Source: https://www.bna.com/irs-chief-counsel-n17179877499/
Timestamp: 2017-05-22 17:32:43
Document Index: 101553864

Matched Legal Cases: ['§25', '§7520', '§2501', '§25', '§2033', '§2038', '§2512', '§25', '§7520', '§7520', '§25', '§7520']

IRS Chief Counsel Advises Sale of Stock in Exchange for Self-Cancelling Note Treated as a Taxable Gift | Bloomberg BNA
IRS Chief Counsel Advises Sale of Stock in Exchange for Self-Cancelling Note Treated as a Taxable Gift
In CCA 201330033, the Chief Counsel's Office advised that (1)transfers of stock from Taxpayer to grantor trusts in exchange fora self-cancelling installment note (SCIN) constituted a deemed giftto the extent that the fair market value of the notes was less thanthe fair market value of the property transferred to the grantortrusts; (2) the notes should be valued based on a method that takesinto account the willing-buyer, willing-seller standard of Regs.§25.2512-8 and should also account for Taxpayer's medical historyon the date of the gift rather than relying on the mortalitytables; and (3) there was no estate tax consequence associated withthe cancellation of the notes with the self-cancelling feature uponTaxpayer's death where the transfers constituted a gift. By statingthat value of the SCIN is not determined by applying the mortalitytables, the IRS appears to upend the accepted practice forcalculating the risk premium on SCINs.
A SCIN is an estate planning technique used to transfer valueout of the estate of an individual without incurring gift tax. Thetransaction works by having a client sell an asset to a familymember or trust, often an intentionally defective grantor trust, inexchange for a promissory note that includes a self-cancellationfeature, whereby the note terminates and the outstanding balance iscancelled if the client dies during the term of the note. Inaddition to interest on the promissory note, a SCIN includes aso-called risk premium for the self-cancellation provision. If theclient survives, then the client is wholly repaid on the note,including the risk premium. However, if the client does notsurvive, the asset and the remaining note balance are removed fromthe client's estate, and value has been shifted transfer-tax freeto the buyer without any additional obligation on the note.
Taxpayer owned a number of assets of substantial value,including stock in a certain corporation (the "Stock"). Inthe year before he died, Taxpayer established separate grantortrusts for the benefit of his family members and funded certain ofthe newly created grantor trusts with the Stock. Taxpayersubsequently transferred additional Stock to the grantor trusts inexchange for promissory notes with a certain term of years based onthe Taxpayer's life expectancy as determined in the tables in theregulations under §7520 of the Internal Revenue Code of 1986, asamended (the "Code"). The promissory notes contained aself-cancelling feature that effectively relieved the issuer, thegrantor trust in this case, of the obligation to make any furtherpayments on the note if the Taxpayer died before all of thepayments under the notes had come due. The SCINs required onlypayments of interest during the note term and the payment ofprincipal to Taxpayer on the last day of the term. The total facevalue of the SCINs was almost double the value of the Stock. Thishigher face value of the SCINs was a premium designed to compensateTaxpayer for the risk that he would die before the end of the noteterm and therefore neither the principal nor a significant amount,if not all, of the interest would be paid. Taxpayer died less thansix months after the transfers, and therefore, no interest orprincipal payments were made on the notes. Taxpayer's estate fileda federal gift tax return for the year in which the transfers weremade on which it disclosed the transactions but did not report anytaxable gift as a result of those transactions. Taxpayer's federalestate tax return did not include any portion of theself-cancelling notes.
In general, §2501 imposes a tax on the transfer of property bygift. Section 2512(b) provides that where property is transferredfor less than an adequate and full consideration in money ormoney's worth, then the amount by which the value of the propertyexceeds the value of the consideration is deemed a gift that isincluded in computing the amount of gifts made during the calendaryear. Regs. §25.2512-4 provides that the fair market value of thenotes, secured or unsecured, is presumed to be the amount of unpaidprincipal, plus accrued interest to the date of the gift, unlessthe donor establishes a lower value. In addition, §2033 of the Codegenerally provides that the value of the gross estate shall includethe value of all property to the extent that the decedent had aninterest in such property at the time of his death including,pursuant to §2038, the value of any interest in property which thedecedent has at any time made a transfer that, in general terms,was subject to change at the date of his or her death through theexercise of certain powers by the decedent (except in the case of abona fide sale for an adequate and full consideration in money ormoney's worth).
The Chief Counsel's Office began its analysis by reviewing theprinciples applicable to the self-cancelling feature of the notes,stating that (1) in general, a transaction where property isexchanged for promissory notes will not be treated as a gift if thevalue of the property transferred is substantially equal to thevalue of the notes, (2) the face value and length of payments ofthe notes must be reasonable in light of the circumstances, (3) todetermine whether the gift tax applies, the IRS must determine thevalue of the Stock that Taxpayer transferred to the grantor trustsshortly before his death and the value of the notes taking intoconsideration the notes' self-cancelling feature, and (4) if thefair market value of the notes is less than the fair market valueof the property transferred to the grantor trusts, the differencein value is deemed a gift under §2512(b) and Regs. §25.2512-8.
