Florida Estate Planning: Mortality Risk Discounts?
For transactions like an installment sale or a SCIN, the tax goal is to eliminate gift tax by making the present value of the future payments equal the present consideration for those payments. When the future payments are contingent upon the recipient surviving to receive the payments (as in a SCIN), the payments must usually be higher in order to compensate for the risk that the payments will not be made because of death. But different sections of the Internal Revenue Code have differing interest rate requirements, and the unusually low interest rates that now exist can turn a "mortality risk premium" into a "mortality rate discount."
BACKGROUND:
Many estate planning techniques have the goal of transferring valuable income-producing or appreciating assets from an older generation to a younger generation with the least estate tax, gift tax, or income tax cost. One example is an intra-family installment sale, such as a sale of appreciating real estate by an older (and wealthier) family member to a younger (and less wealthy) family member in exchange for a note with fixed future payments of principal and interest. The sale should produce net transfer of wealth from one generation to another, and a net transfer tax savings, if the assets being transferred can earn more income, or appreciate faster, than the interest being paid on the installment note.
A self-canceling installment note ("SCIN") can have similar benefits, but offer the additional benefit of allowing the unpaid balance of the note to effectively pass free of estate tax upon the death of the payee-seller because, under the terms of the note, the payments end upon the death of the payee-seller. A SCIN has an added cost, however, because the installment payments must be higher in order to compensate the payee-seller for the risk that death might occur before all the payments have been made.
Or at least, that's been the result in the past.
The NumberCruncher program can illustrate this "mortality risk premium" in a SCIN because the program allows the user to enter a "no-risk-premium market interest rate" and then calculates the "mortality risk premium" as the difference between that market rate of interest and the interest rate required to make the future payments equal the present value of the transaction.
But over the last year, NumberCruncher users have reported something very puzzling, which is that the "mortality risk premium" is often a negative number, which they assume is a flaw in the program. The negative result is not a flaw in the program, however, but is the product of the differing interest assumptions made in the Internal Revenue Code ("Code"), and the historically low (and peculiar) interest rates that have existed for the last year.
IRC VALUATION PRINCIPLES:
Generally speaking, the present value of a future payment is discounted by the income that could have been earned over that future period. So, for example, the payment of $100 after one year has to be compared with what would exist in one year if that $100 had been invested today. If the $100 could have earned $5 (i.e., 5%) in that year, then if I had that $100 today I could have $105 in one year.
To figure the present value of $100 in one year, I work backwards. If I could have $105 in one year if I had $100 today, then $100 is the present value of $105 to be received in one year. The present value of $100 to be received in one year is therefore $100/$105, or $95.24. And, sure enough, if I invest $95.24 at 5% for one year, I will have $100 at the end of the year.
When the future payment is contingent on a person being alive (or having died), then there must be a mortality component to the calculation, and it's basically a matter of probabilities. If a payment is to be made in one year, but only if a person is living, and if there is a 10% chance that the person will die in that one year period, then the payment is worth 10% less.
Code section 7520 says that the present value of life estates, remainders, and annuities must be determined using (a) an interest rate equal to 120% of the "applicable federal mid-term rate" defined by Code section 1274(d), and a mortality table based on the U.S. census (which is therefore updated every 10 years).
But Code section 7872 says that intra-family loans must be valued using the applicable federal rate ("AFR") that corresponds to the term of the loan, which could be the short-term rate (which is based on the average yield on federal securities with maturities of three years or less), the mid-term rate (which is based on maturities of more than three years but not more than nine years), or the long-term rate (which is based on maturities of more than nine years).
There is actually very little guidance on how to determine the future value of payments under a SCIN. NumberCruncher has taken the conservative position that, because SCIN payments are essentially equivalent to an annuity for the shorter of a term or life, the valuation rules of section 7520 should apply, which means that the future payments are discounted to present value using the section 7520 rate and (at present) Table 2000CM.
Other commentators have reached different conclusions. See, e.g., Jerome M. Hesch and Elliott Manning, "Coordinating Income Tax Planning with Estate Planning: Uses of Installment Sales, Private Annuities and Self-Canceling Installment Notes," 36th U. Miami Philip E. Heckerling Inst. on Est. Plan. Ch. 10, p. 10-35 (Matt. Bender 2002).
So a SCIN with a term of 10 years would be valued using an interest rate of 120% of the mid-term rate, while a note in an intra-family loan would be valued using 100% of the long-term rate. What has that meant in the past, and what does it mean now?
CURRENT (AND HISTORIC) INTEREST RATES:
Looking at interest rates in the past, specifically the AFRs that have been published since 1984, there have usually between relatively narrow gaps between the mid-term and long-term rates. For example, the mid-term and long-term rates were 8.31% and 8.32%, respectively, in August of 1989.
In August of 1994, the rates were 7.05% and 7.67%, so the long-term rate was 109% of the mid-term rate. That ratio was 105% in August of 1999, and got as high as 130% in August of 2004, but usually the long-term rate was less than 120% of the mid-term rate.
