What is it?

A SCIN allows you to sell property to your heirs in exchange for an interest-bearing promissory note that obligates them to pay you in installments over a specified term. When the note expires and has been paid in full, your heirs will own the property. Assuming the property has appreciated in value, it will be worth more than your heirs paid for it. Further, the property will have been removed from your estate.

A special feature of a SCIN is that the note automatically cancels if you should die during the term of the note (hence the term "self-canceling"). In that case, your heirs stop making further payments, and will own the property free and clear. This strategy works best with property that is rapidly appreciating, and when the seller is not expected to reach his or her life expectancy.

The tax rules

To ensure the validity of a SCIN, it must strictly conform to these IRS rules:

• The selling price must be at least the fair market value of the property at the time of the sale, based on an independent appraisal from a qualified appraiser.
• The term of the note must be less than your (the seller's) life expectancy at the time of the sale.
• You must use an interest rate no lower than that set by the IRS (the applicable federal rate, or AFR).
• You must include a risk premium (to offset the possibility that you may not receive all the payments). This premium can be met by increasing either the selling price or the interest rate.

The benefits to you (the seller)

The benefits of a SCIN may not be easy to see at first. In fact, you might think you'd be worse off for selling property for cash plus a premium, which could actually increase your estate (this may occur if the seller outlives the installment period).

But, in reality, the payments are made over the note's term, which may end before the SCIN is paid back. And, you'll likely dispose of this money (by spending it or making gifts, for instance), so it won't be in your estate at your death.

You will pay taxes, but only as each payment is received. Payments of principal will be part tax-free return of basis and part capital gain. Payments of interest are taxable as ordinary income. Note, however, that if you die before the note ends, your estate must recognize any remaining capital gain, even though no more payments will be received.

The effect of a SCIN is to tax the transfer of property at the lower capital gains and ordinary income tax rates instead of at the higher estate tax rates. It also "freezes" the value of the property on the date of sale, so any future appreciation in the property that is in excess of the interest and risk premium is transferred estate tax free.

Additionally, the income taxes you pay further reduce your estate.

The tax consequences to your heirs

Your heirs will receive a basis in the property equal to the amount they pay for it: its fair market value on the date of sale plus any selling price risk premium.

Also, the payments of interest may be tax deductible in the year they're paid, subject to certain limitations.

Selling price risk premium vs. interest rate risk premium

As previously stated, a SCIN must include a risk premium.

If you choose to increase the selling price, you will recognize a larger amount of capital gains, and your heirs will have a higher basis in the property.

If you choose to increase the interest rate, you will have a greater amount of ordinary income, and your heirs will have a larger deduction.

You should analyze the actual after-tax consequences and resulting cash flows of each alternative to decide which is best for you.

Although the new valuation rules are currently focused on charitable contributions (including conservation easements), it is widely believed that Congress and the IRS will expand the new rules to all tax valuations in general. Cautious taxpayers may want to apply the new rules to any tax-related transactions involving appraisals, such as valuations required for noncharitable gifts or a buy-sell agreement.

New rules

The new rules generally require that you obtain a "qualified appraisal" from a "qualified appraiser" for donations of property worth over $5,000 (other than cash and publicly traded securities), and you must attach an appraisal summary (IRS Form 8283) to your tax return. These rules apply to valuations for income, gift, and estate tax purposes.

What is a qualified appraisal?

Generally, a qualified appraisal is:

• Made no earlier than 60 days before the donation is made, and no later than the due date of your tax return (including extensions), and
• Signed and dated by a "qualified appraiser"

Who is a qualified appraiser?

Generally, a qualified appraiser is an individual who:

• Has earned an appraisal designation from a recognized professional appraiser organization, or has otherwise met "minimum education and experience requirements" for valuing the type of property subject to the appraisal, and
• Regularly performs appraisals for pay

"Minimum education and experience requirements" include:

• Successfully completing college or professional level coursework that is relevant to the property being valued, and
• Obtaining at least two years of experience in the trade or business of buying, selling, or valuing the type of property being valued

Again, in plain English

More simply stated, to get a qualified appraisal, you must retain an appraiser who holds a professional designation, such as ISA (International Society of Appraisers), ASA (American Society of Appraisers), or AAA (Appraisers Association of America), or someone who has received the requisite schooling and experience.

While these stricter standards are meant to improve the appraisal industry, they have actually shrunk the world of qualified appraisers, for the time being at least. For example, a knowledgeable and skilled expert with years of experience at Sotheby's, but no professional designation or time in the classroom, may no longer be qualified to make appraisals under the new rules.

