CHANGE IN APPROACH BY IRS BUT STILL SOUND ESTATE PLANNING CONTINGENCY
It is obvious that no one knows when they will shake off their mortal coil and pass from this earthly realm. The IRS and the law in general consult their own mortality tables to guide certain decisions. These tables are based on probabilities and generalities, drawn up by bean counting actuarians. They are undoubtedly reliable enough to warrant an individual to make a decision that may take decades to play out or even by institutions to guide their decision making. Insurance companies calculate risk by consulting them and Courts sometimes use them to determine future damages. They can be used by those engaging in estate planning for many things, but, in particular to help calculate a risk premium in a limited set of circumstances. A self cancelling installment note can be a method and means to transmit wealth to the next generation if properly structured. A recent Chief Counsel Advisory (CCA) opinion by the IRS called into question one specific means to calculate risk for a self cancelling installment note but did not question the overall appropriateness of the use of a self cancelling installment note. The self cancelling installment note works by one person selling an asset or loaning a certain sum of money, pursuant to a promissory note, with at least a minimal amount of interest charged.
In addition, the promissory note acknowledges that in the event that the person who holds the promissory note (the lender) passes away while the note is still being repaid, the remaining balance of both principal and interest is considered paid in full. The note must incorporate a specific increased interest rate in light of the increased risk that the note holder/lender may not collect the entire amount. If unfortunately the note holder/lender passes away the money passes outside the estate, without incurring any estate or gift tax liability and without any additional legal obligations for the borrower.
Prior to 2013 the generally accepted method to calculate risk was consult the IRS’s mortality tables. The closer a lender was to the end date under the mortality tables, the higher the premium. On July 26, 2013 the IRS released CCA 201330033, which called into question the specific method by which the lender and borrower calculated the risk premium and translated that into a higher interest rate for the borrower. Under the facts of the case, the lender/seller sold a certain number of shares of stock to the borrower/buyer for an undisclosed sum of money. An increased risk premium was built into the interest rate, by reference to the mortality tables. Soon after the parties consummated the transaction, the lender/seller was diagnosed with a terminal illness and passed away approximately six months later. The borrower/buyer did not even make his first payment under the terms of the note.
The IRS concluded that the parties calculated the interest rate improperly and thus did not properly qualify as a self cancelling installment note. The IRS treated the transaction as a gift. Unfortunately, the IRS did not indicate the appropriate manner to translate the risk into an increased interest rate. It did not set out any formula. It only noted that instead of consultation with the mortality tables, there had to be a specific reference to the medical history of the lender/seller as of the date of the transaction. Going forward parties may need to consult with a physician to get a better picture of the lender’s health and incorporate those findings into the final promissory note.