Self Canceling Installment Note

Self Canceling
Installment Note
Help your business owner clients take
advantage of today’s low interest rates.
For agent use only. Not for public distribution.
Take advantage of today’s
low interest rate environment with
a Self Canceling Installment Note
Perhaps you have clients who are business owners and who want to transfer their business
interests to the next generation while minimizing the potential impact of the estate tax.
One frequently used technique is an installment sale – the
business owner (or “Seller”) sells his or her interest in the
business to one or more members of the younger generation
in exchange for a promissory note with payments of principal
and interest scheduled over a period of years. So long as
the Seller charges an adequate rate of interest, such a sale
keeps the transfer of business interest from being a taxable
gift and has the potential to remove future growth in the value
of the business from the Seller’s taxable estate. However,
the unpaid balance of the promissory note is included in the
estate at the Seller’s death.
A Self Canceling Installment Note (SCIN) can be an excellent
way for a Seller to transfer a business to a child and remove
the entire value of the business from the Seller’s estate.
Just like a traditional Installment Note, the note must bear
an interest rate at least equal to the Applicable Federal
Rate (AFR), which is currently at historic lows. The “Self
Canceling” part of the installment note means that the note
is canceled upon the death of the Seller. In order to avoid
the cancellation of the note from being a gift, a SCIN must
A Self Canceling Installment Note
can be an excellent way for a Seller
to transfer a business to the next
generation and remove the entire
value of the business from the
Seller’s estate.
For agent use only. Not for public distribution.
contain a “risk premium” that compensates the Seller for the
possibility of death prior to receiving full payment on the note.
The cancellation provision should be bargained for as part
of the consideration for the sale and should include a higher
than market value price (principal risk premium) or higher
than market interest rate (interest rate premium) as part of the
terms of the SCIN.
Although the key advantage of a SCIN is the cancellation
feature which eliminates any estate tax on the balance on the
installment note remaining at the Seller’s death, the remaining
gain on the balance on the note must be reported for income
tax purposes on the fiduciary income tax return (Form 1041)
for the Seller’s estate.
It is also important to note that this technique can only be
used if the client has a better than 50% chance of living at
least one year at the time the arrangement is put into place,
and that there is a presumption that someone who lives 18
months after entering into a SCIN satisfied the 50% chance of
living requirement, unless the opposite is proven by clear and
convincing evidence. While structuring the sale as a SCIN removes the risk of
having some or all of the value of the business included
in the Seller’s estate, there is another risk involved in the
sale – the risk that the Buyer will die before the end of the
SCIN’s term. The Seller may want the Buyer to purchase life
insurance on his or her life to provide for continued payments
in the event of the Buyer’s death. In such situations, term
life insurance is often used. But if the Seller also needs a
source of supplemental retirement income, then using a life
insurance product with the potential to accumulate cash
surrender values – such as Voya Indexed Universal LifeGlobal Choice (Voya IUL-Global Choice) – may prove to be
another solution.
Jim Jones is 65 years old and is the owner
of a business worth $1,000,000.
Jim would like to retire soon and his daughter, Janet, age
40, would like to buy him out. While Jim wants to make sure
Janet has life insurance coverage to cover her obligation, he
also is looking for something that could help provide him with
supplementary retirement income.
Possible solution:
Jim offers to sell his business to Janet in exchange for a
Self Canceling Installment Note. The interest rate on the note
reflects the current mid-term AFR rate plus a premium. The
Voya® Life Companies’ underwriting guidelines specify that
coverage for debt repayment can be for up to 75% of the loan
amount. Therefore, Jim purchases a $750,000 Voya IUL-Global
Choice policy on Janet’s life, names himself as policyowner, and
creates an Endorsement Split Dollar agreement to endorse part
of the death benefit to Janet. The amount endorsed to Janet is
based upon the amount of the obligation due to Jim based on
the terms of the SCIN. Jim uses part of the proceeds from the
Janet’s payments to pay for the life insurance coverage.
If something should happen to Janet during the term of the
note, Janet’s estate will have valuable death benefit protection
to help cover her obligation to Jim. Assuming Janet survives
the term of the SCIN, Jim can later use the cash values of the
Voya IUL-Global Choice policy to help supplement his income
in retirement.
How does it work?
Jim and Janet enter into an agreement for Janet
to buy Jim out over a 9 year period using a self
canceling installment note. Jim has his attorney
draft the note and determine the appropriate
“risk premium” on the interest rate.