More recently, the mid-term rates have gotten much lower and the gap with long-term rates much larger. Beginning late last year, and up to the present, the long-term rate has been between 150% and 170% of the mid-term rate.
So in the past, 120% of the mid-term rate (used by section 7520) has been more than (or at least close to) the long-term rate, but now the long-term AFR is more than the 7520 rate, and often significantly more.
Let's look at how that affects a SCIN calculation in NumberCruncher. If a 55-year-old wanted to enter into a 10-year amortized SCIN in August 2009, then the 7520 discount rate would be 3.4$ and the note would have to bear an interest rate of 4.2205% percent in order for the present value of the payments to equal the face amount of the note.
In its SCIN calculations, NumberCruncher works backwards, starting with the present value of the transaction, calculating the present value of the payments that would be required to equal that present value, and then calculating the interest rate for the note that will produce those payments. Because the note is amortized, the principal amount of the note is irrelevant to the calculation.
If we assume that the "no-risk-premium market interest rate" is the same as the discount rate used by section 7520 then the difference between the 3.4% discount rate and the interest rate calculated for the note would be 0.8205%, which would represent the increase (or premium) in the interest rate necessary to overcome the mortality risk.
But the long-term AFR for August is 4.26%, which means that the required interest rate for the note with mortality risk is 0.0395% LESS than the required interest rate that would be required for a note with no mortality risk. The "mortality premium" has become a "mortality discount." Change the age to 50, so that the chance of death within the term is less, and the interest rate on the note goes down to 3.9242%, meaning that the "discount" increases to 0.3358%.
The mortality risk is still there, of course, which you can see in NumberCruncher by entering a market interest rate equal to the 7520 discount rate. But what would otherwise be a mortality risk premium is being exceeded by the difference between the section 7520 rate (120% of the mid-term rate) and the higher long-term rate that would apply under section 7872 to a simply promissory note.
Whether or not there will be a mortality "premium" or "discount" will therefore depend on both the difference between the two interest rates and the actual mortality risk, which will depend on the age (or ages) of the payees (there is less mortality risk for a younger ages than older ages, and much less risk when the SCIN is a joint-and-survivor note with two measuring ages) and the term of the note (the longer the term, the more the payments are spread out over time and the greater the risk that death will occur before the payments are made).
COMMENT:
Because different Code sections can be used to value SCINs with payments contingent on survival and "regular" notes with non-contingent payments, different interest rates are required by those sections, and the current financial markets have produced an unusual pattern of interest rates, it is possible for a note that is contingent on survival to pay a lower interest rate than a note with non-contingent payments and yet have the same present value for gift tax purposes.
Practitioners considering the use of installment sales or other intra-family loans and wishing to minimize the loan payments should therefore check both their calculations and their assumptions because introducing a mortality factor might produce a lower allowable interest rate and lower payments.
In other words, there can be a mortality discount instead of a mortality premium.
BACKGROUND:
Many estate planning techniques have the goal of transferring valuable income-producing or appreciating assets from an older generation to a younger generation with the least estate tax, gift tax, or income tax cost. One example is an intra-family installment sale, such as a sale of appreciating real estate by an older (and wealthier) family member to a younger (and less wealthy) family member in exchange for a note with fixed future payments of principal and interest. The sale should produce net transfer of wealth from one generation to another, and a net transfer tax savings, if the assets being transferred can earn more income, or appreciate faster, than the interest being paid on the installment note.
A self-canceling installment note ("SCIN") can have similar benefits, but offer the additional benefit of allowing the unpaid balance of the note to effectively pass free of estate tax upon the death of the payee-seller because, under the terms of the note, the payments end upon the death of the payee-seller. A SCIN has an added cost, however, because the installment payments must be higher in order to compensate the payee-seller for the risk that death might occur before all the payments have been made.
Or at least, that's been the result in the past.
The NumberCruncher program can illustrate this "mortality risk premium" in a SCIN because the program allows the user to enter a "no-risk-premium market interest rate" and then calculates the "mortality risk premium" as the difference between that market rate of interest and the interest rate required to make the future payments equal the present value of the transaction.
But over the last year, NumberCruncher users have reported something very puzzling, which is that the "mortality risk premium" is often a negative number, which they assume is a flaw in the program. The negative result is not a flaw in the program, however, but is the product of the differing interest assumptions made in the Internal Revenue Code ("Code"), and the historically low (and peculiar) interest rates that have existed for the last year.
IRC VALUATION PRINCIPLES:
Generally speaking, the present value of a future payment is discounted by the income that could have been earned over that future period. So, for example, the payment of $100 after one year has to be compared with what would exist in one year if that $100 had been invested today. If the $100 could have earned $5 (i.e., 5%) in that year, then if I had that $100 today I could have $105 in one year.
To figure the present value of $100 in one year, I work backwards. If I could have $105 in one year if I had $100 today, then $100 is the present value of $105 to be received in one year. The present value of $100 to be received in one year is therefore $100/$105, or $95.24. And, sure enough, if I invest $95.24 at 5% for one year, I will have $100 at the end of the year.
