This Chief Counsel Advice involved a taxpayer who entered into two transactions in which he sold stock in exchange for a SCIN.
The first transaction involved an interest-only note with a face value of nearly double the value of the stock to account for the risk premium. The second transaction was similarly an interest-only note, but the risk premium was incorporated into the interest rate on the note. In each instance, the note matured near the taxpayer’s life expectancy, had a self-cancelling feature and the risk premium was calculated using Section 7520 and related mortality tables. Shortly after the transaction, the taxpayer was diagnosed with an illness and passed away within six months, having never received an interest or principal payment on either SCIN.
In considering how the FMV should be determined for the above transactions, the IRS stated that it didn’t believe that the Section7520 tables applied to value notes and that those tables applied “only to value an annuity, any interest for life or term of years, or any remainder.”12 The IRS further stated, “these notes should be valued based on a method that takes into account the willing-buyer willing-seller standing in §25.2512-8. In this regard, the decedent’s life expectancy, taking into consideration decedent’s medical history on the date of the gift, should be taken into account.”13 The IRS concluded that “because of the decedent’s health, it was unlikely that the full amount of the note would ever be paid. Thus, the note was worth significantly less than its stated amount, and the difference between the note’s fair market value and its stated amount constitutes a taxable gift.”14
The facts in the CCA don’t indicate that the taxpayer had any known illness at the time of the transaction. Further, in stating that the Section 7520 tables weren’t applicable, the IRS disregarded a generally accepted practice of calculating the risk premium on a SCIN, similar to the method employed by IRS itself in Dallas. More importantly, the IRS didn’t state what the appropriate method is to calculate a risk premium. The IRS noted certain bad facts that were present in this situation that may have affected its decision or may affect future decisions, including the fact that the notes didn’t pay principal until the end of the term, and the IRS didn’t think the taxpayer had a reason to enter into the transaction (for example, to receive to a steady stream of income in retirement). The IRS reasoned that “the arrangement in this case was nothing more than a device to transfer the stock to other family members at a substantially lower value than fair market value of the stock.”15