Janet will make installment payments to Jim until
the earlier of full repayment of the note or until
Jim’s death.
Jim buys a life insurance policy on Janet’s life. He
has his attorney draft an Endorsement Split Dollar
agreement and endorses a death benefit amount
to Janet to help pay for the sale amount of the business.
Jim will pay gift taxes on the economic benefit cost of
the endorsed death benefit amount. This amount can
be decreased each year to match Janet’s obligation
amount, easing the cost of the economic benefit.
If Janet dies before Jim, the death benefit proceeds
received by her stated beneficiary of the endorsement
agreement can be used to continue the installment
payments to Jim.
If Jim dies before the end of the installment note,
the note is cancelled and the Janet has no further
obligation to make payments on the note. The
Endorsement agreement can be terminated and
Jim’s estate can dispose of the policy as it sees fit.
If Jim survives the term of the note and Janet pays
the note in full, Jim can now use the policy cash
values to help supplement his income in retirement.
Or he could transfer the policy back to Janet for her
personal insurance needs.
For agent use only. Not for public distribution.
Why a SCIN and why now?
Jim and his financial and tax advisors want to take
advantage of today’s low interest rates while also
providing a potential source of supplemental income
in retirement. A SCIN has the potential to remove
appreciated property from his estate. If he dies during the
term of the SCIN, the note is canceled and Janet would
become full owner of the business with no gift tax due on
the balance of the note.
Now is a good time to transact a SCIN due to historically
low interest rates. As of November 2014 the Mid-Term
AFR was 1.9%. The interest rate “risk premium” is based
on the IRS section 7520 rate which as of November was
2.28%. So, using the Mid Term AFR with the interest rate
“risk premium” factored in, Janet’s payment would be
$135,164 over the 9 year period of the note.
Assuming they both survive, starting in
year 16, Jim could potentially take over
$53,000 in cash value distributions from
the policy for 14 years to supplement his
income in retirement.
What have we accomplished?
Jim, Janet, and their attorney create the terms of the SCIN
and determine that Janet’s annual payment to Jim should
be $135,164 for 9 years. Jim uses $29,128 of this payment to
maximum fund a $750,000 Voya IUL-Global Choice policy
on Janet’s life for 9 years.
If something should happen to Janet during the term of the
note, Jim has valuable death benefit protection on her life to
cover her obligation.
Total premiums paid
Projected loan/
withdrawal amount
Cumulative loan/
withdrawal amount
Net surrender value
at age 121
Other case design parameters include: Cash Value Accumulation Test • Option A death benefit • 8.49% hypothetical crediting rate
A portion of the policy’s surrender value may be available as a source of supplemental retirement income through policy loans and withdrawals. Income tax free policy distributions
may be achieved by policy loans or withdrawing to the cost basis (usually premiums paid). This assumes the policy qualifies as life insurance, is not a modified endowment contract and
is not lapsed or surrendered with an outstanding loan. Policy loans and withdrawals may reduce or eliminate index credits, generate an income tax liability, reduce available surrender
value and reduce the death benefit, or cause the policy to lapse. Additionally, loans may limit the ability to make elections to the Indexed Strategy; if a loan results in amounts being
deducted from a block prior to its block maturity date, no elections from the Fixed Strategy to the Indexed Strategy will be processed in the 36 months following the loan.
There are special rules that apply to installment sales of property between related persons if the related person who purchased the property sells it within 2 years of the purchase.
Neither Voya nor its affiliated companies or its representatives give tax or legal advice. Your clients should consult with their legal advisors regarding their individual situation. These
materials are not intended to be used to avoid tax penalties, and were prepared to support the promotion or marketing of the matter addressed in this document. The taxpayer should
seek advice from an independent tax advisor.
Voya IUL-Global Choice, policy form series #1186-09/12 with an equity indexed feature, varies by state and may not be available in every state. It is issued by Security Life of Denver
Insurance Company, a member of the Voya® family of companies. Not available in New York. The cost of insurance rates, policy expense charges, Fixed Strategy interest rate, index
cap, and participation rate are subject to change. All guarantees are based on the financial strength and claims paying ability of Security Life of Denver Insurance Company which is
solely responsible for the obligations under its own policies.
.For agent use only. Not for public distribution. ©2015 Voya Services Company. All rights reserved. CN-0115-11319-0217
165651 01/28/2015