In our estates practice we frequently find debts held in an estate that are owed by a family member of the decedent. Frequently these loans are forgiven or are distributed out to the debtor (usually a child of the decedent) pursuant to the terms of the Will. Even when such debts are not specifically mentioned by the will such debts are normally included in the child’s share of the estate and cancelled as part of that child’s distribution. For most debts, no tax problems ensue. Unlike most forgiveness of debt, a forgiveness of debt that is in the nature of a distribution under a Will generally is not taxable income to the debtor family member.
Debts owed to the estate that arise from a previous sale of property by the decedent present a very different picture, however. Assume that Father sells stock in a closely held company to Son. The stock shares transfer immediately, and Son agrees to pay off Father over a period of ten years, giving him a promissory note evidencing that – in other words, an installment sale. Unless Father elects out of installment sale treatment and agrees to be taxed on the whole gain in the year of the stock transfer (which would be uncommon), this deferred payment arrangement also qualifies as an installment sale in the eyes of the IRS. For tax purposes, that means that each year Father is taxed only on portions of the payment received that year. That would mean in this example that for each year father received payments, those payments are divvied-up as return of father’s basis in the stock (no tax) or as capital gain.
Death could get in the way of course. Assume that Father dies in year three of the payment schedule. The promissory note from Son is an asset of the estate. If the note is cancelled by the Estate, the cancellation generates no taxable income for the Son; however, the estate (which is now the installment seller/lender) has to recognize receipt of the balance of the note proceeds (subject to possible adjustment) less the decedent’s remaining basis in the property at the time of cancellation as a capital gain. Essentially, the taxable gain is accelerated into the year the debt is forgiven.
An installment sale can be a great approach to selling an asset. Because no third party lender is involved, it can be a way to get a transaction done with a particular buyer that otherwise might not get done. When it is done with a child it can be a way of selling the property while leaving the flexibility to later work out the pay-off of that payment as part of the seller’s estate plan. However, ultimately the Internal Revenue Service will find a way to tax the gain.
Apart from simply being ready for the above-outlined tax result, there may be steps that can be taken to mitigate the tax damage an installment sale can do. Additionally, for very large estates, there is also the potential that too sweet an installment sale to a child could be re-characterized as a part gift to the child which could impact gift and later estate tax matters. In either case, these transactions should not be handled casually. If you have any questions about the effects of debt in your future estate, please do not hesitate to call.
– Rod Fluck