Further, because the meaning of the new rules needs some clarification, some appraisers may be unsure about whether they're qualified, and they may be unwilling to risk incurring potential penalties. Needless to say, finding a qualified appraiser has become a more daunting task.

Practical guidance

Your best bet is to hire an appraiser who holds a professional designation related to the property being appraised. Contact the societies listed above for referrals. However, while it may be easy to find such an appraiser for certain types of property, like real estate, it may not be so easy for other types of property.

Here are some other tips:

• Talk to your financial or tax professional for more information
• Obtain documentation about the appraiser's education and experience, and how often he or she conducts appraisals for a fee
• Most importantly, make sure the appraiser is aware of the new appraisal rules, including what is required and the potential penalties

Furthermore, most states impose their own transfer taxes. Together, these taxes can take an enormous bite whenever substantial wealth is being handed down, and over time they can erode a family's fortune. This can be troublesome to individuals who would prefer to have their legacies benefit their own family members. It's from these circumstances that the dynasty trust evolved.

How does a dynasty trust work?

The law allows generation-skipping transfers to go untaxed up to a certain amount by providing a lifetime exemption (currently $2 million per taxpayer, or $4 million per married couple). Typically, a dynasty trust is funded with amounts that take full advantage of the GSTT exemption. The trust then provides for future generations for as long as it exists. Although the trust assets effectively move from generation to generation, there are no corresponding transfer tax consequences.

To enjoy this tax benefit, access to trust property by the beneficiaries must be limited. You can decide how narrow or broad a beneficiary's access will be within those limits. For example, if you wish to give a beneficiary as much control as possible, you can name the beneficiary as trustee, and give the beneficiary the right to all income and the right to consume principal limited by "ascertainable standards" (i.e., health, education, maintenance and support). The beneficiary can be given even more control by granting a special (or limited) testamentary power of appointment (i.e., the power to name successive beneficiaries).

On the other hand, if you want to restrict access to the trust as much as possible, you can name an independent trustee who has sole discretion over distributions coupled with a spendthrift provision. The trustee will have full authority to distribute or not distribute income or principal to the beneficiary as the trustee deems appropriate. The spendthrift provision will prevent the beneficiary from voluntarily or involuntarily transferring his or her interest to another before actually receiving a distribution. The greater the restrictions, the less likely creditors or other claimants will be able to reach trust property.

How long can a dynasty trust last?

A dynasty trust can last as long as state law allows. In states that still have a "rule against perpetuities," the life of a trust is limited to 21 years after the death of the last beneficiary to die (which conceivably could be 100 or more years). Trusts in the states that have abolished their rules against perpetuities can, in theory, last forever.

The bottom line

A dynasty trust can meet the objectives of high-net-worth individuals concerned about intergenerational planning.

A dynasty trust is not a do-it-yourself project, however. See an experienced estate planning attorney for more information.

Outright cash gifts

A common way to help with college costs is to make an outright gift of cash or securities. But this method has drawbacks. If you gift the money directly to your grandchild, he or she might spend it on something other than college. Second, a gift of more than the annual federal gift tax exclusion amount ($12,000 for individual gifts, $24,000 for joint gifts) might have gift tax and generation-skipping transfer tax (GSTT) consequences (GSTT is the tax imposed on gifts made to someone who is more than one generation below you).

Another drawback to outright gifts is that the gifts become assets of the student, and the federal government treats student assets more harshly than parent assets for financial aid purposes. Students must contribute 20% of their assets each year toward college costs, compared to 5.6% for parent assets.

529 plans

A 529 plan can be an excellent way for grandparents to contribute to a grandchild's college education while simultaneously paring down their own estate. There are two types of 529 plans: college savings plans, which are individual investment-type accounts whose funds can be used at any accredited college in the United States or abroad, and prepaid tuition plans, which allow prepayment of tuition at today's prices for the limited group of colleges (typically in-state public colleges) that participate in the plan. Grandparents can open a 529 account and name their grandchild as beneficiary (only one person can be listed as account owner, though), or they can contribute to an already established 529 account.

A big advantage of 529 plans is that under special rules, grandparents can make a joint lump-sum gift of up to $120,000 ($60,000 for individual gifts) to a 529 account and completely avoid federal gift tax, provided a special election is made to treat the gift as if it were made in equal installments over a five-year period and grandparents don't make any additional gifts to their grandchild during this time.

Significantly, this money is considered removed from the grandparents' estate, even though one grandparent can still retain control over the funds if he or she is the 529 account owner. But there are two things to keep in mind here: (1) if a grandparent contributes money, makes the special election, and then dies during the five-year period, a portion of the gift is recaptured into the estate for estate tax purposes; and (2) funds in a grandparent-owned 529 plan can still be factored in when determining Medicaid eligibility, unless these funds are specifically exempted by state law.