When the future payment is contingent on a person being alive (or having died), then there must be a mortality component to the calculation, and it's basically a matter of probabilities. If a payment is to be made in one year, but only if a person is living, and if there is a 10% chance that the person will die in that one year period, then the payment is worth 10% less.
Code section 7520 says that the present value of life estates, remainders, and annuities must be determined using (a) an interest rate equal to 120% of the "applicable federal mid-term rate" defined by Code section 1274(d), and a mortality table based on the U.S. census (which is therefore updated every 10 years).
But Code section 7872 says that intra-family loans must be valued using the applicable federal rate ("AFR") that corresponds to the term of the loan, which could be the short-term rate (which is based on the average yield on federal securities with maturities of three years or less), the mid-term rate (which is based on maturities of more than three years but not more than nine years), or the long-term rate (which is based on maturities of more than nine years).
There is actually very little guidance on how to determine the future value of payments under a SCIN. NumberCruncher has taken the conservative position that, because SCIN payments are essentially equivalent to an annuity for the shorter of a term or life, the valuation rules of section 7520 should apply, which means that the future payments are discounted to present value using the section 7520 rate and (at present) Table 2000CM.
Other commentators have reached different conclusions. See, e.g., Jerome M. Hesch and Elliott Manning, "Coordinating Income Tax Planning with Estate Planning: Uses of Installment Sales, Private Annuities and Self-Canceling Installment Notes," 36th U. Miami Philip E. Heckerling Inst. on Est. Plan. Ch. 10, p. 10-35 (Matt. Bender 2002).
So a SCIN with a term of 10 years would be valued using an interest rate of 120% of the mid-term rate, while a note in an intra-family loan would be valued using 100% of the long-term rate. What has that meant in the past, and what does it mean now?
CURRENT (AND HISTORIC) INTEREST RATES:
Looking at interest rates in the past, specifically the AFRs that have been published since 1984, there have usually between relatively narrow gaps between the mid-term and long-term rates. For example, the mid-term and long-term rates were 8.31% and 8.32%, respectively, in August of 1989.
In August of 1994, the rates were 7.05% and 7.67%, so the long-term rate was 109% of the mid-term rate. That ratio was 105% in August of 1999, and got as high as 130% in August of 2004, but usually the long-term rate was less than 120% of the mid-term rate.
More recently, the mid-term rates have gotten much lower and the gap with long-term rates much larger. Beginning late last year, and up to the present, the long-term rate has been between 150% and 170% of the mid-term rate.
So in the past, 120% of the mid-term rate (used by section 7520) has been more than (or at least close to) the long-term rate, but now the long-term AFR is more than the 7520 rate, and often significantly more.
Let's look at how that affects a SCIN calculation in NumberCruncher. If a 55-year-old wanted to enter into a 10-year amortized SCIN in August 2009, then the 7520 discount rate would be 3.4$ and the note would have to bear an interest rate of 4.2205% percent in order for the present value of the payments to equal the face amount of the note.
In its SCIN calculations, NumberCruncher works backwards, starting with the present value of the transaction, calculating the present value of the payments that would be required to equal that present value, and then calculating the interest rate for the note that will produce those payments. Because the note is amortized, the principal amount of the note is irrelevant to the calculation.
If we assume that the "no-risk-premium market interest rate" is the same as the discount rate used by section 7520 then the difference between the 3.4% discount rate and the interest rate calculated for the note would be 0.8205%, which would represent the increase (or premium) in the interest rate necessary to overcome the mortality risk.
But the long-term AFR for August is 4.26%, which means that the required interest rate for the note with mortality risk is 0.0395% LESS than the required interest rate that would be required for a note with no mortality risk. The "mortality premium" has become a "mortality discount." Change the age to 50, so that the chance of death within the term is less, and the interest rate on the note goes down to 3.9242%, meaning that the "discount" increases to 0.3358%.
The mortality risk is still there, of course, which you can see in NumberCruncher by entering a market interest rate equal to the 7520 discount rate. But what would otherwise be a mortality risk premium is being exceeded by the difference between the section 7520 rate (120% of the mid-term rate) and the higher long-term rate that would apply under section 7872 to a simply promissory note.
Whether or not there will be a mortality "premium" or "discount" will therefore depend on both the difference between the two interest rates and the actual mortality risk, which will depend on the age (or ages) of the payees (there is less mortality risk for a younger ages than older ages, and much less risk when the SCIN is a joint-and-survivor note with two measuring ages) and the term of the note (the longer the term, the more the payments are spread out over time and the greater the risk that death will occur before the payments are made).
COMMENT:
Because different Code sections can be used to value SCINs with payments contingent on survival and "regular" notes with non-contingent payments, different interest rates are required by those sections, and the current financial markets have produced an unusual pattern of interest rates, it is possible for a note that is contingent on survival to pay a lower interest rate than a note with non-contingent payments and yet have the same present value for gift tax purposes.
Practitioners considering the use of installment sales or other intra-family loans and wishing to minimize the loan payments should therefore check both their calculations and their assumptions because introducing a mortality factor might produce a lower allowable interest rate and lower payments.
In other words, there can be a mortality discount instead of a mortality premium.
posted by Noah Davis at
1:23 PM
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