In addressing the issue of the extent to which transfers of theStock from Taxpayer to the grantor trusts in exchange for theself-cancelling notes constituted a deemed gift, the ChiefCounsel's Office distinguished the present case from the facts ofEstate of Costanza v. Commissioner.1 InCostanza, the appellate court stated that aself-cancelling note signed by family members will be presumed tobe a gift and not a bona fide transaction but that the presumptionmay be rebutted by an affirmative showing that there existed at thetime of the transaction a real expectation of repayment and anintent to enforce the collection of the indebtedness. Thecourt concluded in Costanza that the presumption hadbeen rebutted because the father could not gift the businessproperties at issue to his son being that he required a steadystream of income in order to retire and there existed a realexpectation of repayment at the time of the transaction. The ChiefCounsel's Office explained that in Costanza, the decedentrequired the payments for retirement income and, thus, had a goodreason, other than estate tax savings, to enter into thetransaction but that in contrast, Taxpayer in this case hadstructured the note such that the payments during the termconsisted of only interest with a large payment on the last day ofthe term of the note. The Chief Counsel's Office concluded that thearrangement in the present case was nothing more than a device totransfer the Stock to other family members at a substantially lowervalue than the fair market value of the Stock on the basis that asteady stream of income was not contemplated and that Taxpayer hadsubstantial assets and did not require the income from the notes tocover his daily living expenses.
The Chief Counsel's Office concluded, further, that the §7520tables did not apply to value the self-cancelling notes in thissituation, reasoning that §7520, by its terms, applied only tovalue an annuity, any interest for life or term of years, or anyremainder and did not apply to notes decedent received in exchangefor the Stock that he sold to the grantor trusts. In addition, theChief Counsel's Office stated that the self-cancelling notes shouldbe valued based on a method that takes into account thewilling-buyer, willing-seller standard in Regs. §25.2512-8, as wellas Taxpayer's life expectancy, taking into consideration decedent'smedical history on the date of the gift.
In addressing the issue of whether there were any estate taxconsequences associated with the cancellation of the notes with theself-cancelling feature upon Taxpayer's death, the Chief Counsel'sOffice discussed two other cases involving self-cancelling notes.In Estate of Moss v. Commissioner,2 the Tax Courtheld that the self-cancelling notes were not included in thedecedent's estate where, at the time of sale, there was nothing toindicate that his life expectancy would be shorter than theapproximate ten years of life expectancy that was indicated bygenerally accepted mortality tables but the decedent discoveredthat he had cancer and died shortly after the sale. In Estateof Musgrove v. United States,3 the Court ofFederal Claims held that a transfer by the decedent to his son,less than one month before the decedent's death, in exchange for anunsecured, interest-free demand note with a cancellation on deathprovision was not bona fide where the decedent was an 84 year oldman suffering from angina, arteriosclerosis and hypertension, thedecedent's son needed to borrow money to satisfy a debt of hissister's estate, the decedent offered to loan the funds to his sonin exchange for a demand note with a cancellation upon deathprovision, the decedent indicated that he did not believe he wouldever need to make a demand for repayment, and the son indicatedthat he did not know if or when he could ever repay the debt.
The Chief Counsel's Office found that there were similaritiesbetween Taxpayer in the present case and the decedent inMusgrove, because in each case the decedent who received apromissory note with a self-cancelling feature was in very poorhealth and died shortly after the note was issued and there was alegitimate question as to whether the note would be repaid in eachcase. The Chief Counsel's Office noted that because of Taxpayer'shealth in the present case, it was unlikely that the full amount ofthe note would ever be paid. Thus, the Chief Counsel's Officeconcluded that the note was worth significantly less than its facevalue, the difference between the note's fair market value and itsface value constituted a taxable gift, and that there was no estatetax consequences associated with the cancellation of the notes uponTaxpayer's death.
By stating that the transferor's life expectancy had to beconsidered in light of his particular medical history as of thedate of the gift to determine the value of the SCIN rather thanapplying the mortality tables, the IRS appears to upend theaccepted practice for calculating the risk premium on SCINs. Thestandard applied by the IRS creates uncertainty regarding how tocalculate the risk premium in future transactions and may alsoinvite IRS challenging to prior SCIN transactions in which the§7520 mortality tables were used, even if no medical condition wasknown at the time of the transfer.
This commentary also appears in the October 2013 issue ofthe Real Estate Journal. For more information in theTax Management Portfolios, see Wojnaroski, 805 T.M., PrivateAnnuities and Self-Canceling Installment Notes, and in TaxPractice Series, see ¶6350, Estate Planning.
1 320 F. 3d 595 (6th Cir. 2003),rev'g T.C. Memo 2001-128.
2 74 T.C. 1239 (1980), acq. in result,1981-2 C.B. 1.
3 33 Fed. Cl. 657 (1995).