The IRS doesn’t like it when debts are cancelled. When a lender forgives a loan, the tax code generally treats the amount of cancelled debt as income to the borrower, who then pays income tax on that amount. Fortunately, there are some exceptions to this general rule. One of them is a self-cancelling installment note, commonly called a “SCIN.”
A SCIN can be a very useful tool in estate and tax planning. Let’s say that Mom sells the family business or cottage to Junior in an installment sale that is not structured as a SCIN. While a non-SCIN installment sale certainly has advantages, it also has disadvantages. If Mom should die before all the payments are made, the present value of the unpaid installments is included in Mom’s estate for estate tax purposes. Further, the remaining installments are still owed by Junior.
On the other hand, if the installment sale is structured as a SCIN, both of these disadvantages are avoided if Mom should die before all the payments are made: The present value of the unpaid installments is removed from Mom’s estate, and Junior’s remaining payments are extinguished.
Two features are essential if a SCIN is to pass muster. First, the term of the loan must be shorter than Mom’s life expectancy. Second, Junior must pay a “risk premium” in the form of an above-market sales price or interest rate, or both. The end result is that if Mom lives out her life expectancy, she’s enjoyed the full benefit of the income stream from the installment sale and has moved a significant asset out of her estate. If she doesn’t survive until all the payments are made, then the asset is still out of her estate, and Junior enjoys the benefit of debt cancellation without an accompanying income tax hit.
SCINs can be tricky. Before entering into one, the parties should consult with both tax and legal counsel to ensure that it is properly structured and is the best fit for the circumstances.