Of course, grandparents can contribute smaller, regular amounts to their grandchild's 529 account instead. Contributions grow tax deferred, and withdrawals used for college expenses are completely tax free at the federal level (and often at the state level).

Another interesting feature of 529 plans is that under current law, grandparent-owned 529 accounts are excluded by the federal government's financial aid formula--only parent-owned 529 plans count. So a grandparent-owned 529 plan won't impact a grandchild's chances of qualifying for aid (however, there's no guarantee this will be the rule in the future because Congress periodically tinkers with the financial aid rules).

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about specific 529 plans is available in each issuer's official statement, which should be read carefully before investing.

Pay the college directly

Another excellent way for grandparents to help their grandchildren with college costs is to pay the college directly. Under federal law, tuition payments made directly to a college aren't considered taxable gifts, no matter how large the payment. But this is true only for tuition--room and board, books, fees, and the like don't qualify for this benefit. Aside from the obvious tax advantage, paying tuition directly to the college ensures that your money will be used for education. Plus, it removes the money from your estate.

For more information on any of these options, talk to a qualified financial professional.

Should you take the cash?

Obviously, if you need the funds immediately, taking a lump-sum distribution from the 401(k) plan may be your only viable alternative. But you'll have to pay ordinary income tax on the distribution (except for the amount of any after-tax contributions and qualified Roth distributions). Special tax rules may apply if the plan participant was born before January 2, 1936--consult a tax professional for details.

A lump sum might also be attractive if you're entitled to a distribution of employer stock. You may be able to pay ordinary income tax on just the participant's basis in the stock, and defer tax on the appreciation (called "net unrealized appreciation," or NUA) until you sell the stock in the future--at capital gain rates.

What's a disclaimer?

When you disclaim (i.e., refuse to accept) 401(k) assets, they pass instead to the plan participant's contingent beneficiary, or estate if there is no contingent beneficiary. In general, you must give the plan written notice of your intent to disclaim the funds within nine months after the participant's death. But be careful not to exercise control over the funds in the meantime (for example, by choosing a distribution option or by exercising investment control), or you may lose your ability to disclaim the funds.

A disclaimer may be an attractive option if you're sure you won't need the funds, and the transfer to the contingent beneficiary makes good economic and estate planning sense.

The problem with 401(k) plans

If you're like most beneficiaries, your goal will be to stretch payments out as long as possible, taking full advantage of the tax deferral offered by retirement plans. This means either leaving the assets in the 401(k) plan, or rolling them over to an IRA.

For most, leaving the funds in the 401(k) plan isn't the best choice for two reasons. First, the investment alternatives available to you in a 401(k) plan are limited to the ones selected by the employer. Second, the distribution options offered by a 401(k) plan typically aren't as flexible as those available in an IRA. In fact, many 401(k) plans require beneficiaries to take distributions shortly after the participant's death.

Roll the funds over to an IRA

Unless the 401(k) plan offers a unique investment alternative, rolling the 401(k) assets over to an IRA will usually be your best choice. IRAs offer virtually limitless investment options. And when it comes time to take distributions from the plan, IRAs offer the most flexible payment provisions. But, before deciding on a rollover, make sure you understand any fees and expenses that may apply.

Unlike annuity payments, a lump-sum distribution from a cash balance plan can be rolled over to an IRA or to another employer's plan that accepts rollovers. This might be an attractive alternative if you don't immediately need the income when you retire.

If you're a surviving spouse, you'll have to decide between rolling the funds over to your own IRA, or to an IRA that you establish in the participant's name, with you specified as the beneficiary (this is referred to as an "inherited IRA"). Which should you choose?

In most cases, you'll be better off rolling the funds over to your own IRA. Rolling the funds over to an inherited IRA is typically appropriate only if you're not yet age 59½ and you think you'll need the funds before you reach that age. That's because distributions from an inherited IRA aren't subject to the 10% early distribution penalty tax. (In contrast, distributions from your own IRA before age 59½ are subject to the 10% penalty tax unless an exception applies.)

If you're not the surviving spouse, you don't have the option of rolling the 401(k) assets over to your own IRA. But thanks to the Pension Protection Act of 2006, you may be able to make a direct rollover of the 401(k) funds to an inherited IRA. A 401(k) plan isn't required to offer this option, so check with your plan administrator. This new rule applies to distributions you receive after 2006.

The rules governing inherited 401(k) plan accounts are complex. A financial professional can help you sort through the alternatives, and make the decision most appropriate for your individual circumstances.