, the chances that the seller might outlive the note go up substantially. In such case, instead of excluding the note’s unpaid balance from the seller’s gross estate at death, the seller who outlives the term of the note would wind up with more assets in his or her estate than were sold at the beginning because of the receipt of the mortality premium. Obviously, this is an unfavorable result from an estate planning standpoint. Based on this scenario, if the Davidson case goes the IRS’ way, you can bet your life we will see fewer SCINs used as an estate planning technique. Perhaps of more concern is the fact that all of the SCINs set up under the previous interpretation of the “rules” might now be subject to attack by the IRS.

Footnote:

(1) One of the reasons a transaction may be deemed a gift rather than a sale is if there is no reasonable means by which the note might be repaid. Since a SCIN is terminated at the death of the seller and if the seller cannot reasonably be expected to survive the term of the note, there is no reasonable expectation of repayment.

Sources:

Kenneth Crotty, Jerome Hesch, Edward P. Wajnarowski, Jr., Alan S. Gasman. IRS position Puts More Skin in the Game of Using SCINs. Estate Planning. Vol. 41/No. 1. (January 2014). 3-12.

Jonathan G. Blattmachr, Mitchell Gans.  Jonathan G. Blattmachr & Mitchell Gans on the Davidson Estate LISI Estate Planning Newsletter #2135. http://www.LeimbergServices.com. (August 28, 2013).