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George F. Bearup, J.D. Senior Legal Trust Advisor

11-Dec-18

Discharge or Bequest of an Installment Note

Take-Away: Interesting income tax consequences occur if a decedent-parent bequeaths or cancels an unpaid installment note back to the child who is obligated to make the payment.

Example: A parent might sell the family cottage or a closely held business interest to a child on an installment note basis. How the capital gain from that sale that is recognized and reported on the parent’s death can be confusing, along with the tax consequences if the installment obligation is discharged or cancelled or the subject of a specific bequest.

Background:

  • Bequests: Specific bequests under a Will or trust usually come in two varieties. A pecuniary bequest of a specific amount of money, or a specific bequest of a particular item of property or an identified asset. As a generalization, the distributions of specific bequests do not carry out distributable net income (DNI) to the recipient beneficiary. [IRC 663(a)(1).] As a result, the estate or trust that makes the distribution of an installment obligation will not be entitled to claim a distribution deduction from its income when it fulfills a specific bequest under the Will or trust. [IRC 661.] Nor will the beneficiary who receives the specific bequest asset be required to report any DNI as part of their taxable income. [IRC 662.] This distinction is because a specific bequest is generally viewed as being in the nature of a distribution of principal from the estate or trust. [IRC 102.] But how unreported capital gains in the form of the unpaid installment obligation are recognized by the estate or trust is not so straightforward.
  • In-Kind Distributions: If an unpaid installment obligation, i.e. the note, is used by the fiduciary to satisfy in-kind a specific pecuniary bequest, normally that distribution will not carry out with it the estate or trust’s DNI. However, if a distribution of the unpaid installment obligation, i.e. the note, is used by the fiduciary to satisfy a residuary bequest, the distribution of the note will carry out DNI to the beneficiary. [IRC 662.] An estate or trust usually does not recognize gain or loss on an in-kind distribution, unless the distribution is made in satisfaction either of an obligation to pay money or an obligation to distribute property other than the property that is distributed in-kind. An estate or trust will recognize gain (or loss) if appreciated assets are distributed in-kind to satisfy a pecuniary bequest, which can prove to be a trap if appreciated assets are used by a trustee to fund a pecuniary marital deduction formula gift or to fund a martial deduction trust. [Treas. Reg. 1.663(c)-5.]
  • IRD: Sales proceeds held by the decedent in the form of an installment note are a common example of income in respect of a decedent (IRD) that must be addressed on the decedent-seller’s death. When an individual receives a payment on an installment sale of an asset, the payment is normally reported by the seller as the receipt of three distinct elements: (i) interest, which is taxed as ordinary income; (ii) the portion of principal that represents capital gain; and (iii) the portion of principal that represents a return of basis, which is not taxable. [IRC Sections 453, 453A, and 453B.] When that installment obligation is acquired from the decedent-seller, the portion of each payment that represents capital gain is treated as IRD. [IRC 691(a)(4); Treas. Reg. 1.691(a)-5.] There is no ‘step-up’ in any income tax basis on this IRD, just like there is no ‘step-up’ in basis on other forms of IRD (e.g. IRA proceeds that are paid to the decedent’s trust) on the death of the decedent. [IRC 1014(c).] In short, the payments received by the estate, or the beneficiary, on an installment obligation will continue to be reported by the estate or the beneficiary and taxed in the same manner that the payments were being reported by the decedent-seller- the built-in gains in the installment obligation do not disappear on the seller’s death. [Treas. Reg. 1.691(a)-5.]
  • Reported Gain: The gain reflected in the installment obligation is not accelerated on the death of the decedent-seller, or on the transfer of that installment obligation to a beneficiary who is entitled to receive it under the decedent-seller’s Will or trust. The estate, or the beneficiary, will continue to report the gain over time as the payments are received under the installment obligation. However, if the decedent-seller’s estate or the beneficiary sells the installment obligation or transfers that obligation to a non-beneficiary, the seller must then recognize gain as IRD, using the fair market value of the installment obligation and the decedent’s basis in the asset that is sold, adjusted to reflect the portions of the basis that were previously received by the decedent-seller or by the decedent’s estate. [Private Letter Ruling 8806048.]
  • Obligor is Beneficiary: A different set of rules apply if the beneficiary of the decedent-seller’s estate also is the obligor under the installment obligation that is an estate asset. If the decedent-seller bequeaths the installment obligation to the person who is obligated to make the installment payments, the estate will then realize gain equal to the amount of gain that had not yet been reported by the decedent-seller prior to his/her death. [IRC 691(a)(5).] The gain is measured by the difference between fair market value of the installment obligation and the decedent-seller’s remaining basis in that installment obligation.
  • Discharge of Related Party’s Obligation: This same result occurs if the decedent-seller discharges the installment obligation on their death- the result is an implied bequest of the unpaid installment obligation to the person who gave the note. If the decedent-seller discharges the installment obligation at death in his/her Will or trust, and the decedent-seller and the obligor are related, then the value of the installment obligation discharged will not be less than its face value. In the case of such discharge-on-death, or specific bequest of the installment obligation to the related obligor of the installment obligation, the decedent-seller’s estate must recognize gain no later than the conclusion of the estate administration, unless some act of cancellation occurs prior to that time. [Private Letter Ruling 8806048.]
  • Residuary Bequest: A residuary bequest under the deceased-seller’s Will or trust that includes the installment obligation, however, does not automatically transfer the obligation to the obligor on the death of the decedent-seller. Instead, that transfer will take place in the tax year during which the installment obligation is actually transferred to the obligor. That is the case even if state law provides that the assets of the decedent’s estate vest immediately in the beneficiaries, subject only to the delays caused by the administration of the decedent’s estate. [Private Letter Ruling 880648.]
  • Cancellation: If the cancellation of the installment obligation takes place on the decedent-seller’s death the cancellation is treated as if the transfer had been made by the estate of the decedent-seller. Presumably that transfer will be deemed to have taken place in the first tax year of the decedent-seller’s estate. If the installment obligation is held by a ‘person’ other than the decedent-seller, such as the decedent-seller’s revocable trust which is treated as a separate ‘person’, the cancellation of the installment obligation will be treated as a transfer immediately after the decedent-seller’s death by that ‘person’, i.e. by the decedent’s trust.

Cancellation and an Insolvent Estate:  Beyond the somewhat bewildering IRD tax consequences of an installment note that is ‘discharged,’ ‘cancelled’, ‘forgiven’ or bequeathed on the decedent-seller’s death, what if the decedent-seller died with an insolvent estate and there remain unpaid creditors? A provision in the decedent-seller’s Will or trust to ‘forgive’ or ‘cancel’ the unpaid installment obligation may not be binding or be given full effect, as the installment obligation remains an asset of the estate as of the date of the decedent-seller that must first be used to pay creditors who possess valid and enforceable claims against decedent-seller’s estate. While an insolvent estate is usually pretty unlikely to be encountered, a cancellation of the beneficiary’s debt under a Will or trust may not be the best way to protect the beneficiary if there are outstanding creditors of the decedent-seller. Forgiving or discharging the installment obligation during the parent’s life, as a gift, might work, but then again the gift could be set-aside as a voidable transaction under the Uniform Voidable Transfer Act if that discharge rendered the parent insolvent.

Conclusion: I don’t know about you, but my head spins trying to decipher these IRD tax rules that turn on whether a specific or residuary bequest of the installment obligation is used in a Will or trust or the implications of a discharge of the debt.