Advanced Estate Planning

What Is a Self-Cancelling Installment Note?

Good estate planners are focused on finding techniques that can minimize or possibly even eliminate gift and estate taxes when transferring assets to family members.  That is because the transfer of wealth through a last will and testament and the probate process can be expensive, time consuming, emotionally draining, and heavily taxed.

The most helpful strategies that estate planners have used, however, can come with substantial disadvantages.  One of those disadvantages being mortality risk.  For example, if you do not live longer than the term of a trust, you will not realize the tax benefits of that trust.

So, how do you eliminate that mortality risk?  A self-cancelling installment note.  This blog will cover the basics of what a self cancelling note is, how it works, and how it can be beneficial to your overall estate plan.

If you wish to transfer assets to family members or other loved ones, while you are alive and still have control over the process, but want to avoid as much transfer tax as possible, you will want to speak with a qualified estate planning attorney.

At Doane & Doane, we have the best of the best when it comes to estate planning legal experts.  Our attorneys have helped many, many clients take a good look at their assets, consider their desires, and formulate a workable estate plan that ensures that the maximum amount of your assets go to your beneficiaries, rather than lost in taxes.  Call us for a free consultation today at 561-656-0200.

How Does a Self-Cancelling Installment Note Work?

To use a self cancelling note, you would first sell your business or some other asset to your children, a loved one, or a trust created for their benefit. In exchange for that sale, you would receive an installment note that generates interest.

It is a sale, so as long as the price of the sale is reasonable (not some nominal amount like $1), it will be treated as such for tax purposes, and no taxable gift has occurred.  The benefit there is that you do not need to use any allotted yearly gift tax exclusion, or lifetime gift tax exemption.

It is called an “installment note” because it mirrors an installment sale, which prices the assets at their fair market value and charges interest at a rate required by law on each installment payment.

The “self-cancelling” feature means that if you die during the term of the note (which cannot be longer than your actuarial life expectancy at the time of the sale), then the “buyers” (your children, or other loved ones) are relieved of any future payment obligations, and receive the entire asset free of any transfer taxes.

In layman’s terms, the self-cancelling installment note is similar to a bet against your life expectancy.  As morbid as that sounds, it can result in significant tax benefits to your children.  If you pass away before the note’s term, then your “buyers” obtain the full asset without transfer taxes, and without having to make any further installment payments.  If you outlive the note’s term, however, the “buyers” pay the full purchase price for the asset, but still avoid gift taxes.

What About the “Premium?”

Notably, the “buyers” in the self-cancelling installment note transaction have the chance to receive the entire asset without paying the full purchase price if you pass away before the note’s term.  That is a significant benefit.

To pay for that benefit, the “buyers” of the self cancelling note must pay a “premium.”  That premium is typically either in the form of a higher purchase price, or a higher interest rate.

The calculation to arrive at the premium takes into account your age as well as the duration of the note.  You need to be careful because a premium that is too low may result in the Internal Revenue Service (IRS) charging a partial gift tax.

There are benefits to either type of premium. A premium in the form of a higher purchase price means that your capital gains rate will be higher. A premium in the form of a higher interest rate will increase the “buyers’” income tax deductions.

The premium, however, is not without risk. Remember, the main benefits of a self-cancelling installment note come if you die before the term is up. It is not as helpful if you outlive your life expectancy because your “buyers” will have paid, in installments, for the asset at a premium.  Also, if you outlive the term, then you have received more money than the original asset – so, your estate might end up bigger, rather than smaller, when all is said and done.

Why Get a Self-Cancelling Installment Note?

Given the cost-benefit of a self-cancelling installment note, the incentive to create one comes, frankly speaking, when you are in poor health and do not expect to reach life expectancy.  In that circumstance, transferring assets through a self-cancelling installment note is a viable, smart option.

Please note, however, that the life-expectancy issue has been the subject of some estate cases.  If a person’s death is imminent then that person might not be able to transfer assets using a self cancelling note. The IRS looks at intra-family asset transfers with close scrutiny.  Accordingly, where there was no reasonable probability that the transferor could live to the end of the note’s term, then courts have unwound such self-cancelling installment note transactions.

Thus, when considering the self-cancelling installment note option, there should be a realistic possibility that you, the transferor, have a reasonable likelihood of living to the end of the note’s term.

Consult with a Palm Beach Estate Attorney

If you are intrigued by the self-cancelling installment note option after reading this blog, or have been considering including one in your estate plan, then you should contact a seasoned estate planning attorney to understand all of the advantages and disadvantages involved.

At Doane & Doane, we are prepared to give you sound, accurate advice on a self-cancelling installment note.  Also, if that is something that would be a solid option based on your circumstances, then we can reliably ensure the transaction will be handled properly.  Call us at Doane & Doane today, at 561-656-0200.